ECB's AT1 Proposal and Its Impact on Bank Funding and Investor Returns

The European Central Bank's (ECB) 2025 regulatory proposal for Additional Tier 1 (AT1) instruments has sparked significant debate among investors, bankers, and regulators. At the heart of the discussion lies a tension between simplifying capital frameworks and preserving the resilience of the European banking system. While the ECB aims to reduce complexity by streamlining capital buffers and enhancing operational resilience, the vagueness surrounding AT1's role in crisis scenarios-exacerbated by recent legal challenges-has introduced uncertainty for both banks and investors. This analysis examines the ECB's proposed changes, their implications for risk-rebalancing and capital structure adjustments, and the ripple effects on investor returns.

Regulatory Ambiguity and the AT1 Conundrum

The ECB's 2025 proposal outlines two potential paths for AT1 instruments: either enhancing their loss-absorbing features without altering their fundamental role or removing them entirely from the going-concern capital stack according to the proposal. This duality reflects the ECB's acknowledgment of AT1's limitations, particularly its limited loss-absorbing capacity compared to Common Equity Tier 1 (CET1) instruments. However, the lack of a clear, binding framework for AT1 treatment in stress scenarios has left banks and investors in a regulatory gray area.

A pivotal example of this ambiguity emerged in October 2025, when a Swiss court ruled that the write-off of Credit Suisse's AT1 bonds during its 2023 collapse was unlawful according to the ruling. This decision not only challenged the enforceability of contractual expectations for AT1 holders but also exposed the absence of harmonized legal frameworks across jurisdictions. As noted by Bloomberg, the ruling "undermines the perceived seniority of AT1 instruments and raises questions about the ECB's ability to ensure consistent resolution mechanisms" according to Bloomberg. Such legal uncertainties could deter institutional investors from holding AT1 bonds, forcing banks to seek alternative, potentially costlier capital sources.

Risk-Rebalancing and Capital Structure Adjustments

The ECB's 2025 Supervisory Review and Evaluation Process (SREP) revealed that euro area banks remain well-capitalized, with a weighted average CET1 ratio of 16.1% and a leverage ratio of 5.9% according to the SREP. This robustness has allowed the ECB to maintain CET1 requirements at 11.2% for 2026 while reducing the non-binding Pillar 2 Guidance (P2G) from 1.3% to 1.1% according to the ECB's announcement. However, the reduction in Pillar 2 buffers-despite heightened geopolitical and macroeconomic risks-has raised concerns about whether banks are adequately prepared for tail risks.

The ECB's proposal to merge capital buffers into two categories-a non-releasable buffer and a releasable buffer-aims to simplify the regulatory landscape according to the proposal. Yet, this simplification risks obscuring the nuanced interplay between capital adequacy and risk management. For instance, the ECB's emphasis on operational resilience and IT capabilities according to the proposal highlights the growing importance of non-traditional risks, such as cybersecurity threats and digital transformation challenges. If AT1 instruments are reclassified or phased out, banks may need to recalibrate their capital structures to prioritize CET1 issuance, which could increase funding costs and dilute shareholder returns.

Investor Confidence and Return Dynamics

Investor confidence in AT1 instruments has been further eroded by the ECB's cautious stance on regulatory clarity. According to Reuters, the ECB's supervisory priorities for 2026–2028 emphasize resilience to geopolitical risks and macro-financial uncertainties, even as it allows banks to enhance shareholder payouts through higher dividends and share buybacks according to Reuters. This duality creates a paradox: while the ECB seeks to support investor returns in the short term, its focus on resilience signals a potential tightening of capital requirements if macroeconomic conditions deteriorate.

The reduction in Pillar 2 Guidance has provided banks with more flexibility to return capital to shareholders, but this benefit is partially offset by rising counter-cyclical capital buffer (CCyB) requirements from other authorities according to financial reports. For investors, this means that returns on AT1 instruments may become more volatile, as banks navigate a fragmented regulatory landscape. Additionally, the ECB's call for greater integration of ESG risks into bank strategies according to regulatory updates could further complicate capital allocation decisions, particularly for institutions with exposure to high-risk sectors like commercial real estate.

The Path Forward: Balancing Clarity and Resilience

The ECB's AT1 proposal underscores a broader challenge in European banking regulation: balancing simplicity with resilience. While the ECB's efforts to reduce complexity are commendable, the lack of clarity around AT1's role in crisis scenarios risks undermining the very stability it aims to preserve. As noted by the European Banking Authority (EBA), the 2025 EU-wide stress test demonstrated that banks could withstand severe adverse scenarios with CET1 ratios above 12% according to EBA results. However, stress test scenarios often assume orderly market conditions, and the Credit Suisse case illustrates how legal and regulatory ambiguities can amplify systemic risks during crises.

To address these concerns, the ECB must provide clearer guidance on AT1's treatment in resolution frameworks. This includes harmonizing legal definitions of loss absorption and ensuring that contractual expectations for bondholders are aligned with regulatory objectives. Failure to do so could lead to a flight from AT1 instruments, forcing banks to rely more heavily on CET1-a costly and potentially inflationary solution.

Conclusion

The ECB's 2025 AT1 proposal represents a critical juncture for European banking. While the reduction in Pillar 2 Guidance and the emphasis on operational resilience offer short-term benefits for banks and investors, the lingering ambiguity around AT1's role in crisis scenarios poses long-term risks. Investors must remain vigilant, factoring in the potential for regulatory recalibration and the impact of geopolitical uncertainties on capital structures. For the ECB, the path forward lies in striking a delicate balance: simplifying rules without sacrificing clarity, and ensuring that AT1 instruments serve their intended purpose as a reliable component of the banking system's capital architecture.