European Banking Authority Heightens Scrutiny Over AT1 Bonds

In recent times, the European Banking Authority (EBA) has heightened its regulatory scrutiny over capital buffer assessments for banks. In a report published at the end of June, the EBA issued specific guidance around the “prudential valuation of non-CET instruments”—particularly, Additional Tier 1 (AT1) instruments.

AT1 bonds emerged following the Global Financial Crisis of 2008, designed to buffer a bank’s capital structure during periods of volatility. Ironically, the role of AT1 bonds came into question following the banking crisis of 2023, which saw three U.S. banks fall in less than a week and the emergency acquisition of Credit Suisse less than two weeks later.

At the time of its merger with multinational investment bank UBS, the Swiss Financial Market Supervisory Authority (FINMA) wrote off the bank’s AT1 bond holdings, thus eliminating their value to zero. The EBA report addresses the role of AT1 instruments, providing new guidance and regulatory requirements to ensure the instruments are not overstating or understating capital buffers.

Below, we explore the history of AT1 bonds in the banking industry, recent market events triggering regulatory scrutiny, the EBA’s guidance on AT1 instruments going forward, and the implications for banks with greater demand for standardization and transparency related to these holdings. 

A search for “AT1 bonds” on the AlphaSense platform shows a 104% increase in document activity over the last 90 days.

The History of AT1 Bonds

Additional Tier 1 bonds originated in the European banking system following the global financial crisis of 2008. With the belief that banks should have elevated capital structures to support lending and rely on in times of crisis, AT1s came into existence.

AT1 bonds, part of a bank’s capital buffer, are designed to enhance financial stability by absorbing losses during periods of financial distress. They belong to a broader family of assets called contingent convertible bonds that can be converted into equity during periods of volatility. AT1 bonds generally exhibit higher yields compared to traditional bonds due to their inherent risk, which stems from their ability to convert into equity or to be written down during critical events, thereby bolstering a bank’s resilience.

While AT1 securities sit in a relatively subordinated position in banks’ capital structure (beneath ordinary, senior debt, and tier 2 debt holdings), they are ordinarily prioritized above equity instruments such as common shares or stock.

During periods of financial crisis, such as the global banking crisis in 2023, the intended purpose of AT1 bonds is to diversify bank assets and ultimately eliminate the need for government bailouts. By design, they cushion banks’ equity, reduce debt, and preserve deposits.

Market Events Triggering Regulatory Intervention

Shortly after the fall of Silicon Valley Bank (SVB) in March 2023, Credit Suisse found itself in sudden turmoil, plagued by ongoing losses, flawed strategies, and poor risk management practices. The collapse of three U.S. banks in this time period triggered fear of an imminent global financial crisis similar to that of 2008.

Less than two weeks after the collapse of SVB, UBS swept in to acquire the failing Credit Suisse as it teetered on the brink of collapse. At the time of its purchase, Swiss regulator FINMA wrote off the bank’s AT1 bond holdings, thus eliminating their value to zero.

In June 2024, a group of Credit Suisse AT1 bondholders filed a lawsuit against the Swiss government seeking relief for their lost assets, totaling nearly $82 million. While the bank’s equity shareholders were allotted some type of payout following the acquisition, AT1 bondholders were left with nothing.

Following the 2008 financial crisis, the EBA modified the Basel III framework to protect AT1 bondholders in the event of a bank failure, prioritizing the value of those assets above equity stock holders. The outrage among Credit Suisse’s AT1 bondholders stemmed from the belief that their assets would also be protected.

However, according to FINMA, the Credit Suisse AT1 bonds contained “explicit contractual language” that they would be “completely written down in a ‘viability event’ in particular if extraordinary government support” was granted. This context enabled FINMA to prioritize equity holders ahead of AT1 holders in the Credit Suisse instance.

Broker research sourced from the AlphaSense platform indicates that European regulators have identified capital structure as an ongoing headwind for banks. It is believed that the Credit Suisse fall-out in March 2023 was largely due to inadequate capital amounts at the parent level, driven by the group’s structure at the time.

It is no surprise then that there is increased scrutiny over AT1 bonds, which the EBA warns can over or understate a bank’s capital buffer without adequate valuation protocols.

European Banking Authority Guidance on AT1 Holdings

The EBA plays an integral role as a governing body to strengthen and protect the European financial system by identifying systematic risks and implementing fair, consistent, and transparent regulation. Its mandate is to ensure the integrity, efficiency, and orderly functioning of Europe’s banking sector.

Recently, the EBA increased its scrutiny over AT1 bonds and their implications on capital buffers, issuing updated findings at the end of June. In the report, the regulatory body observed discrepancies in the valuation of AT1 instruments, specifically in the “carrying amount” (the value recorded in the balance sheet) and its nominal or outstanding value.

In their findings, the EBA report deduced: “For the calculation and reporting of regulatory capital ratios, it is essential that capital instruments consistently reflect their actual loss absorbency capacity. Measuring non-CET1 capital instruments for prudential purposes using the carrying amount (accounting value) is necessary to prevent overestimation or underestimation of the total capital available to cover losses.”

The regulatory body’s expanded guidance around non-CET instruments was accompanied by new AT1 standardized templates aimed at mitigating the complexity of the instruments and more accurately capturing their value for reporting purposes.

As with other EU initiatives impacting the financial sector, the EBA will likely continue to closely monitor its guidance around non-CET instruments such as AT1 bonds and issue best practices to ensure banks are adequately capturing their capital ratios. Stricter guidance will compel banks to integrate more vigorous risk management practices, ultimately protecting operational function and investor confidence.

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