Public Statement

Strengthening the going-concern role of AT1: options and trade-offs

The effectiveness of Additional Tier 1 (AT1) instruments in fulfilling their primary role as going-concern capital has been compromised by low trigger thresholds, discretionary activation, and insufficient incentives for recapitalization. In practice, AT1 instruments are often used to support orderly resolutions of failed companies rather than preventing them from occurring in the first place. This is a critical concern, given that the failure of a significant number of banks could have far-reaching consequences for the financial system as a whole.

Restoring the going-concern role of AT1 instruments would require three key elements: sufficiently dilutive and market-linked conversion mechanisms to absorb principal losses, the elimination of discretionary triggers that can be used to avoid recapitalization, and CET1-linked triggers that are set high enough to support recovery. Such reforms could help to ensure that banks have sufficient capital buffers to withstand economic shocks and maintain stability in times of crisis.

However, any reforms aimed at strengthening the going-concern role of AT1 instruments would need to be carefully balanced against potential adverse implications for banks' funding costs, buffer usability, and resolution funding. For example, increasing the CET1-linked triggers could make it more expensive for banks to access funding markets, which could have unintended consequences for their ability to lend and support economic growth.

Why it matters

The effectiveness of Additional Tier 1 (AT1) instruments in supporting orderly resolutions of failed financial institutions is a pressing concern for regulators and market participants alike. As the going-concern role of AT1 instruments, designed to operate as capital that can be converted into liquid assets in times of distress, is increasingly called upon, it has become clear that their primary function is being undermined by low trigger thresholds, discretionary activation mechanisms, and insufficient incentives for recapitalization.

In practice, this has significant implications for the stability of the financial system. When AT1 instruments are unable to fulfill their intended role as a safety net, banks may be forced to seek alternative forms of support, which can lead to higher funding costs and reduced access to liquidity markets. Furthermore, the lack of effective AT1 instruments can also undermine the ability of regulators to design more efficient resolution frameworks, which could ultimately increase the cost of resolving failed institutions.

Restoring the effectiveness of AT1 instruments requires a nuanced approach that takes into account both the benefits and drawbacks of their use. This may involve reforms such as eliminating discretionary triggers, introducing more market-linked conversion mechanisms, and setting CET1-linked triggers that are high enough to support recovery. Any such reforms must be carefully weighed against potential adverse implications for banks' funding costs, buffer usability, and resolution funding, and will likely require a coordinated effort from regulators, industry participants, and standard-setting bodies.

Key points

Additional Tier 1 (AT1) instruments are designed to provide going-concern capital but their effectiveness is often compromised by low trigger thresholds and discretionary activation mechanisms.
The primary role of AT1 Instruments in supporting an orderly resolution of a gone concern is undermined by insufficient incentives for recapitalisation and limited loss-absorption mechanisms.
Restoring the function of AT1 Instruments requires three key elements: dilutive, variable, and market-linked conversion as a principal loss-absorption mechanism, elimination of discretionary triggers, and CET1-linked triggers set at high enough levels to support recovery.
Such reforms must be carefully balanced against potential adverse implications for banks' funding costs, buffer usability, and resolution funding.
The implementation of these reforms could have far-reaching consequences for the global banking system and its ability to manage risk effectively.
Ultimately, strengthening the going-concern role of AT1 Instruments will require a nuanced approach that balances competing interests and priorities.

Institutional context

Institutional context The Basel Committee on Banking Supervision's (BCBS) framework for capital adequacy has played a crucial role in shaping international standards for bank capital and risk management. The development of Additional Tier 1 (AT1) instruments as part of this framework aims to enhance the resilience of banks during times of stress, with a focus on supporting orderly resolution processes. However, the effectiveness of AT1 instruments in fulfilling their primary role as going-concern capital has been questioned due to concerns over low trigger thresholds and discretionary activation mechanisms.

Regulatory bodies have long recognized the need for reforms aimed at restoring the going-concern function of AT1 instruments. The Basel III package, agreed upon by G20 leaders in 2010, introduced new requirements for bank capital, including a Common Equity Tier 1 (CET1) ratio that has since become a cornerstone of regulatory frameworks worldwide. More recently, the BCBS has revisited the role of AT1 instruments as part of its ongoing efforts to strengthen the resilience of banks and promote financial stability.

The International Organization of Securities Commissions (IOSCO) and the Financial Stability Board (FSB), both part of the G20's standard-setting bodies, have also been actively engaged in discussions on bank capital and resolution mechanisms. The IOSCO has issued guidance on AT1 instruments, while the FSB has developed recommendations for improving bank resilience and promoting orderly resolutions. As these regulatory efforts continue to evolve, they are likely to have a significant impact on the development of international standards for trade finance and the role of AT1 instruments in supporting documentary trade finance.

Practical considerations

Practical considerations for strengthening the going-concern role of AT1 instruments involve a multifaceted approach that addresses key challenges in their implementation.

To enhance the effectiveness of AT1 instruments, regulators and market participants must implement measures to increase the incentives for banks to maintain sufficient levels of AT1 capital. This can be achieved by introducing more stringent trigger thresholds, aligning them with those of Common Equity Tier 1 (CET1) capital, which provides a clearer signal to investors about the bank's solvency. Additionally, regulators should consider implementing a more transparent and consistent framework for determining when going-concern triggers are activated, reducing the discretionary nature of these decisions.

Furthermore, market participants must adopt more variable and market-linked conversion mechanisms as principal loss-absorption mechanisms, which can help to better align AT1 instruments with the evolving risk landscape. This may involve introducing more complex and nuanced conversion structures that reflect changes in market conditions and asset quality. By doing so, practitioners can enhance the ability of AT1 instruments to support orderly resolution and minimize the need for writedowns.

Ultimately, restoring the going-concern role of AT1 instruments requires a concerted effort from regulators, market participants, and banks themselves to address the existing challenges and implement practical solutions that balance the need for sufficient capital buffers with the potential implications for funding costs and buffer usability.

Source: BIS Research Papers