AT1 Bonds: The new financial weapons of mass destruction?

In the aftermath of the 2008 financial crisis, the Basel-III accord introduced a new instrument, the Additional Tier-1 (AT1) bond, to protect depositors of a bank on a “going concern” basis. The essential element of this instrument is the imposition of losses on its holders without the bank being liquidated, if the Common Equity Tier-1 (CET 1) ratio falls below a threshold level. The bonds are also known as perpetuals as they do not have a redemption date, and carry the following features:
 
* Callable at the initiative of the issuer only after a minimum period of five years, with prior supervisory approval

 
* The bank must have full discretion to cancel payments of coupon/dividends
 

* Coupon/dividends must be paid out of distributable items
 
* Principal loss absorption at a pre-specified trigger point through
·                     Conversion to common shares or
·                     A write-down mechanism.
 
AT1 bonds are quasi equity instruments that seek to protect depositors, while leaving investors in the bonds in high risk circumstances.
 
Why invest in AT1 Bonds?
 
The answer can be summarised in a single word: yield.
 
Scenario in today’s yield starved world:
 

US government 10 year Treasuries	2.41 %
German 10 year Bunds	0.39%
Japanese 10 year Bonds	0.06 %
UK 10 year Gilts	1.35%

(As on 27^th October 2017)

 
In comparison, AT1 bonds stand out, with bonds of top rated global banks offering around 5%.
 
Indian PSU banks’ yield on rupee perpetuals have been ranging between 8 per cent and 12.5 per cent until recently. But AT1 bond prices have been on a tear ever since the announcement of the bank capitalization plan with yields falling sharply from these levels.
 
Are AT1 Bonds serving the purpose?
 
Earlier this year, Banco Popular of Spain faced mounting losses and a run on the bank by its depositors. In a deal orchestrated by the European Commission, the larger Spanish bank Santander, took over Banco Popular, while imposing a write-down on AT1 bond holders for nearly 2 billion Euros. In the rescue of the Italian bank Montei Dei Paschi, 4.5 billion euros were converted into ordinary shares, though retail investors were spared.

 
The recent instances broadly prove that AT1 bonds are working as intended, though some pundits question if the write-downs happened at the European banks only when they were on the verge of becoming a “gone concern”.
 
The Indian experience
 
The experience with weak public sector banks in India offers a study in contrast. The Indian government’s willingness to support its subsidiary banks through additional capital to prevent an AT1 bond write-down, is perhaps a reflection of its worries of a contagion risk to the banking system and its own credibility in the traditional role of a promoter.

 
Banks have to provide for 50% of outstanding secured loans when a defaulter is referred to the National Company Law Tribunal under the Insolvency and Bankruptcy Code, and 100% if the defaulter goes into liquidation. This will affect the capital adequacy ratio of the weaker PSU banks in India. With large problem loan exposures being referred to the NCLT for resolution, these banks would require significant amounts of additional capital to meet the standards for common equity tier 1 ratio as per the Basel III accord. This ideally should first happen through conversion of AT1 bonds into equity capital. The bank recapitalization plan ultimately paid for by tax payers, will result in bail out of institutional holders who have been enjoying high returns on account of the risky nature of AT1 bonds. This raises the issue of moral hazard. It also goes against the very raison d’etre of the AT1 bonds which envisage bond holders absorbing losses. The US government bailout of Wall Street Banks during the financial crisis attracted scathing criticism that it was tantamount to private profits and socialized losses.

 
Basel standards permit coupon payment only from distributable items. Further loan loss provisioning by weak PSU banks could lead to reserves being wiped out. Capital infusion by the government can potentially save the principal portion of AT1 bonds from a write-down, but this does not address the issue of coupon payments. It is worthwhile to note that many debt mutual funds in India and provident funds have exposure to AT1 bonds of weak PSU banks.
 
The next Financial WMD’s?
 
A final word on the potential of AT1 bonds to wreak havoc in the global financial system from a systemic perspective, with many investors complacent or unaware of the onerous conditions of these bonds. An AT1 bond write-down for institutional holders and/or coupon default could very well trigger a run on the bank by retail depositors who may fear that they may be next in the line to take a hit. As long as the problem is localized as observed recently in Europe, there is no risk to the broader banking system. But en masse write offs of AT1 bonds at multiple banks in the event of a scenario like the last financial crisis is a real possibility. If depositors stampede to the exits, the inter connected banking system would again be at risk as witnessed during the dark days of 2007-8.

 
Governments, regulators and financial market participants can perhaps take comfort from the recent statement of Janet Yellen, the Chairperson of the Board of Governors of the US Federal reserve, that she does not foresee another financial crisis in our lifetime. Let’s hope that she is right! Readers may however take note that she did appear to back track on her remarks in a subsequent testimony to the US Senate. This piece first appeared in Artha, an e-magazine of the Indian Institute of Management, Calcutta