Over the past few years, AT1 bonds have been in the headlines for two extremely different reasons. In one case, investors lost their money as a result of the bank collapse. In another instance, there were even apprehensions when the bank was robust. These scandals, which apply to Yes Bank and distribution schemes involving HDFC Bank, is a sign of a larger problem: AT1 bonds are not only risky, but have two specific risks. Understanding this distinction is crucial for both investors and regulators.
(AT1) bonds are perpetual bonds issued by banks and therefore they do not have a maturity date, and investors do not have a claim to receive the principal back at a specified time. Instead, they are paid quite higher coupon payments, which, in theory, are indefinite. Because of such a perpetual and loss-absorbing character, the AT1 bonds are usually considered to be quasi-equity and not pure debt. These instruments are issued by the banks as per the rules of the Reserve Bank of India to comply with their Capital Adequacy Requirements (CAR), which are based on the Basel III standards that were introduced in the aftermath of the 2008 world financial crisis in which capital is determined based on risk-weighted assets. The capital collected by AT1 bonds is used as a cushion to curb losses in case of financial strain.
These are in the form of contingent convertible bonds (CoCos), which may be written down or converted to equity in the event that the capital of the bank reduces to certain predetermined levels, thus enhancing its balance sheet. Whereas such bonds are usually accompanied by a call option which gives the bank issuing them the option to redeem them after a period of time, investors are restricted to the facilities of secondary market sales where such bonds are listed and not by a put option. Notably, AT1 bonds are quite risky: the issuers have the freedom not to pay coupons, without defaulting, and in the worst-case scenario, when a bank turns out to be non-viable, the bonds may be written off without obtaining investor approval. In case of default, these bonds rank lower than other debt, which is why these are subordinate debt.
Additional Tier-1 dealings are high yield securities which usually have a loss absorbing characteristic, that is, they can be written off should the capital of a lender be less than a critical threshold, which occurred in the case of Yes Bank. The write-down of AT1 bonds in 2020 in the case of Yes Bank was made in a regulator-led reconstruction scheme, in which the Reserve Bank of India invoked the loss-absorption properties of such instruments after the bank’s capital position had got to the point of non-viability; the purpose was to maintain the capital position without assistance of the taxpayer, which is the design of the AT1 bonds under Basel III. It was, however, the first of its kind in world and national precedence: in the case of Credit Suisse (2023), regulators wrote down AT1 bonds despite offering some residual value to equity holders, a practice that essentially inverted the conventional creditor pecking order, and was based on contractual provisions of a so-called viability event under Swiss law, unlike the situation in the case of Lakshmi Vilas Bank (2020), where the bank was recapitalized by DBS Bank India and AT1 bonds did not face a similar write-down.
The Yes Bank write-down, in its turn, has prompted major judicial issues in India, as the courts have questioned whether investors knew enough, and whether the write-down complied with the contractual and regulatory norms; though later judicial proceedings, including ones in the Supreme Court, have settled some of the issues about the sanctity and predictability of the AT1 instruments, leaving ambiguity on a much broader topic of whether the investors were well-informed and whether the write-down was conducted under the contractual and regulatory standards in future crises.
The problem of HDFC Bank with AT1 bonds is the manifestation of a completely different aspect of risk—it is not the failure of the issuer but the distribution and perception of the investors. There were concerns in the HDFC scenario, unlike in the case of the Yes Bank episode, where the bank was making losses, regarding the way in which complex instruments, such as AT1 bonds (and in certain cases even global AT1 exposures), were sold to clients, such as HNIs and NRIs. The main issue was not how the instrument itself worked but rather the possibility of incongruity between the risk nature of the product and the way it was marketed, i.e., purported to be a high-yield fixed-income investment.
This is a reputational overhang and not a balance sheet effect: although the bank does not have direct financial losses as an issuer or obligor, it may experience a potential trust loss among its wealth management client base, increased scrutiny of its activities by regulatory authorities such as the Securities and Exchange Board of India, and the potential threat of litigation or customer complaints. In the long-run, these episodes may have an impact on investor confidence and cross-selling possibilities and introduce higher compliance costs, which in turn have a more subtle and long-lasting effect on future business. In financial intermediation, credibility and transparency are as important as capital strength.
Taken together, the cases imply that the next step in regulation should go beyond capital adequacy and focus on market behavior and transparency of risk transfer. It has been argued strongly that AT1 bonds should be limited to institutional or sophisticated investors, that risk disclosure should be uniformly and plainly presented, in writing specifying loss scenarios (including write-down before equity), and that distributor suitability and fiduciary standards should be further tightened to discourage mis-selling. Also, regulators should make the principles of hierarchy of creditors clear and aligned, particularly in situations of resolving them, to eliminate uncertainty such as the one in Credit Suisse and the subsequent litigation that occurred after Yes Bank. It is also important to enhance the alignment between the Reserve Bank of India and the Securities and Exchange Board of India on the issuance, disclosure and distribution norms.
Finally, the most important regulatory imperative is to make sure that an advanced capital instrument is accompanied by equally strong investor protection and transparency mechanisms, so that financial stability can be attained without the betrayal of trust in the system.
