The EBA’s laudable effort to tame Additional Tier 1 issuances

This week, the EBA issued its preliminary report on the monitoring of Additional Tier 1 (AT1) instruments of EU.

It is a great document for outsiders to obtain a feel for what these instruments are like and how they behave in their regulated habitat. For example, an important critique pertains to the complexity of these instruments. But the EBA cuts this critique down to size, and rightly so, by informing the reader in paragraph 17: “[a]lthough they are complex instruments, issuances are in general quite standardized, except for features which are by nature institutions’ specific … .” Spot on, the instruments themselves are not very complex! Complexity arises from the number of issuances, which are all unique.

The report also highlights the unrelenting attempts from the banks to lower the costs of capital instruments, e.g. by promising easier call conditions than legally permitted.

Most controversial is the section on contingent clauses, starting at paragraph 55. These clauses ensure that the instruments keep their debt characteristics after disqualification as capital instruments. For example, after disqualification a contingent clause ensures that the bank will recommence paying interest on the instrument. The risk is that disqualification (and activation of the clause) will render a whole arrays of instruments ‘must pay’. This may constitute a threat to financial stability.

The problem for the EBA is of course that it cannot regulate instruments that are not regulatory capital. Once out the regulatory basket, the instruments are fair game.

To me this signifies an important design flaw of Basel III: to prevent the adverse “must pay” effect, it is probably best to eliminate the entire Additional Tier 1 category, or only allow equity accounting for AT1.

Unfortunately, I am afraid that it is too late. But it worries me too, given that regulators increasingly stress the importance of the leverage ratio, which has AT1 as numerator.

A couple of other highlights:

Paragraph 29 is odd, as it allows calls below par to crystallize a gain that is similar to a fair value gain – of which the CRR outlaws recognition in Article 33 1. (b).

Paragraph 35 on the one cent floor per instrument is just a great example of structuring – for beginners, that is. The solution is simple and effective. Keep the instruments after a write down in the books for only one cent each, and deduct these single cents from CET1.

I struggle with the preëmption right that gives shareholders the chance to buy the shares after conversion. This is hard to avoid, however in case of trouble and when shares are written down first, as envisioned by the BRRD, the old shareholders, after conversion, will be given the right to become the new shareholders. In that case, a full wipe-out of old shareholders will not happen. Alas.

Paragraph 49 is an encore, as it featured in the earlier report: “Prudential provisions or clauses of importance from a prudential point of view should not be written in italics.” Lol!