The report accompanies the 3rd edition of Scope’s AT1 and Tier 2 Handbook. This is our annual compendium of detailed individual analytical reports on specific bank capital securities and includes new research on capital securities from inaugural issuers as well as updated reports on securities rated previously. Scope rates over 75 securities issued by 19 European banks in 11 countries, with our coverage mirroring the significant activity in the market.

Question: Why have coupon cancellation risks increased?

Pauline Lambert: Over the last six months or so there has been a marked increase in the perception of coupon cancellation risks. This is due primarily to three factors: (i) Since January 2016, the various buffers which comprise the combined buffer began phasing-in, (ii) Amidst demands for greater transparency, EBA Opinion 2015/24 clarified that Pillar 2 capital requirements are considered minimum requirements which sit between Pillar 1 requirements and the combined buffer in the capital stack, and (iii) European issuers of AT1 securities disclosed their capital requirements stemming from the ECB’s supervisory review and evaluation process (SREP).

With the improved disclosure on capital requirements, we note that the distance to required CET1 levels for many banks within the EU are in fact much less than they were in 2015 as disclosed CET1 capital requirements have roughly doubled. Effectively, banks must maintain CET1 capital levels in excess of 9.5% to 10% in order to avoid breaching the combined buffer requirement and incurring mandatory restrictions on distributions, including coupons on AT1 securities. The situation for banks in the UK, Switzerland and the Nordic countries is somewhat different as regulators in these countries had communicated and frontloaded various capital requirements somewhat earlier.

Question: What about potential future developments?

Lambert: First, we highlight that in 2019 when the various buffers have been phased in, the overall distances to required CET1 levels appear to decline further. However, over time, issuers could refine their targets and management buffers in response to regulatory and market demands.

Second, we believe that it is important to take a broader view and not just to focus on whether an issuer has breached the combined buffer requirement due to the discretionary nature of coupons and the broad powers of regulators. We question how comfortable regulators and investors would be if an issuer were not meeting all capital requirements while technically not breaching the combined buffer requirement. Leverage ratio and MREL/TLAC requirements are also relevant for assessing an issuer’s solvency position.

Question: What about principal loss absorption risks?

Lambert: In our view, the risk of an issuer hitting the specified trigger on an AT1 security has generally receded. The triggers for write-down or conversion are clearly defined and fixed. However, issuers continue to bolster their capital positions to meet higher regulatory solvency norms. For example, if minimum CET1 requirements are around 10%, banks are unlikely to maintain capital positions that risk breaching a high trigger of 7%, let alone a lower trigger of 5.125%.

The report titled 'AT1 bank securities: Have the risks changed for investors' as well as the 'AT1 and Tier 2 Handbook: 3rd edition' can be found at www.scoperatings.com.