Banks' additional Tier 1 (AT1) instruments have remained under regulatory scrutiny since March 2023, when the failure of Credit Suisse sparked turmoil in the sector. Approximately Swiss franc (CHF) 16 billion of the AT1 instruments issued by Credit Suisse were written down to zero as part of UBS' subsequent government-facilitated takeover of Credit Suisse. This heavy loss for the AT1 investors highlighted the risks associated with these instruments when banks fail.

At the same time, the write-downs clearly demonstrated AT1 instruments' function in recapitalizing or resolving a bank that is no longer viable--both through the contractual terms and the powers that governments have in a stress scenario. The AT1 instruments therefore played the recapitalization role that regulators intended for cases where a bank is no longer viable.

However, the 2023 turmoil raised questions about the broader role of AT1 instruments. S&P Global Ratings expects to see further regulatory discussion of whether AT1 instruments are playing a clear enough part in preventing or delaying a bank from getting to the point where it is no longer viable. These discussions may lead to greater clarity on AT1 instruments' going-concern loss-absorbing function.

Our criteria for assigning ratings to AT1 hybrid instruments already incorporates the potential for regulatory intervention and for payments to be stopped on a going-concern basis, whether due to contractual features or relevant regulatory frameworks or laws. We typically rate AT1 instruments at least four notches below the stand-alone credit profile on the issuing bank. We can rate instruments lower under our criteria if any regulatory changes materially affect our view of the risk of a coupon suspension or a write-down or conversion of a specific AT1 instrument or instruments in a particular jurisdiction. However, the regulators haven't decided on any specific changes at this point.

Regulatory Questions But No Kneejerk Responses

The most striking recent suggestion was the reference to a potential abolition of AT1 instruments in the Dutch Finance Ministry's report on policy directions for improving banking sector resilience, published in March 2024, around the anniversary of the Credit Suisse events. This report covered a wide range of potential policy directions. It advocated a reform of AT1 capital to reduce complexity and strengthen loss-absorbing triggers as part of its focus on what it described as the basic direction of policy responses.

A reference in the "better buffers" section of the report to the potential abolition of various capital instruments--including AT1 instruments--drew significant market attention, but this was one of a long list of options. That section also mentioned the opacity of some existing AT1 structures. The report advocated additional research into the complexity and effectiveness of AT1 instruments, referring to previous Basel comments.

The Basel Committee on Banking Supervision highlighted the issue of AT1 complexity in its October 2023 publication, "Report on the 2023 banking turmoil," stating that there "may be merit in further assessing the complexity, transparency and understanding of AT1 instruments in a holistic manner." The Financial Stability Institute of the Bank for International Settlements' September 2023 research paper, "Upside down: when AT1 instruments absorb losses before equity", also suggested increasing the transparency and disclosure of AT1 instruments' characteristics. We expect to see regulators heighten their focus on disclosure and transparency because of the Basel comments.

We've also seen other jurisdictions announce potential reviews of AT1 structures that appear to focus on clarifying these instruments' ability to bear losses before a bank approaches nonviability. For example, the Swiss Federal Council's April 2024 report into strengthening the country's "too big to fail" framework discusses how it is exploring options that could strengthen these hybrid capital instruments' ability to absorb losses at an early stage.

One possible development is the introduction of clearer rules governing the suspension of interest payments and restrictions on buybacks, should a bank report sustained losses. Alternatively, Swiss AT1 instruments typically set the trigger for equity conversion or write down at a common equity Tier 1 (CET1) ratio of 7%; this could be increased to at least 10%.

The Australian Prudential Regulation Authority (APRA) released a discussion paper in October 2023 that discusses similar themes, such as raising the write-down or conversion trigger from the 5.125% CET1 level currently typical in Australia, or introducing limitations on when AT1 coupons can be paid. The APRA report also discusses topics such as the complexities of having a predominantly retail AT1 investor base.

Questions about the going-concern effectiveness of AT1 predate the events of 2023. For example, the European Systemic Risk Board discussed in its "Report of the Analytical Task Force on the overlap between capital buffers and minimum requirements" from 2021 how "banks seem to be reluctant to cancel AT1 coupon payments." It cited the continued payment of coupons during the COVID-19 pandemic, when all EU banks had to cancel ordinary dividends. The authors also referred to how conversion and write-down triggers are often set at levels when a bank would breach required capital buffers, and concluded that AT1 capital could not serve a buffer role.

How Early Is Early Enough?

A key question is whether a bank can, in practice, use its AT1 instruments early enough in a stress scenario to help prevent or delay the point where it is no longer a going concern. AT1 instruments have this capacity in theory due to their unlimited capacity to stop paying coupons and lack of contractual refinancing dates. However, banks may be reluctant to use these features preemptively if they are concerned that this could weaken market confidence in them.

Although Credit Suisse's AT1 instruments were written down fully, and therefore contributed to the bank's recapitalization once it was no longer viable, the instruments never stopped paying coupons. They continued to be redeemed and refinanced even when that led to higher servicing costs.

Banks are highly confidence-sensitive, so the financial benefit of not paying a coupon or not refinancing at a higher servicing cost could be quickly outweighed if that action leads to an outflow of funding.

This risk also applies to ordinary share dividends. We have seen banks continue to pay dividends until a late point in their decline, and be slow to cut their absolute levels. Credit Suisse never stopped paying ordinary dividends in the lead-up to March 2023, even announcing a 2022 ordinary dividend on March 14, 2023 that it was subsequently not allowed to pay. It continued to pay dividends--albeit at lower levels--even when it had to do so from its distributable reserves due to its losses. In this way, even the common equity did not delay the collapse of the bank as much as it could have done in theory.

Reducing Issuer Discretion About When To Stop Coupons

One route that regulators have used for ordinary dividends and that they may consider extending to AT1 instruments is to reduce issuer discretion by introducing rules about when AT1 coupons must be stopped. For example, in Europe during the COVID-19 pandemic, bank regulators announced a blanket suspension on ordinary dividends, but did not prevent banks from paying AT1 coupons.

We expect that ordinary dividends should typically be stopped or cut before AT1 coupons are. We are not surprised that AT1 coupons were excluded from the regulatory bans on dividend payments during the COVID-19 pandemic, given the length and scale of this event. However, banks could have been prevented from paying AT1 coupons if the stress magnified.

Regulators may consider introducing additional rules for when AT1 coupons must be cut, such as the inability to use certain reserves to pay AT1 coupons, or the prevention of AT1 coupon payments if a particular financial or earnings trigger is breached.

We expect to see this form part of regulatory discussions about how to clarify when AT1 coupons can be stopped before the point of nonviability. Regulators may consider whether new rules could be more direct in their effect on AT1 coupons than the current broad restrictions on capital distributions that kick in if a bank breaches various capital buffers.

More detailed rules about when AT1 coupons must be stopped won't by themselves fully prevent the potential effect on market confidence. It could still take time for market participants to begin to see coupon nonpayment as truly precautionary or preemptive. This would likely require a transition to a new status quo where temporary suspensions are seen as normal in more minor stress scenarios. Banks are already wary of using the flexibility that the buffer approach gives (see "Bank Regulatory Buffers Face Their First Usability Test" published on June 11, 2020).

Rules can have counterintuitive effects, however. Investors could interpret them as guidance about the only situations when AT1 coupons would be stopped, even if coupons continue to be entirely discretionary. A bank could therefore be discouraged from stopping coupons on a discretionary basis, and could wait until the rule kicks in. We've seen this in the past for some bank hybrid instruments that combined "may stop" and "must stop" coupon features. Rules based on capital ratios or even earnings metrics only address bank stresses that show up in these ways, and show up quickly enough. These metrics are lagging metrics and don't address the other ways in which a bank's viability can come under threat, such as via liquidity outflows or other funding pressures.

The level of an AT1 coupon isn't directly linked to the level of common dividends in the current regulations. For example, an AT1 coupon doesn't automatically get cut by 10% if the ordinary dividend is cut by 10%. Initiatives to align cuts in AT1 coupons with those in common dividends could more closely align the downside risks of these different asset classes, but pose questions about the appropriate alignment of upside risks and the demarcation between the two classes.

Finally, the cost saving from coupon nonpayment typically isn't enough to reverse a bank's financial position by itself, and therefore would have to be part of a broader set of management actions. This could include contemplating the way in which AT1 instruments can absorb losses more significantly via a write-down or conversion.

Balancing Early Write-Downs Or Conversions With The Treatment Of Common Shareholders

The Basel capital standards require an AT1 instrument to be either written down or converted into common equity. If there's a quantitative trigger, the latest this could occur is when the CET1 ratio falls below 5.125%, a point that the standards cite as still being a going-concern point for a bank, but when we believe a bank would typically no longer be viable. As we discuss above, we see several regulators contemplating whether to require higher trigger levels. Instruments may also have qualitative triggers. Some countries such as the U.S. use different AT1 frameworks that focus on preferred shares without write-down or conversion features.

Higher CET1 trigger levels would ensure that the write-down or conversion takes place at an earlier point in the capital ratio decline, when the bank could still be a going concern. They'd still only kick in when the stress is visible in the capital ratio though. Some of Credit Suisse's AT1 instruments had triggers of 7%, but they were written down at the same time as the 5.125% instruments because the bank became nonviable while the CET1 capital ratios were still above the trigger levels. Focus on the CET1 trigger alone can distract from the extent of these instruments' ability to bear losses in other circumstances.

A challenge with higher triggers is that they can lead to the AT1 investors faring worse than common shareholders if the instrument has a write-down feature. This is because the AT1 instruments are written down--whether fully or not--without the AT1 investors having the same potential as the common shareholders to benefit if the bank subsequently recovers. This puts the spotlight on the relative position of AT1 investors versus common shareholders and on the perceived equity of treatment.

If it's a conversion feature, then the AT1 investors may be entirely aligned with the shareholders. We don't expect all AT1 instruments to become convertible instruments because investors may have restrictions on holding convertible instruments, or may favor one type of instrument over another based on jurisdictional considerations. We note that UBS has used a conversion feature instead of a write-down in its AT1 issues since it took over Credit Suisse.

The Relative Position Of AT1 Instruments Versus Common Equity Has Inbuilt Tensions

AT1 instruments have been designed to provide a layer of protection that supplements that provided by common equity, as is evident from the AT1 instruments' exclusion from CET1. However, there are inherent tensions in their position versus that of common shareholders.

One of the most controversial aspects of the Credit Suisse write-downs was that AT1 instruments were fully written down while shareholders retained some value and had potential for further upside. The EU regulatory authorities were quick to remind investors that they expect common equity instruments to be the first to absorb losses under the EU resolution framework; only after these have been depleted would EU law require AT1 instruments to be written down. The Bank of England also confirmed that AT1 instruments rank ahead of CET1 and behind Tier 2 in the hierarchy, and that holders of such instruments should expect losses in resolution or insolvency based on their positions in this hierarchy.

The hierarchy begins to look less clear if AT1 instruments do indeed absorb losses on a going-concern basis. This is because the resolution or insolvency ranking isn't relevant in these cases, whereas the impact of coupon nonpayment, write-down, or conversion is.

AT1 coupons are noncumulative, so investors never get the missed coupon back even if the bank subsequently returns to strength, whereas we've seen from the COVID-19 pandemic that a bank can compensate common shareholders for missed dividends if it does return to strength. This may contribute to banks' reluctance to stop AT1 coupons preemptively.

We've seen several investors and banks propose that cumulative coupons could address this problem, and potentially reduce risks for investors and thus coupon costs for banks. We typically see instruments with noncumulative coupons as more equity-like than those with cumulative coupons because they don't lead to a buildup of deferred coupons for the issuer to have to repay. Hybrid instruments with cumulative coupons are eligible for equity content treatment in our financial metrics under our criteria, if the relevant prudential regulator allows this, because typically, the issuer has sufficient time to recover before the deferred coupons are due to be paid. We state in our criteria that a cumulative coupon must be deferrable for at least five years for the hybrid to be eligible for equity content.

AT1 investors may also fare worse than common shareholders if a write-down occurs while the bank is a going concern because shareholders may still be receiving dividends and will continue to benefit from any potential upside. AT1 instruments with partial or temporary write-downs may alleviate this pressure, but at the cost of adding complexity to instrument structures.

AT1 instruments that convert into common equity align the fates of AT1 investors and shareholders more closely, depending on the terms of the conversion.

In light of the regulatory references to transparency and clarity, we expect that any moves to increase the going-concern loss-absorption capacity of AT1 instruments would also involve more disclosure and discussion about how AT1 investors and shareholders would fare in different scenarios, such as in a liquidation, resolution, or if there is a breach of a trigger.

AT1 Call Option Approvals

Another feature of the Credit Suisse case was that the bank continued to redeem the AT1 instruments on the optional call dates and replace them with higher-cost instruments. The Basel Committee has stated that banks must not expect supervisors to approve the exercise of a call option "for the purpose of satisfying investor expectations that a call will be exercised". It has also said that banks should not expect their supervisors to permit them to call an AT1 instrument if they intend to replace it with an instrument issued at a higher credit spread.

The market often interprets this as implying that regulators would not approve noneconomic refinancings, but there are different views on what regulators would consider noneconomic. We think that further clarity about when regulators would consider a call noneconomic could be helpful for investors and issuers alike.

AT1 Hybrid Capital Reform Is Not A Silver Bullet For Regulators

While the AT1 framework is on the broader regulatory agenda, we don't think that regulators see AT1 reform as the silver bullet to lower the risk of bank failures. We therefore expect regulatory initiatives to be linked to broader enhancements to regulatory and supervisory frameworks, such as initiatives looking at transparency, disclosure, and the general use of the capital buffer framework.

We Include AT1 Instruments In Our Bank Capital Measures, But With Limits

This is because we see AT1 instruments as a weaker form of capital than common equity. However, we continue to typically include them--subject to limits--in our measure of bank capital, namely, the risk-adjusted capital (RAC) ratio. We typically include them because of their role in regulatory going-concern capital and the fact that banks can use them in stress scenarios. But we limit their inclusion in the RAC ratio because we see them as less able to absorb losses than common equity, for the reasons we outline earlier in this article. We don't treat AT1 hybrids differently in our RAC ratio based on whether they have a write-down or conversion feature.

We'd exclude AT1 instruments from the RAC ratio if they were no longer included in regulatory going-concern capital. We typically see regulators using a transition period when they exclude an instrument from regulatory capital. We would still include a bank's AT1 hybrid instrument in our RAC ratio, subject to our limits, for as long as it was still included in Tier 1 capital under a regulatory grandfathering approach, assuming that it was otherwise consistent with our criteria for equity content. We base our view of a bank's capital not only on the RAC ratio, but also on factors such as our view of the bank's regulatory capital flexibility and the quality of its capital base.

Related Criteria

• Hybrid Capital: Methodology And Assumptions, March 2, 2022

Related Research

• Swiss Federal Council Plans To Strengthen The Country's Too-Big-To-Fail Banking Framework, May 29, 2024
• Credit FAQ: Will Australia Increase The Likelihood Of Bank AT1 Loss Absorption?, Oct. 19, 2023
• Credit FAQ: Asia-Pacific AT1 Hybrids Investors: Understanding The Credit Suisse Fallout, March 24, 2023
• Swiss Regulator's Statement On Credit Suisse AT1 Confirms Impact Of Documentation And Legislative Powers, March 23, 2023
• European Bank AT1 Hybrids In A Post-Credit Suisse World, March 21, 2023
• Bank Regulatory Buffers Face Their First Usability Test, June 11, 2020
• Europe's AT1 Market Faces The COVID-19 Test: Bend, Not Break, April 22, 2020