Additional Tier-1 bonds (AT-1)

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Context: Recently, the Reserve Bank of India (RBI) has made a proposal to write-down Additional Tier-1 (AT-1) bonds as part of the SBI-led restructuring package for Yes Bank.

Relevance:
Prelims: Current events of national and international importance.
Mains: GS III-

  • Indian Economy and issues relating to planning, mobilization of resources, growth, development, and employment. Inclusive growth and issues arising from it.
Introduction
  • Recently, India’s fourth-largest private lender YES bank was placed under a moratorium by RBI and its perpetual debt additional tier-1 (AT1 bonds) would become worthless if RBI does ask mutual funds to write down their value.

Basel-III Norms
  • It is an international regulatory accord that introduced a set of reforms designed to improve the regulation, supervision and risk management within the banking sector, post-2008 financial crisis.
  • Under the Basel-III norms, banks were asked to maintain a certain minimum level of capital and not lend all the money they receive from deposits.
  • According to Basel-II, I norm banks' regulatory capital is divided into Tier 1 and Tier 2, while Tier 1 is subdivided into Common Equity Tier-1 (CET-1) and Additional Tier-1 (AT-1) capital.
  • Common Equity Tier 1 capital includes equity instruments where returns are linked to the banks’ performance and therefore the performance of the share price. They have no maturity.
  • Additional Tier-1 capital is perpetual bonds that carry a fixed coupon payable annually from past or present profits of the bank.
  • They have no maturity, and their dividends can be canceled at any time.
  • Together, CET and AT-1 are called Common Equity. Under Basel III norms, the minimum requirement for Common Equity Capital has been defined.
  • Tier 2 capital consists of unsecured subordinated debt with an original maturity of at least five years.
  • According to the Basel norms, if minimum Tier-1 capital falls below 6%, it allows for a write-off of these bonds.
What is AT1 capital?
  • There are different tiers (hierarchies) of capital (money). The top tier or T1 has the “equity” capital — that is, money put in by the owners and shareholders. It is the riskiest category of capital.
  • There are different types of bonds (such as AT1 and AT2), which a bank floats to raise money from the market. Last is the depositor — the one who parks her money in the bank’s savings account.
What are Additional Tier-1 bonds?
  • They are a type of unsecured, perpetual bonds that banks issue to shore up their core capital base to meet the Basel-III norms.
  • AT1 bonds are issued by banks to supplement their permanent or Tier 1 capital which is mainly made up of equity shares.
  • AT1 bonds are supposed to remain permanently with the bank and pay investors interest for perpetuity.
  • These bonds are perpetual and carry no maturity date and they carry call options that allow banks to redeem them after five or 10 years.
  • The rating for these bonds is one to four notches lower than the secured bond series of the same bank. For example, while SBI’s tier-II bonds are rated AAA by Crisil, its tier I long-term bonds are rated AA+.

Key features of Additional Tier-1 bonds 
  • These have higher rates than tier-II bonds.
  • These bonds have no maturity date.
  • The issuing bank has the option to call back the bonds or repay the principal after a specified period of time.
  • The attraction for investors is a higher yield than secured bonds issued by the same entity.
  • Individual investors too can hold these bonds, but mostly high net worth individuals (HNIs) opt for much higher risk, higher-yield investments.
  • Given the higher risk, the rating for these bonds is one to four notches lower than the secured bond series of the same bank. For example, while SBI’s tier-II bonds are rated AAA by Crisil, its tier I long-term bonds are rated AA+.
Risk
  • However, it has a two-fold risk:
    • First, the issuing bank has the discretion to skip coupon payment. Under normal circumstances, it can pay from profits or revenue reserves in case of losses for the period when the interest needs to be paid.
    • Second, the bank has to maintain a common equity tier I ratio of 5.5%, failing which the bonds can get written down. In some cases, there could be a clause to convert into equity as well.
    • Given these characteristics, AT1 bonds are also referred to as quasi-equity.
Differences between Common Equity (CET) and Additional Capital (AT1)
  • Equity and preference capital is classified as CET and perpetual bonds are classified as AT1. Together, CET and AT1 are called Common Equity.
  • By nature, CET is the equity capital of the bank, where returns are linked to the banks’ performance and therefore the performance of the share price.
  • However, AT1 bonds are in the nature of debt instruments, which carry a fixed coupon payable annually from past or present profits of the bank. 

RBI’s Regulations Over Banks

  • In a situation where a bank faces severe losses leading to erosion of regulatory capital, the RBI can decide if the bank has reached a situation wherein it is no longer viable.
  • The RBI can then activate a Point of Non-Viability Trigger (PONV) and assume the executive powers of the bank.
  • By doing so, the RBI can do whatever is required to get the bank on track, including superseding the existing management, forcing the bank to raise additional capital and so on.
  • However, activating PONV is followed by a write-down of the AT-1 bonds, as determined by the RBI through the Banking Regulation Act, 1949.

 

Why did Yes Bank collapse?
  • Deteriorating Financial Position:
    • Due to the inability to raise capital to address potential loan losses and resultant downgrades, the financial position of Yes Bank degraded over the last few years.
  • Governance Issues:
    • The bank was experiencing serious governance issues and practices in recent years which have led to a steady decline of the bank. The bank has under-reported NPAs of Rs 3,277 crore in 2018-19.
  • Non-serious Investors:
    • The bank was engaged with a few private equity firms for exploring opportunities to infuse capital as per the filing in stock exchange in February this year.
  • The outflow of liquidity:
    • The bank was facing a regular outflow of liquidity. It means that the bank was witnessing the withdrawal of deposits from customers. In fact, the deposits are bread and butter of a bank.
RBI’s revival plan
  • Recently, the RBI released its “draft” revival plan for Yes Bank and State Bank of India has decided to pick up a 49% stake and hold on to at least 26% for the next three years.



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