AT1 enhancements mulled after ECB report

Adjustments to coupon payment-related aspects of AT1 could be the most viable way of reforming their structure, according to Crédit Agricole CIB proposals produced after the ECB called for either the removal of the instrument from the capital stack or enhancements to their loss-absorption capacity.

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On 11 December, the European Central Bank proposed simplifying EU banking rules, with its Governing Council endorsing 17 recommendations, addressed to the European Commission, of an ECB high-level task force formed in March 2025. The ECB report tackle not only AT1, but ranges across topics including MREL and TLAC, leverage ratio, and buffers.

The proposals come ahead of a Commission Banking Report due this year, which is set to focus on EU bank competitiveness, but may cover related matters, such as completing the Banking Union, simplifying capital and macro-prudential decision-making, and reducing national gold-plating of regulations. This could put forward legislative amendments for deliberation by the European Parliament and Council.

The ECB’s second recommendation focuses on adjusting the design or role of mainly AT1, but also Tier 2.

“The value added by including Additional Tier 1 (AT1) (and Tier 2) instruments in the going-concern capital stack has been questioned,” says the task-force report. “The degree of going-concern loss-absorbing capacity of AT1 instruments is unclear.”

Two options are cited by the ECB: “enhancing” the capacity of AT1 to absorb losses when a bank is operating normally, which it says could be Basel-compliant and maintain resilience; or removing “non-equity elements” — i.e. AT1 and Tier 2 — from the capital stack — provided that Basel compliance and capital neutrality are not compromised — and either replacing them with CET1 instruments or eliminating them without any replacement.

The ECB itself raises doubts over the latter options of replacement or elimination, due to their impact on bank resilience, Basel-compliance, and capital neutrality.

Analysis by Crédit Agricole CIB on a representative group of 23 systemic banks across Europe finds that the removal of AT1 and Tier 2 would reduce return on tangible equity by 2.3% on average, with the impacts ranging from 1.1% to 3.8%.

“Replacing AT1 and Tier 2 means more CET1, which is problematic because they have very clearly said that any move is supposed to be capital neutral,” says Doncho Donchev, executive director, DCM Solutions at Crédit Agricole CIB (pictured). “At a time when European banks are finally starting to make decent returns, they would face significant impacts, so this option is a non-starter.”

While the ECB report says that the going-concern loss absorption capacity of AT1s is unclear, it sticks to high level principles and does not explain the instrument’s shortcomings in more detail or highlight which features are not functioning to this end, and hence how they could be enhanced.

The most recent guidance in this regard potentially comes from a March 2022 paper, albeit in a different context: an ECB response to the Commission on its review of the macroprudential framework, where the focus was on banks’ avoidance of MDA (Maximum Distributable Amount) breaches for AT1 reasons, thereby hindering them taking advantage of buffers. Three changes were nevertheless suggested: AT1 coupons to be paid only by profitable banks (not only P&L profit, but potentially also positive retained earnings); allow calls only when AT1 replaced with a cheaper instrument; and have only a point of non-viability (PoNV) trigger (i.e. not a 5.125% trigger).

‘Balanced compromise’ proposed

Looking at the historical context of AT1’s development and experience, as well as the various stated aims of any reform of the instrument, the ECB’s earlier suggestions, and Basel imperatives, Crédit Agricole CIB’s DCM Solutions team propose a “balanced compromise” focusing on MDA and other features on coupon payments — partly for the advantages this would bring, and partly because they consider alternative changes either to be unworkable or to be tinkering with elements of the instrument that are already functioning well.

“If there’s real momentum and there’s going to be reform of AT1, the coupon cancellation mechanism should be the focus,” says Michael Benyaya, co-head of DCM Solutions & Advisory at Crédit Agricole CIB.

Beyond reforming the MDA formula, they propose cancelling AT1 coupons in full if a bank is in breach of its requirements, thereby enhancing its loss absorption. This would be alongside supervisory discretion to cancel coupons.

At the same time, coupons would be cumulative, balancing the appeal of the instrument to investors and putting it on an appropriate footing vis-à-vis equity. Donchev notes how banks compensated investors by paying dividends that had earlier been cancelled during Covid.

“The problem with AT1 right now is, if you cancel coupons, they’re lost forever,” he says. “There’s no catch-up element. So what we’re saying is, cancel them more easily, but to align AT1 with equity — the more junior instrument — make sure that coupons can also be cumulative, on a fully discretionary basis.”

Similarly, they propose the introduction of dividend stoppers, or, where these are not possible, intent-based dividend pushers.

Tweaks to the principal loss absorption mechanism (PLAM) — such as oft-discussed increases to the 5.125% level that is now widely regarded as redundant — are possible, note Crédit Agricole CIB’s team, but carry various drawbacks, not least that higher trigger levels are only likely to see banks strengthening their capital ratios to the extent that the new level simply becomes too low again.

Removing it completely and retaining only the PoNV trigger is therefore their recommendation.

“Increasing the CET1 trigger will bring little supervisory value,” says Benyaya (pictured). “The CET1 trigger will never be high enough to be truly going-concern for a G-SIB. And the AT1 instrument needs to remain marketable — we need to find investors who will invest in it — and if the CET1 is something like 15%, no one will buy it.

“We propose removing this CET1 trigger entirely, to simplify the instrument,” he adds. “We believe this would be Basel-compliant, because in their criteria that trigger is not required for equity-accounted AT1 instruments.”

The idea of allowing calls only when AT1 replaced with a cheaper instrument, as previously floated by ECB staff, could lead to unintended consequences, they note.

“Eventually instruments could be issued in such strong markets that they would effectively become perpetual,” says Donchev, “which is a dangerous spiral that needs to be avoided. Issuers can be flexible and investors will judge them by their call policy and act accordingly, with any cost impact not just on one AT1 instrument but the whole capital stack.

“Indeed, they shouldn’t do anything about calls,” he adds, “because the call rules are the one element that has been proven to work.”

Finally, technical elements allowing for debt accounting valued by issuers should be retained, according to Crédit Agricole CIB’s team.

The ECB has said that any changes to AT1s should only apply to instruments issued after a certain date once laws have been updated. Crédit Agricole CIB nonetheless highlight that, should issuers find it appropriate to update their AT1s from grandfathered instruments to those compliant with any new rules, some changes will be possible without bondholder approval — not being potentially detrimental to their interests — but others will not.

“Changes around coupon cancellation may not need any agreement from bondholders,” says Donchev. “You wouldn’t necessarily even need to change the documentation, if it already refers to potential future articles, meaning that the regulators have a lot of freedom to change the law, and then there’s automatic application.

“If they change the trigger level, that would be different. With the exception of one specific prominent bank issuer, such changes would not come within the scope of changes allowable without bondholder consent.”

However, they note that alongside the possibility of incentivising investors in consent solicitations, issuers have the option of other types of liability management exercises, such as exchanges or buy-backs and new issues.

It’s all to play for

The ECB report is seen as the central bank putting down a marker ahead of this year’s Commission report.

The six person task force included representatives of national central banks, including the Banque de France and Bundesbank, but only one official responsible for banking supervision, Sharon Donnery, ECB representative on the supervisory board of the Single Supervisory Mechanism. The Bundesbank has previously been a critic of AT1 and is meanwhile focused on a simplified framework for smaller banks.

The European Banking Authority, which would be expected to play a role in any AT1 reforms, has been a defender of the instrument and stressed the importance of maintaining the status quo. Outgoing EBA chairperson José Manuel Campa this week echoed the regulator’s stance, but also noted that coupon payment-related issues are something that could be tackled.

Critical in deciding the future of the instrument, according to Donchev, could be quantitative impact studies conducted on the basis of any legislative proposals that emerge, which would inform the direction the European authorities may take.

Like the ECB, the Basel Committee on Banking Supervision has said little officially on reform of the instrument. In Switzerland, AT1 are in play amid post-Credit Suisse positioning, while reform is understood to be on the agenda as banking regulation is reformed in the UK, which could influence EU thinking.

Globally, the only jurisdiction to remove AT1 from the capital stack has been Australia, and New Zealand is due to follow shortly.

“But let’s not forget,” says Donchev, “that Australia allowed large banks to replace AT1 with more than 80% Tier 2 and very little CET1. That’s how they made the proposal workable.”