Opinion

AT-1 bonds are conceptually flawed

Manjesh Roy | Updated on February 21, 2021

Banking on trust   -  istock.com/

Equity is the best way to shore up banks’ capital. AT-1 bonds are pro-cyclical and can lead to systemic failures

After the 2008 global financial crisis, the Bank for International Settlement (BIS) identified higher capital adequacy for banks as an important means to prevent systemic crisis.

Under the Basel III norms, banks are required to have higher capital relative to the size of their risk weighed assets.

The complex Basel III framework allows instruments/money other than equity (Tier I) to also be counted as capital (under Tier II & Tier III), subject to conditions. Perpetual, Non-Cumulative Preference Shares and Perpetual Debt Instruments, also known as Additional Tier I or AT-1 bonds, emerged as instruments to shore up Tier I capital of banks.

The issue of AT-1 instruments by banks is governed by a July 2015 RBI circular. Its important features include the loss absorbing capacity of these bonds through conversion to equity/write-off/write down, on breach of pre-specified trigger point and at the point of non-viability; the latter as determined by the RBI. Caveats are required to be provided to investors.

In terms of seniority of claim, these unsecured instruments are subordinate to the claims of perpetual debt, Tier II capital instruments, depositors and general creditors of bank but superior to claims of equity holders. However, write-down of equity is not required before the write down of these bonds. AT-1 bonds have call option at the end of five years and offer yield of 200 to 300 bps higher than bank fixed deposits.

AT-1 bond is a debt instrument in normal times and takes the character of equity in times of crisis, thereby, purportedly augmenting the equity capital of banks when they need it most. But there are some problems with this premise.

In macroeconomic management, counter cyclical policies are usually used to moderate ‘boom-bust’ economic cycles. So when the economy show signs of heating there is a tightening of policies and when it slows down, accommodative policies are used.

However, the AT-1 bond is the antithesis of this, as it fuels pro-cyclicality. In this regard, it would be instructive to delve on leverage and its systemic impact.

At present, the yield on 10-year Government security (G-Sec) is about 6 per cent. However, by borrowing short term money, say at repo rate of 4 per cent, the return on this G-Sec can be magnified significantly through leverage.

With 100 times leverage, the 10-year G-Sec, yielding about 6 per cent, can be made to give a return on investment of 206 per cent! This ‘excess return’ through leverage is not risk free as there is a vast mis-match between the tenure of assets on one hand and the tenure of liability on the other. If roll-over of the short term borrowing does not happen for any reason, then the entire own funds (equity) is wiped out instantly.

Systemic threat

This illustration is not a mere theoretical construct; it is the build-up of such concerted leveraged positions of financial entities, albeit through complex derivatives, and its inevitable collapse, that led to the 2007-08 global financial crisis.

Leverage, therefore, is not an entity specific risk but is systemic in its scope and impact. There are also limitations of the Basel framework in not factoring in the level of leverage of the borrower i.e. the capital adequacy of banks..

Looking at AT-1 bonds through the framework of leverage, when the going is good, AT-1 bonds are debt instrument and when there is deterioration in bank’s capital adequacy, these bonds can be converted to equity or written off. Thus in good times, AT-1 bonds increase the leverage of the bank, boosting the return of the equity holders, thereby engendering the boom or pro-cyclicality. Through leverage, the benefits of upside are reaped by the equity holders but the downside is borne by or shared with these bond holders.

Therefore, AT-1 bonds provide perverse incentive for the equity holders to adopt a high risk strategy to boost their return through this one-way bet. That is exactly what happened in YES Bank wherein 100 per cent of the AT-1 bonds of about ₹8,500 crore was written off as against 49 per cent of the equity that was written off, in its March 2020 restructuring. The erstwhile promoter had also cashed out his entire holding prior to the bursting of the bubble, whereas the option to exit was not readily available to these bond holders due to illiquid secondary markets.

Protecting retail investors

While SEBI has proactively protected the retail investors by restricting the direct availability of AT-1 bonds to them, these investors may still have indirect exposure to this exotic instrument through MFs, Pension Funds, Insurance etc.

If the goal was to enhance capital of banks, then infusion of equity is the best option. However, increasing leverage (through ‘sophisticated’ AT-1 bonds) to enhance banks’ capital, is eerily reminiscent of the advocacy for increasing arms sales to bolster world peace!

AT-1 bonds engender pro-cyclicality and if widely used, has the potential to impact systemic stability. AT-1 bond is constructed on a conceptually flawed premise and merits a revisit.

The author works in the financial sector. The views expressed are presonal

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Published on February 21, 2021
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