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Corona crisis shows AT1s are not fit for purpose

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By Tyler Davies
31 Mar 2020

If regulators won’t turn off banks' additional tier one capital coupons during the coronavirus crisis, they will never find reason to.

The European Central Bank’s supervisory arm (SSM) took an unprecedented step when it told banks last week that they shouldn’t pay any dividends for the next six months.

It argued that financial institutions really needed to be using all of their cash to help keep the economy alive through the Covid-19 pandemic, rather than doling it out to shareholders.

Some market participants feared that AT1 instruments could be next in line. Issuers of these deeply subordinated bonds have full discretion on whether or not to pay their coupons, which can also be switched off by the relevant financial authorities.

But it looks increasingly likely that AT1 holders won’t join shareholders in paying for the cost of Europe’s coronavirus response, given that SSM head Andrea Enria told the Financial Times on Tuesday that this simply wasn’t in his plans.

Instead, the AT1 market could be heading towards a genuine moment of reckoning: if the instruments can’t be made to absorb losses as intended during a crisis, are they really fit for purpose?

Of course there are some very sensible reasons why it might not be the right time for AT1 bondholders to take a financial hit.

For one thing, the resulting reverberations in the financial markets could have a severely detrimental impact on the industry’s overall cost of capital.

European banks are hardly likely to turn over a tonne of money in the next few years, so their attractiveness as an investment has tended to hinge on their ability to provide a reliable stream of fixed returns in the bond market.

It is also worth bearing in mind that missing an AT1 coupon would be very different from missing a dividend distribution.

While equity investors might expect to earn back the cash they missed out on at a later date, AT1 bondholders would have to come to terms with the fact that their interest payments had gone for good.

And finally, market participants like to point out that the asset class remains relatively small in the grand scheme of things.

Turning off AT1 coupons for a year would only probably save euro area banks an extra €5bn of cash, whereas the SSM’s Enria puts the impact of dividend suspensions over the next six months at a whopping €30bn.

However, none of these arguments can really get away from the fact that AT1s are failing to play the role in this crisis that they were specifically designed to play — that of going concern capital.

Most of all, it is troubling to hear market participants saying that coupon suspensions would lead to Armageddon in the capital markets.

The terms and conditions of AT1 bonds make it abundantly clear that interest payments can be switched off when the going gets tough.

If investors have to be shielded from that risk now, it is difficult to see how the same logic wouldn’t hold true at any other time.

Complaints about the design of the AT1 market are more reasonable.

It is clear, for example, that the non-cumulative nature of AT1 interest means the instruments can end up seeming junior to equity, since dividends can be always be made back up again at a later date.

And it is also true that the asset class is probably too small to make much of a difference when institutions have a big need for capital.

Now is exactly the right time to be delving back into these issues.

The coronavirus crisis could end up having long-lasting consequences in financial markets for things as varied as asset valuations and work practices and corporate social responsibility.

It should also serve as a timely reminder that market participants need to have another look at how debt capital works.

The first thing they should be asking themselves is: what is the point of AT1s?


By Tyler Davies
31 Mar 2020