DBRS has released a commentary titled European Banks’ AT1 Instruments at a Crossroads: Regulatory Reassessment and Market Implications and I have tucked away a copy HERE:
This commentary assesses the ECB’s December 2025 recommendations within the broader policy debate on the effectiveness of Additional Tier 1 (AT1) instruments as going-concern capital. While the ECB’s recommendation provides limited details, its stance points to two potential pathways: a structural redesign of AT1 instruments or complete removal from the going-concern capital stack.
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AT1 as a Going Concern Capital Instrument: Operational Challenges
AT1 instruments, while designed to be going-concern capital capable of absorbing losses through conversion or write-down, have shown certain functional and operational limitations. The 2023 Credit Suisse AG case—occurring outside the EU—represents the only major instance where AT1 instruments absorbed losses ahead of CET1 and outside a formal resolution process. This case created uncertainties, triggered legal challenges, and underscored doubts about the instrument’s effectiveness as a going-concern buffer. By contrast, past cases such as Banco Popular Español S.A. in 2017 show that AT1 triggers typically activate only at the point of non-viability, effectively functioning as gone-concern tools rather than early-stage stabilisers.Structural features, including quantitative contractual triggers, further constrain the usability of AT1 instruments in going-concern situations. Most EU instruments feature a 5.125% CET1 trigger (with higher thresholds in the UK and Switzerland and none in Canada). Yet experience shows that authorities tend to intervene before quantitative triggers are breached, particularly when crises are liquidity-confidence driven despite capital ratios remaining above thresholds.
Market behaviour has also raised issues related to AT1s: coupons, though discretionary and noncumulative, are rarely cancelled; issuers routinely call instruments at the first call date (typically after five to seven years), subject to regulatory approval. This is because the coupon reset mechanism often makes the post-reset cost unattractive, and failing to call could be perceived by investors as a sign of weakness. If the issuer does not call, the bond rolls into a reset period with a new coupon based on a five-year swap rate plus the original spread (typically in the range of 350 basis points (bps) to 450 bps).
Potential Policy Scenarios
In our view, regulators will likely review some of the following options: (1) raise quantitative triggers (potentially credit negative for AT1s); (2) remove contractual triggers and treat AT1 more like equity (as in Canada); (3) tighten call and coupon conditions to reduce adverse signalling and improve going-concern credibility; or, in the most radical scenario (4) eliminate AT1 instruments, replacing them with CET1 and/or Tier 2 capital. A CET1-only replacement would increase capital costs and effectively raise capital requirements, while removal without a substitute would diminish systemwide loss-absorbing capacity, underscoring the policy trade-off between simplicity, cost, and resilience.Australia Backs Out
In December 2024, the Australian Prudential Authority (APRA) announced its decision to eliminate AT1 instruments from the prudential capital stack, reflecting the regulator’s assessment that AT1 has not operated as a dependable going-concern buffer and instead introduces contagion and legal-execution risk. Moreover, the Australian AT1 market differs from other jurisdictions because a significant shareof banks’ AT1 instruments is held by retail investors—primarily high-net-worth individuals—adding further complexity and making loss absorption potentially more challenging than if these instruments were predominantly held by institutional investors.Under the revised framework, which is effective from 1 January 2027, Australian banks will replace AT1 instruments with CET1 and Tier 2 capital. All outstanding AT1 instruments will be fully phased out by 2032 by gradually removing regulatory recognition and making no changes to the existing legal terms, including subordination, of these outstanding instruments. APRA also recalibrated the minimum leverage ratio to 3.25% of CET1, from 3.50%, preventing unintended tightening linked to the withdrawal of AT1 capacity.
Those who have been reading my commentary on this stuff for the past fifteen years will know that of the four alternative policy responses outlined:
- (1) raise quantitative triggers (potentially credit negative for AT1s);
- (2) remove contractual triggers and treat AT1 more like equity (as in Canada);
- (3) tighten call and coupon conditions to reduce adverse signalling and improve going-concern credibility; or, in the most radical scenario
- (4) eliminate AT1 instruments, replacing them with CET1 and/or Tier 2 capital.
I prefer #1: going to a higher trigger for loss absorption. Canada’s low trigger regime is just plain stupid, having very little effect on market discipline as OSFI has vapours at the idea of banks having to confess that they haven’t been 100% up to scratch.