Its first findings are included in a new report published this week entitled “AT1 Capital Instruments: Background and key risks for investors”. In the near future, Scope will also publish a detailed methodology for the rating of AT1 bank capital instruments.

Dramatically growing market for AT1 securities, but key risks remain
The market for these instruments is still in its infancy but has grown dramatically over the last year to approximately EUR 100bn. In the current environment of low investment yields and increasing regulatory capital requirements, interest in AT1 capital instruments remains high amongst both investors and financial institutions.

In its report, Scope points out that the structure of AT1 capital instruments is driven by their primary role in strengthening banks’ capital positions. Specifically, they aim to provide a private-sector alternative for recapitalizing financial institutions, aside from the issuance of new equity -- which can at times be less appealing due to dilution effects. While AT1 securities have been in high demand from investors during the last year or so, Scope cautions that the regulatory framework dictating their structure (CRD4-CRR) aims primarily to minimize systemic risk and provide depositor protection, rather than to increase their market appeal. “Specifically, in addition to their subordinated status under the priority of claims, investors face risks related to coupon cancellation and principal loss absorption” noted Pauline Lambert, senior bank analyst at Scope who authored the report.

Existing coupon cancellation risks
First, distributions under AT1 capital instruments are at the full discretion of the issuer and non-payment does not constitute an event of default. Scope does not believe that financially sound issuers would casually exercise this discretion as the reputational risk could be material and impact future market access for funding. Second, an issuer is prohibited from making distributions if it breaches certain capital requirements.

Principal loss absorption risks
Contained in the terms of AT1 capital instruments is a specified trigger level which leads to write-down or conversion into equity if the issuer’s CET1 capital position breaches the trigger. Under CRD4-CRR, the minimum trigger level is 5.125% but can be higher. In addition, AT1 capital instruments may be written down or converted when relevant authorities determine that an issuer has reached the point-of-non-viability, a more qualitative measure subject to interpretation.
Scope further emphasizes that the investment risks highlighted above are inherent to AT1 capital instruments in general – i.e. based on the minimum features that these securities must contain under CRD4-CRR.

Additional risks linked to issuer’s own credit fundamentals
The rating agency adds, however, that individual AT1 securities may display additional risks, due to specific terms and conditions and the issuing bank’s own credit fundamentals. Furthermore, these risks are not static as capital requirements, including capital buffers, are under regular review and in many cases are still being determined.

Download the full report on AT1 bank capital securities