BOE Capital Adviser: AT1s Should Be Ditched If Rules Change

The Bank of England's (BOE) Capital Adviser, Sam Woods, has recommended ditching Additional Tier 1 (AT1) bonds if regulatory rules change, citing their ineffectiveness in absorbing losses while a bank is a going concern and their discretionary distributions that can send negative market signals. This recommendation aligns with the BOE's broader objectives for bank capital requirements, aiming to stabilize banks as going concerns during periods of stress and support resolution to prevent disorderly failures.



The BOE's Capital Adviser, Sam Woods, has recommended ditching Additional Tier 1 (AT1) bonds if regulatory rules change, primarily for the following reasons:

1. Ineffectiveness in absorbing losses while a bank is a going concern: AT1 bonds are designed to absorb losses before shareholders, but in practice, they have not been effective in this regard. Woods noted that international experience, such as the case of Credit Suisse in 2023, shows that AT1 bonds absorb losses only at a very late stage of a bank failure, failing to stabilize the entity earlier in stress.
2. Discretionary distributions: Distributions on AT1 bonds are discretionary, meaning banks under financial stress can cancel distributions to conserve capital. However, Woods argued that the market signaling effects from cancelling distributions are more detrimental than the minor benefit of additional financial support.
3. Market signaling effects: The discretionary nature of AT1 distributions can send negative signals to the market, potentially exacerbating a bank's financial stress. Woods suggested that the market signaling effects of cancelling distributions are more detrimental than the minor benefit of additional financial support.

These reasons align with the BOE's broader objectives for bank capital requirements, which aim to:

1. Stabilize banks as going concerns during periods of stress: By replacing AT1 bonds with more reliable forms of capital, the BOE seeks to ensure that banks have sufficient capital to absorb losses and continue operating during times of stress.
2. Support resolution with the capital strength needed to prevent a disorderly failure: The BOE wants to ensure that banks have adequate capital to support a resolution process, preventing a disorderly failure that could have broader negative consequences for the financial system and the economy.

The proposed changes in AT1 regulations, such as those announced by the Australian Prudential Regulation Authority (APRA), could significantly impact the pricing and demand for these instruments. APRA's decision to phase out AT1 capital requirements and allow banks to replace them with cheaper and more reliable forms of capital, like Tier 2, could lead to a decrease in the demand for AT1 bonds. This shift in regulation may result in lower prices and higher yields for AT1 instruments, as investors may perceive them as less attractive due to the reduced regulatory support.

Investors might consider alternative investment options as a result of these changes. Some potential alternatives include:

1. Tier 2 bonds: With the increased availability of Tier 2 bonds due to APRA's changes, investors may shift their focus to these instruments. Tier 2 bonds are typically less risky than AT1 bonds and offer a more stable return, making them an attractive alternative for risk-averse investors.
2. Equity investments: Investors seeking higher returns might consider allocating more funds to equity investments. While equities carry higher risk, they also offer the potential for capital appreciation and dividend income.
3. Money market funds and short-term debt: For investors prioritizing liquidity and safety, money market funds and short-term debt instruments could be an appealing alternative. These investments typically have lower yields but offer quick access to cash and minimal risk of loss.
4. Infrastructure and real estate investments: Investors looking for stable, long-term returns might consider infrastructure or real estate investments. These assets can provide steady cash flows and are less sensitive to market fluctuations compared to traditional financial assets.

In summary, the BOE's recommendation to ditch AT1 bonds if regulatory rules change aligns with the BOE's broader objectives for bank capital requirements. The proposed changes in AT1 regulations could lead to a decrease in demand and lower prices for AT1 bonds, making alternative investment options more attractive to investors. The specific alternatives will depend on the individual investor's risk tolerance, investment goals, and market conditions.