Short and concise analysis on concepts or recent events in the financial markets from the ASG Capital Team.
Today, we talk about the AT1 (Additional Tier 1)
This podcast outlines some of the moving parts associated with Additional Tier 1 bonds, better known as AT1, also known as or Cocos. These instruments are an essential part of the capital structure of many international banking institutions. AT1 were designed to act as an additional shock absorber alongside equity shareholders to cover losses in the case of a winding down of a bank.
These instruments were imposed on the industry by regulators outside of North America. When AT1 bonds were first introduced. There was no ambiguity as to their frontline status when faced with the collapse of a bank. Furthermore, they were not designed to be sold to the general public but destined to an international institutional investor base capable of managing banking insolvency risk.
With the advent of the bail in rules, equity and AT1 ones are exposed first to potential losses from the collapse of a leveraged banking institution before moving on to unsecured bond, senior bondholders and even bank deposits over and above the insured amount. Any direct implication of a government in the takeover of a bank exposes owners, investors, lenders and depositors to this bail in risk.
In the case of an indirect involvement of the state or local central bank authority through an organized takeover with another private banking institution, for example, then equity and AT1 instruments are the only assets likely to take a hit. Thereby sparing senior bondholders and depositors from any losses. The absorption of Banco Popular by Santander Spain confirmed this process.
In the case of Credit Suisse, AT1 bonds ended up being the only instruments to take 100% wipe out. This was highly unusual when compared to past takeovers. The offering memorandum for Credit Suisse AT1 bonds provides the authorities the capacity to implement this kind of write off. Yet last weekend’s Credit Suisse policy action set a very uncomfortable precedent.
For other AT1 bond holders potentially facing organized private takeovers managed by the financial authorities behind closed doors, the perception was that the Swiss had deleted the additional aspect of this instrument, designed initially just to be a complementary buffer. Many international banks rely on and are obliged to issue these AT1 bonds as part of their capital structure.
The choices made by the Swiss authorities increased substantially the cost of this capital funding resource overnight. To set their record straight, the European Central Bank and the Bank of England clarified the status for AT1 instruments issued in their respective jurisdictions.
They reminded investors these bonds would absorb losses behind those of equity shareholders in the case of any bank insolvency or takeover.
Both central banks underscored the instruments additional buffer function in a bank’s balance sheet designed at the outset. Regardless of any direct or indirect involvement by financial authorities, the markets immediate reaction that some kind of new risk had been revealed by the UBS takeover Credit Suisse seemed clearly at odds with the shock absorbing status these bonds already had. Rather than rely on any wishful thinking, AT1 bonds offer great returns over time for those investors who are capable to manage the regulatory risk associated with the instrument.
This podcast is for information only. It should not be considered as investment advice. We would recommend seeking professional investment advice when allocating to any asset.
Originally Posted April 4, 2023 – Podcast #16: AT1 (Additional Tier 1)
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