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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is founder of Copper Street Capital and former chief operating officer of Barclays
The Dutch government has recently floated the idea of abolishing a capital instrument known as an AT1 in response to the turmoil created following the collapse of Credit Suisse one year ago. The argument is that investors still don’t fully understand the securities.
Such a move would be a serious mistake. While AT1s — or Additional Tier 1 securities to give them their full name — remain a complex asset class, they perform a valuable function, absorbing losses when banks are stressed. They continue to be indispensable for issuers and investors.
In roughly 10-plus years of existence, approximately $250bn of AT1 capital has been raised for European banks. It is risible to think that the recapitalisation of the European financial system and the subsequent restructuring of balance sheets and business models could have taken place without this hybrid class of securities.
Yet, in the sale of Credit Suisse to UBS, the stricken bank’s AT1s were written down to zero and subordinated to equity holders, who received a cash consideration for their shares. While the procedure may have been strictly legal per the fine print of the securities’ prospectuses, this inversion of the normal “waterfall” of cash flow through the capital structure of Credit Suisse was completely unprecedented. It led to an extreme sell-off of the AT1 market in the following weeks.
This abated only when investors learned that similar language did not exist outside Switzerland, thanks in large part to EU bank regulators, who swiftly distanced themselves from the Swiss. Similar sell-offs occurred in February 2016 over concerns about the ability of Deutsche Bank to pay AT1 coupons and in March 2020 at the start of the Covid-19 lockdowns. In both cases markets recovered as the panic settled — as they did again last year.
Indeed, regulators are mistaken in assuming that the market panic from Credit Suisse is in any way indicative of their lack of value to investors. For countless failing banks — including Credit Suisse — AT1s did the very job they were meant to do, namely provide an additional buffer to facilitate a smooth resolution.
And even now, as market size reaches an equilibrium, the securities have an important role to play in the capital structure of financial institutions. As banks’ capital positions and profitability improve, risk premiums will continue to shrink and AT1s will become tools to allow flexible management of capital mix. This is especially the case if regulators allow an increase in the AT1 portion of loss-bearing capital.
The appetite to hold more common stock of barely profitable institutions was non-existent in the early days of recovery from both the 2007-08 financial crisis and later eurozone sovereign debt troubles. AT1s have also benefited stronger banks, which have been able to avoid further dilutive equity raises, thereby bolstering their returns and leading to a normalisation of the sector. The conditions that have made the securities attractive are unlikely to change anytime soon, as low economic growth and high structural barriers to cost-cutting limit the scope for significant increases in profitability.
This is not to say that AT1s cannot be improved. One of the dilemmas faced by stressed banks is that high coupons lead to valuable capital leakage out from the bank at the worst possible time. Skipping a coupon can quickly spiral into existential risk. This is not the same with skipped dividends, which remain as equity that might be paid out later if not needed. So why not do the same with AT1 coupons?
Removing the cliff-edge would greatly reduce the stigma of coupon skips and aid in capital management in difficult moments. Further efforts should also continue to standardise terms. The “Swiss variation” should be eliminated to bring those issues in line with other jurisdictions. Increasing standardisation and transparency will catalyse a further maturation of the market.
Rather than making heavy-handed interventions in the market, regulators should carefully consider the function of AT1s, as time and time again, they have proved their own value. The AT1 market, while complex, has been a resounding success and it would be wrong to eliminate it.
Perhaps, later down the line, issuers may find themselves in a position where they no longer want to have any AT1s outstanding because costs remain prohibitive against retained equity. Perhaps the instruments will one day outlive their usefulness. But that’s for the market to decide, and regulators should avoid trying to fix what isn’t broken.
