The AT-1 bonds conundrum

Additional Tier-1 (AT-1) category of bonds made global media headlines recently, when the Swiss banking regulator FINMA, while brokering the purchase of Credit Suisse bank by UBS, decided to write down around $17 billion in AT-1 bonds issued by Credit Suisse, while equity holders, though taking a haircut, continued to be shareholders.  Back home, there is an ongoing litigation relating to Rs 8,400 crore worth of AT-1 bonds which were issued by Yes Bank and written off by the administer appointed by RBI while reconstituting the bank with investments from SBI and some other banks. 

AT-1 bonds have their roots in the global financial crisis of 2007-08 wherein the governments’ bailing out of many banks using taxpayers’ money came under heavy public criticism. Thus, the strengthening of the banks’ capital adequacy framework emerged as the main priority. It was realised that in difficult times, when equity capital is needed the most, private investors are generally unwilling to infuse funds in the banks for obvious reasons. Contingent convertible perpetual capital instruments like AT-1 bonds emerged as a solution. These bonds are issued as securities close to equity with perpetual maturity terms, though callable in most circumstances. They are like relatively high yielding bonds in normal times. In difficult times, when the bank’s capital falls below certain levels relative to its assets, as per the contractual terms of their issuance, these bonds convert to equity or are written down. 

As far as the banks are concerned, these instruments combine the best of two worlds: the loss absorption quality of equity and the tax deductibility of debt. They enhance a bank’s value by increasing the tax shield and decreasing bankruptcy costs. During good times, the bank takes advantage of the benefits of debt financing, mainly the tax deductibility of coupon payments. Meanwhile, in bad times, when debt obligations impose the risk of financial distress, these securities would be written off or automatically convert to equity. The call option on these bonds further goes in the favour of banks as they could exercise this option in a falling interest rate scenario, thereby reducing the cost of their debt. In some sense, it is like having the cake and eating it too. Of course, for all these features, the issuing banks have to shell out relatively higher coupon payments on such bonds. As for governments and the banking regulators, these securities are likely to find favour, as they facilitate easier resolution in crisis situation and avoid a bail out using the taxpayers’ money. Investors are attracted towards these bonds by relatively high nominal yield vis-à-vis other debt securities while hoping that the bank doesn’t land up in a distress situation requiring invocation of trigger. Naturally, they are taking a bet on the risk-return matrix and need to read the offer documents carefully before investing. 

As per Basel III norms, the bank’s total available regulatory capital is the sum of tier-1 capital, comprising Common Equity Tier-1 capital (CET-1) and AT-1, and tier 2 capital. Each of the categories has a specific set of criteria that capital instruments are required to meet before their inclusion in the respective category. The criteria is strictest for CET-1 (being the highest quality of regulatory capital), less strict for additional tier-1 and the least strict for tier-2 capital. Banks are required to maintain specified minimum levels of CET-1, tier-1 and total capital, with each level set as a percentage of risk-weighted assets—CET-1 capital is to be more than 4.5%; CET-1 plus AT-1 more than 6%; and total regulatory capital more than 8%.

An important question to be asked is that should the contingent convertible perpetual bonds be categorised as part of the tier-1 capital? Considering that they aren’t a pure equity instrument, they ought to be categorised at a lower level. As per the framework, they could be used to ‘bail in’ the bank with two alternatives, viz., either converting them to equity or writing them down. As they are hybrid instruments, featuring between equity and debt, if one were to go by the logic, the latter alternative should be used only if it is decided to write down the equity. On the face of it, writing down the bonds before writing down the equity appears to be conceptually flawed.

When the Credit Suisse episode spooked the entire market for AT1 bonds worth around $275 billion, with their yields sky rocketing, many European regulators, to calm the market, quickly put out a statement that in their jurisdictions that the AT-1 bonds would be written down only after equity instruments absorbed losses. Similar statements were made by the Hong Kong and Singapore regulators. 

Coming to Indian scenario, as on July 31, 2022, the AT-1 bonds outstanding were Rs 1.02 trillion. About Rs 200 billion are the estimated issuances in FY23, mostly by the public sector banks. This is a sizeable market for both the issuing banks and the investors. Based on actual experienced gained till now in reconstituting banks, an empirical analysis may be done by RBI to ascertain whether the CET-1 of 4.5% is adequate in the Indian scenario. Of course, any prescription to increase this percentage would involve additional costs to the banks. It may be decided that henceforth, if a distress situation in a bank demands that the AT-1 bonds need to be written down, that should be done only after wiping out the equity. 

Sebi issued a circular dated October 6, 2020 stating that for forthcoming issuances of AT-1 bonds, only qualified institutional buyers (QIBs) would be eligible to buy in the primary market and that the minimum lot size shall be Rs 1 crore. In the secondary market, all investors, including non-QIBs, would be eligible but the lot size shall be a minimum of Rs 1 crore. A strict compliance with these instructions should be ensured.

Ajay Tyagi & Rachana Baid, Respectively, former chairman, Sebi and professor, NISM. Views are personal.