I’ve watched, listened to and read far more than I needed to about the AT1 debacle and the accompanying debate around bank capital instruments. I’m getting to the point now where I can’t take much more of the nonsense, scaremongering and backward thinking that’s been spouted in some corners.
Let me throw out a few conclusions right up front: first of all it’s surely right that AT1s should trade more in tandem with equity rather than at an extrapolated yield discount range to senior unsecured debt. They’re called hybrids for a reason. Second, distance to far-off principal write-down triggers should never have been the principal driver of embedded risk.
Given how far well-capitalised banks are from breaching those principal triggers, the quantum of Available Distributable Items to make coupon payments is a more immediate gauge of value and harbinger of potential trouble for those banks in jurisdictions that have narrow definitions. ADIs certainly have more resonance now that banks’ ability to generate retained earnings is less certain.
Beyond the intrinsic credit quality and capital strength of individual names, banks resident in jurisdictions with fewer restrictions on ADI should trade at a premium. Europe does not have anything like a level playing field in this regard (see below) and there are key differences. Oh, and transparency and disclosure at the individual bank level are woefully inadequate.
Before I go any further, let’s go back to basics and state the obvious. (Warning: this may still come as a shock to some of you). AT1 securities were not high-yielding bonds prior to the past few weeks any more than they’re high-yield bonds now – regardless of the fact that that’s how investment banks marketed them and how investors bought them.
Oddly enough, AT1s have always been regulatory capital instruments with principal and interest blocking features. Read the ‘risk factors’ section of any AT1 prospectus and that much becomes patently clear.
Much has been made of their genesis as mitigators of systemic risk, as if last week’s debacle was the fault of regulators. How ridiculous. Yes, AT1s were conceptualised by public policymakers and designed by regulators but they were fully productised by investment bank technicians and structurers and incorporated feedback from treasurers and investors. Don’t talk to me about the lack of a natural buyer base. I’ve heard it a million times and it’s old. Investors have now bought something approaching US$100bn of the stuff. And by the way, no security on earth has a natural buyer base when a market is crashing and burning.
As going-concern loss-absorption instruments, everyone knew what AT1s were for. Their subversion to the bottom of the pile below shareholders in the event of a crisis in order to maintain solvency has similarly been well documented.
Scaremongering
All of the above being the case, where do people get off pushing out grave warnings that banks had better make AT1 coupon payments to avoid upsetting investors who didn’t understand the risks? Or telling issuers – especially those with a lot to do to fill their AT1 buckets – that not paying coupons could close the market and deprive them of the ability to access capital (the ‘cut-off-your-nose-to-spite-your-face’ argument)? That’s emotional blackmail and a disgrace. It’s a re-run of the same scaremongering and blackmail we’ve had for years about banks not calling on call dates.
I’m astounded that people have spun the argument around in this way. Especially since it’s less a case of investors not understanding the risks; more that they ignored them in the stampede to book chunky running yields and chose to see the risks as theoretical.
While I’m on my high horse, why is so surprising that AT1 paper tanked when bank equities had already fallen precipitously and were trading at an average price/book of <0.5x; when credit default swap levels were gapping higher; and solvency chatter was in the ether (even if muted reactions on implied vol suggested the latter wasn’t realistic)?
If anything, the performance of AT1 was a rational and long-overdue delayed reaction. AT1s behaved just how you’d think they ought, especially when equities have better upside in a crisis and are afforded greater protection in the early phases of distress. Similarly, the spread widening phenomenon across the capital structure was rational: senior spreads impacted in a minor way; LT2 quite a bit more but far from alarmingly; AT1s gapping out by 10 full points or more.
ADI clarity?
Deutsche Bank’s note about distributable items to cover AT1 coupons certainly pushed ADI further into the limelight, and everyone immediately set about the task of trying to figure out the quantum of ADIs sitting with European banks that have issued AT1s. On this specific point, I’d like to turn my evil eye on the EU and the pig’s ear that national authorities have been allowed to make of maintaining a level ADI playing field across jurisdictions.
The EBA put out that note in December calling for more certainty and consistency in the application of profits pay-outs to restore capital adequacy. But its focus was the calculation of and transparency around the Maximum Distributable Amount and clarifying the stacking order of capital requirements (Pillar 1 and Pillar 2 sitting at all times below the combined buffer requirement).
On ADI, maybe the Capital Requirements Regulation (Article 4, paragraph 128) is deemed to be sufficient. But read it. Having been told that distributions to holders of CET1 instruments may be paid only out of distributable items, CRR defines the latter as:
“The amount of the profits at the end of the last financial year plus any profits brought forward and reserves available for that purpose before distributions to holders of own funds instruments less any losses brought forward, profits which are non-distributable pursuant to provisions in legislation or the institution’s by-laws and sums placed to non-distributable reserves in accordance with applicable national law or the statuses of the institution, those losses and reserves being determined on the basis of the individual accounts of the institution and not on the basis of the consolidated accounts.”
That has so much latitude you could drive a fleet of buses through it. In a January research note (“Identifying and Calculating Available Distributable Items (ADI): the Example of Italian Banks”), Scope Ratings noted that “the calculation of ADI … involves a deep dive into parent company accounts and national legislation”.
That’s a patently ridiculous state of affairs, especially as the EU stumbles along the road to supposed Capital Markets Union in the midst of lack of harmonisation in key areas like accounting conventions, bankruptcy law and company law. In this particular case, the task facing investors of trying to make head or tail of risks to investment returns, let alone relative value assessments, becomes problematic.
Once that CRR clause has been run through the mangle of national political, regulatory and accounting standards bodies, local company law and applicable by-laws and statutes, ADIs become almost impossible to compare across countries. Something as simple on paper as figuring out what constitutes distributable reserves becomes a task for a research team.
I put the lack of ADI harmonisation to a European regulatory source this week who is active at the pan-European level. Fully expecting a stern brush-off, he said: “I agree with you as regards both the need for harmonisation and the need to reassess the distance-to-coupon-suspension calculation”.
Great, I thought. Maybe I’ve hit a nerve, given last week’s turmoil and it’s been tabled as a discussion at the EBA or somewhere. “But I don’t see this being a big topic for regulators yet, though …”
Oh well …
