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.   

The panel above illustrates our best guess of the cumulative shareholder return — the diminishing cash dividends paid plus ongoing share price, which was in of course in insistent decline over 5 years — compared with the cumulative AT1 return, which are 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.

“Ah yes, you counter, but just try telling that the the distressed investors who bought their AT1s last Saturday.”

But should we feel sympathy for distressed — ahem, ''vultures'' — who buy a 7.25% capital instrument for 20 cents on the dollar during a well-telegraphed existential meltdown?  

''We should not''. Even those who ''did'' read the prospectus.  

One invests in shares to take advantage of rapidly changing market conditions. A share’s price is a capricious, will o’ the wisp sort of thing: it flits about, impishly, by driven by the unpredictable humours of the market, whether they are fundamental, structural, geopolitical, or just the product of the delusional madness of crowds.  

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 rate environment, and ultimate solvency of their issuer, but their value does not jump around. Their main attraction is their scheduled interest income. Investors only benefit from that over time. AT1s reward long-term investment. In ordinary times, their return is a linear function of ''how long ''you have held them, and therefore how for long you provide the bank with tier 1 capital. Day-trading undistressed bonds is not much of a laugh.

It is different in a distressed scenario. Here AT1s are unusually vulnerable: this is the very contingency they are designed to protect ''the bank'' — not the investor; the bank — against. As the bank’s capital ratio approaches the trigger threshold, their performance more and more to resembles the equity: ''Convertible'' AT1s, in their worst case, ''become'' common equity. Their value will converge on the common equity exactly. ''Write-Down'' AT1s will become even ''more'' volatile than common equity.  They are, effectively, binary options: either they are triggered, in which case they are worth zero, or they are not, in which case they recover, will eventually be called at 100 and, in the meantime, will continue to pay fat slugs of interest.  

So, should we feel bad for opportunistic speculators, who picked up the AT1s for a song, but called the market wrong and got hosed? ''No''. This is exactly the bet they were taking.

Should we feel bad for loyal investors who bought at issue, held till the death and were written down to zero? Again, ''no''. They did much better than common equity holders over the life of their investment. It is sad that they got written down, but that is exactly the option they sold when they bought the Notes.  

The tier one 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. Those who read understood that “Perpetual Tier 1 Contingent Write-Down Capital Notes” meant their notes that could be written down in a time of capital stress most likely had a bank to sell last week.