Tier 1 capital: Difference between revisions

Of a regulated financial institution, the capital level below everything else that gives comfort to the bank’s creditors — in particular, its depositors — that their debts will be met and deposit withdrawals honoured.

If you are a regulated financial institution (a bank) — but ''only'' if you are one of those —  you must “hold” a certain percentage of tier 1 capital.

=== Pedantry alert ===

The classic type of tier 1 capital is an institution’s [[Equity securities|ordinary share capital]]. This is known, by the same people who know coronavirus as “[[COVID-19]]”, as “[[tier 1 common equity]]”, or “[[CET1]]”.   

Then the [[global financial crisis]] happened, and the global community of bank regulators and their assorted committees, councils and forums got together, promulgated a largely coordinated set of bank resolution and recovery regimes, in the process savagely increasing tier one capital requirements with which banks had to comply.

When banks complained about this — equity capital is quite the drag on performance — regulators conceded there could be a layer of tier 1 capital which wasn’t ''actually'' common equity, but could be made to ''behave'' like it, should a bank’s chips ever got really down.

On the good days, this layer could behave a lot like debt: it could pay fixed [[Coupon|coupons]], and redeem — ''if'' it redeemed — at par. If things got gnarly, it could convert into common equity, or just go away altogether. <Ref>There is also another level: [[alternative tier 2 capital]]. Let’s leave that be.</ref>

Everyone concluded that since they were wise, had learned lessons and fixed the systemic problems, the prospect of lots of banks’ chips getting really down again, at once, was pretty low, so as long as banks ''issued'' these new capital instruments, how they would work at the sharp end was mostly academic. So it sounds like no-one read the prospectuses. (This must be galling for the poor [[legal eagles]] who ''wrote'' those monsters, but this is not their story.)

Anyway, this new layer of “quasi common equity” came to be known as [[alternative tier 1 capital|“alternative” tier 1 capital]], or “[[AT1]]” which, when said aloud, sounds like “[[eighty-one]]”. People got excited about it. Our favourite [[Credit Suisse|lucky pooch]] even asked, in a thought piece in 2021, “contingent convertible bonds — better than bank equity?”<ref>[https://www.credit-suisse.com/lu/en/articles/asset-management/contingent-convertible-bonds-lu-202101.html See here.] Joking aside, the answer remains, “other than for distressed speculators, ''yes''”. In any case, they are talking about contingent convertibles, not write-down notes.</ref>  

AT1 capital takes the form of [[Interest|interest-bearing]] [[subordinated]] debt which the bank may, but need not, call after a few years, As such, from an investor’s perspective, it is ''perpetual'' in the same way ordinary shares are. But banks can decide to repay it, at par, if they like. This they will only do if times are good and it is cheap to issue more AT1 capital.  

Why does it count as tier 1 capital then? Because it contains an embedded, “contingent,” bomb.   

In certain disaster scenarios it is ''convertible'' into ordinary shares, at which point it ''becomes'' [[CET1]], or may even be written off altogether. To zero. A [[Donut|duck]]. Bupkis.   

Conversions and write-downs are  “contingent” on defined events — ''[[der Teufel mag im Detail stecken]]'' to the max — things like capital thresholds being breached, or regulators concluding the bank is not viable otherwise — so AT1s are also called “[[contingent convertible securities]]” or  “[[co-cos]]”.  

It became clear in March 2023 when [[Credit Suisse]] finally gave up the ghost, that many in the market, including AT1 investors, didn’t fabulously understand how they worked.  

Famously, in that panicked spring weekend in 2023 when it slipped into history<ref>We have a sense [[Credit Suisse]]’s history is not done just yet but that, like Disaster Area frontman Hotblack Desiato, it is merely spending a year dead for tax (and, er regulatory capital) purposes. It may well be back, at least as a high-street banking brand in Switzerland.</ref> the “trinity” of Swiss regulators put a gun to UBS’s head, forced it to absorb [[Lucky]]’s equity (and all the baubles, jewels and hellish instruments of madness and torture embedded in it) — and, by ordinance, directed [[Credit Suisse|Lucky]] to write down its AT1s — which were “Perpetual Tier 1 Contingent ''Write-Down'' Capital Notes,” and names are important here — to zero.

Their indignance was largely driven by foundational conceptions of what [[Subordinated|subordinated debt securities]] are meant to be — that is, senior to equity — rather than even a cursory glance at the terms or, goddammit, even the ''title'' of their Notes. This, from the termsheet, gives a clue:  

But, docs schmocks.  

Wounded AT1 holders were fortified in their dudgeon by other central bankers (BOE, ECB, the Fed) unhelpfully chipping in, saying, for the record, that that is not how ''they'' would expect to treat [[AT1]]<nowiki/>s. You can just imagine FINMA honchos going, “yeah, thanks, Pal,” when a central banker from ''Greece'' — yes, yes, ''that'' Greece — remarked “well, needless to say we’d never do anything like that. We Greeks are civilised, not like the Swiss!”<ref>This is a paraphrase, and an exaggeration for effect, I freely admit. [[https://www.cnbc.com/video/2023/03/20/awe-are-close-to-the-end-of-the-tightening-cyclea-bank-of-greece-governor-says.html?&qsearchterm=stournaras Full interview here.]</ref>  

Now ambulance chasing [[Litigation lawyer|litigator]]<nowiki/>s are whipping up even more foment, indelicately trawling [[LinkedIn]] to raise a pitchfork mob of aggrieved investors to go and sue — well, it isn’t clear ''who'' they would sue, or for what, since this was done by legislation — and even the normally mild-mannered financial analyst commentariat has been periodically erupting into virtual fist-fights about what the [[AT1]]<nowiki/>s do or do not say and whether a trigger event did or did not happen.

Meanwhile, from the investors, there is lots of jilted lover energy: “how could I ever trust a central banker again?” sort of thing, and lots of “who knew Switzerland was a banana republic?” vibes, too.

Now the JC ''likes'' Switzerland, so he is staying right out of that debate: There are plenty of thought pieces from those more learned and temperate than the JC about that. But Switzerland is ''not'' a banana republic, and it is known for its banking acumen. This, we think, will be borne out over time.  

But the conceptual question this all throws up, in the abstract, is an interesting one: should creditors, however subordinated, ever rank ''behind'' common shareholders?   

Surely not?  

Everyone knows AT1s can get converted into equity, at which point they rank equally ''with'' shareholders, and even written off — but there seemed to be the expectation that a write-off would only happen if common shareholders are getting written off too.   

First, a little spoiler: ''effectively'' ranking behind shareholders and ''actually'' ranking behind shareholders may ''feel'' similar — especially if you have just been written down to zero while the shareholders live to see another day — but they are different things. When an is written down AT1 down to zero, its creditors ''actually'' rank ''ahead'' of shareholders. It is just that their claim is zero.

Another spoiler: this cannot have come as a surprise. Issuers ''must'' have contemplated writing AT1s down while shareholders survived: otherwise, why even ''have'' write-down Notes? A write-down contingent on total shareholder annihilation is no different from a normal conversion to equity: you get what the shareholders get: zero. If that is all you wanted, you would just issue normal contingent convertible bonds.  ''But these AT1s were not convertible''. There were “Perpetual Tier-1 Contingent ''Write-Down'' Capital Notes”. Again, that name. Important.   

This is where that pedantry we mentioned at the top is important: “capital” is not a thing: it is a ''difference between things''. If the AT1s are vaporised, it follows that the tier 1 capital — now comprising only common equity — is worth 17bn more. If the Write-Down succeeds, the shareholders will live to see another day.

So the JC thinks those central banks who are on record as saying “we’d never write off AT1s before shareholders” are flat out ''wrong''.

A corporation’s shareholders take all the profit and all the losses of the undertaking. You can only work out what those profit and losses are once every other claim on the enterprise has been settled. Those other claims have the feature of being ''debtor'' claims. Debtor claims all have defined payoffs; equity claims are, “whatever’s left”.  

So, when resolving a company that has gone bust, you must deal with AT1 creditors ''before'' you finally settle up with shareholders. You can do this two ways: you can convert the AT1s into shares or, if its terms permit, you can just write them off altogether. Either way, by the time you deal with shareholders, no AT1s are left. Only shareholders remain.  

Therefore, the AT1 investors do not ''actually'' rank behind shareholders. They ''can’t''. They either ''become'' shareholders, or they are ''goneski''. If they get converted into shares they ''may'' get some recovery, but only once all the company’s other creditors have been repaid in full. A written down AT1 ''has'' been paid in full. The liability was just zero.  

But AT1 investors whose notes are written off  still feel as if they are ''effectively'' ranking behind shareholders. This is their [[lived experience]]: they get nothing and shareholders get something.  

The graphic in the panel above illustrates our best guess of Credit Suisse’s own cumulative shareholder return against the 7.25% Write Down Notes issued in September 2018. You can see the diminishing cash dividends paid plus ongoing share price, which was in insistent decline over 5 years — compared with the cumulative AT1 return, with those much fatter, fixed coupons plus the AT1s’ market value, which we just made up, on the premise that until things got truly dire, it would have been somewhere near par. they were vaporised.  

The thing to notice here is that, for a buy-and-hold, long-term investor, the AT1s’ return, ''event after they were nixed'', was ''miles'' better than the common equity. The accumulated coupons since issue totalled about a third of its issue price. That is far more than the final acquisition price for the common equity.  

Now: should we feel sympathy for distressed investors who buy a 7.25% capital instrument for 20 cents on the dollar, during a well-telegraphed existential meltdown, and find themselves wiped out?   

In ordinary times, debt instruments — even AT1s — are much less volatile. They do not hop about much, day-to-day. They are sensitive to interest rates and the ultimate solvency of their issuer but as long as that isn’t seriously in question their value does not jump around. Their main attraction lies the scheduled interest they pay.<ref>Or amortisation yield, for zero-coupon instruments.</ref> Investors benefit from bet instruments ''over time''.  

In ordinary times, their return is a linear function of ''how long ''you hold them. While you hold them you are funding the bank’s tier 1 capital cushion. That is a long-term exercise.

Should we feel bad for loyal investors who bought at issue, held till the death and were written down to zero?   

It boils down to this: the alternative tier 1 capital layer is there to protect depositors and ensure the stability of the wider financial system, by helping banks to remain a going concern even in times of great stress. That the bank’s ordinary shareholders happen to share that interest is beside the point. AT1s are meant to reward, and did reward, long-term investors.   

The AT1 holders who, last week, understood that “Perpetual Tier 1 Contingent Write-Down Capital Notes” meant their notes could be written down in a time of capital stress had a bank to sell .