November 30, 2016 / 3:26 PM / in a year

BoE puts AT1 through its paces with most severe tests yet

LONDON, Nov 30 (IFR) - UK banks’ Additional Tier 1 bonds would be fair game and converted into equity if they hit severe problems, the Bank of England’s most stringent stress tests yet showed on Wednesday.

This year’s test was the third annual healthcheck by the Bank of England’s Prudential Regulation Authority (PRA) and was more severe than in 2014 and 2015. It was the first based on the central bank’s new approach to stress testing, which includes potential misconduct costs.

It is the first test in which the UK regulator theoretically converted the instruments as a way of getting banks back to a stronger footing, a clear reminder for investors of the potential losses posed by holding this type of debt.

New regulation following the last financial crisis has forced lenders across Europe to beef up their stock of loss absorbing capital in recent years.

By end-2015, the seven participating banks had issued a combined £23bn of AT1, which in the case of UK lenders converts into equity if a bank’s Common Equity Tier 1 (CET1) ratio drops below 7%.

The CET1 ratios of RBS, Barclays and Standard Chartered all slipped below 7% in the stress scenario, forcing the hypothetical conversion of their AT1 bonds.

In the case of the latter two, that helped pushed their CET1 ratios back over the hurdle rate, to 8.3% and 7.2% respectively.

RBS fared worse. Its CET1 ratio only clawed back to 6.7% even after its AT1 was converted, but the bank has already submitted an updated capital plan to the PRA.

“The conversion of AT1 was a positive development insofar as it reflected increased amounts of such loss-absorbing capacity on some banks’ balance sheets,” the Bank of England said.

“Banks for which AT1 converted in the stress were more resilient, all else equal, than if they had not issued AT1 instruments.”

NAILED

The focus on AT1’s ability to absorb losses serves as a timely reminder of the risks posed by the asset class, which suffered a violent sell-off earlier this year simply on fears of coupon suspension.

“To me it’s pretty clear that as an AT1 holder, the BoE will nail you,” said one investor. “Some people don’t always think that way. It’s interesting because if you think about it, RBS hasn’t really been that volatile.”

All three banks have already taken further action over 2016, not taken into account by the tests, which reduces the probability of breaching the trigger. RBS has issued a further £2bn of AT1 since December 2015, for example.

AT1 bonds were narrowly trading up by late morning, reflecting that progress.

A Barclays US$1.5bn 7.875% callable in March 2022 rallied from 97.75 to 98.2, while an RBS US$2.65bn 8.625% callable in August 2021 initially dropped half a point to 97.3 before climbing to 98.2, for example.

The fact that its capital plan has already been approved by the PRA, coupled with already depressed valuations across RBS’ capital structure, means the impact on credit spreads is likely to be very limited, BNP Paribas analysts wrote in a note.

But people “definitely forget” that the debt can be written down, said Filippo Alloatti, a senior credit analyst at Hermes Investment Management.

“It carries some weight if you see that in an official document, within an exercise by the Bank of England. 7%, to some extent, is far away, but it’s still pretty high.”

UK AT1 bonds are more punishing for investors than the majority of European jurisdictions where bonds are structured with a 5.125% trigger, reducing the chance of conversion.

“I think it underlines the value of having high trigger AT1 instruments,” said Roberto Henriques, European credit analyst at JP Morgan. “I think that this might end up with the sector moving to high trigger AT1 structures.” (Reporting by Alice Gledhill, editing by Helene Durand, Sudip Roy)

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