ECB's AT1 Reclassification: Growth Catalyst Amid Regulatory Uncertainty

The European Central Bank's proposal to reclassify Additional Tier 1 (AT1) bonds as equity remains shrouded in ambiguity, lacking concrete implementation details that have left investors and analysts uncertain. This regulatory gray area, while creating confusion and potentially raising banks' funding costs, has paradoxically sparked strong investor demand for AT1 securities in 2025. According to Bloomberg, primary market demand has reached EUR 250 billion year-to-date, vastly outpacing the EUR 42 billion actually issued so far, signaling underlying confidence in European bank stability despite the lack of clarity. According to GAM, primary market demand has reached EUR 250 billion year-to-date, vastly outpacing the EUR 42 billion actually issued so far, signaling underlying confidence in European bank stability despite the lack of clarity.

Banks are responding to this demand and broader pressures by accelerating capital replenishment. AT1 issuance totals EUR 22 billion in 2025, already exceeding the EUR 17.3 billion issued during the same period last year, and is on track to hit a full-year supply of EUR 25 billion – well above initial estimates. Geopolitical risks and shifts away from ECB lending programs like TLTRO-III are key drivers behind this renewed focus on bond markets for capital. According to ING, this environment presents a strategic opportunity for growth-oriented investors, but it demands careful differentiation.

This environment presents a strategic opportunity for growth-oriented investors, but it demands careful differentiation. While the surge in demand underscores the perceived value of AT1s as income tools underpinned by central bank credibility and bank equity outperformance, the regulatory uncertainty and tight valuations pose risks. Investors must prioritize well-capitalized banks with proven track records and strong fundamentals to navigate the potential for future spread widening and the unresolved questions surrounding the ECB's reforms. The lack of clarity means the long-term appeal of AT1s as a cost-effective capital tool remains contingent on how the proposal is ultimately implemented.

Funding Expansion Mechanics

Eurozone banks are ramping up AT1 bond issuance to fuel lending growth, with year-to-date 2025 volumes hitting €22bn, well ahead of €17.3bn in the same period last year. This surge aims to replenish capital buffers amid geopolitical tensions and a shift away from ECB funding programs. Full-year issuance is now forecast at €25bn, significantly higher than initial estimates, reflecting banks' urgent need for flexible capital according to ING. However, this expansion creates a potential funding tension: expected AT1 redemptions will stabilize at €12bn in 2026, leaving a gap between capital raised and maturing instruments if market dynamics shift.

While banks currently sit comfortably with average CET1 ratios at 16.1%, this buffer serves a dual purpose. It shields institutions against near-term shocks but also signals constrained lending capacity. Supervisors warn that maintaining such high ratios under adverse scenarios could limit credit growth, especially as vulnerabilities persist in commercial real estate and SME loan portfolios with non-performing ratios exceeding 4.5%. The proposed ECB reclassification of AT1 bonds as equity heightens this pressure. Though intended to simplify regulations, the lack of specifics threatens to raise banks' funding costs and directly weaken the €12 trillion eurozone lending momentum. Investor uncertainty has already sparked concerns about reduced competitiveness, even as AT1 prices remain stable for now. While banks exploit current market conditions, the regulatory cloud looms as a potential brake on both capital efficiency and loan expansion.

Growth-Offensive Risk Profile

The ECB's dual warnings underscore that aggressive expansion now requires sharper risk discipline. The 2025 stress tests reveal 24 banks could face dividend restrictions under severe trade tensions, with non-performing loans climbing sharply in SME and commercial real estate portfolios. These sectors now show NPL ratios exceeding 4.5%, a clear vulnerability according to supervisory reports. While the euro area banking system's average CET1 ratio sits at 16.1%, institutions with ratios above 17% and diversified funding sources are better shielded against capital strain and rising funding costs.

For growth-focused strategies, this implies two guardrails: First, stress-test expansion plans against scenarios where SME defaults spike 2x current levels and CRE price declines trigger 30% loan-to-value breaches. Second, prioritize liquidity buffers and operational resilience-especially for banks with >20% CRE exposure or reliance on short-term wholesale funding.

The tension lies between maintaining growth momentum and preparing for a "lower-for-longer" capital environment. Even well-capitalized banks face IT resilience risks, with cyber incidents potentially eroding 5-7% of annual profits if unaddressed. Growth remains viable, but only with explicit contingency planning for both cyclical downturns and structural shifts like digital payment competition.

Strategic Growth Playbook

Eurozone banks are seeing unprecedented demand for their Additional Tier 1 (AT1) bonds, with investors flooding the market despite looming regulatory changes. Year-to-date, primary market demand hit a staggering EUR 250 billion, dwarfing the mere EUR 42 billion actually issued according to GAM. This massive participation gap signals strong capital market support, driven by attractive yields, central bank rate cuts, and growing confidence in European banks' stability. Equity performance for these institutions has already outpaced US peers by 45% so far in 2025, reflecting this renewed conviction.

This robust demand presents a clear opportunity: favor institutions demonstrating high cost/performance ratios and strong AT1 issuance metrics. Issuers with proven success in attracting capital, evidenced by consistent issuance volumes despite elevated valuations, likely possess favorable funding profiles and resilience.

. The current penetration rate – the share of eligible banks actively issuing AT1 – is rising rapidly, a key signal reinforcing this growth logic. Investors should prioritize banks with these metrics, seeking exposure to high-quality, investment-grade AT1 debt for income.

However, the path isn't without friction. The ECB's proposed rule revisions introduce significant uncertainty. If the regulator opts to strengthen AT1 features to clarify their role in going-concern scenarios, it could boost investor confidence in the long term but might also increase issuance costs for banks short-term. Alternatively, removing non-CET1 instruments from the capital stack could fundamentally alter demand dynamics and issuer preferences. Monitoring the ECB's final decision and its timing is critical. A move aligning enhanced features with the observed investor demand could validate the current positioning strategy, suggesting the market's growth logic remains intact. Conversely, unexpected changes could trigger spread widening and repricing, testing the resilience of the current high-demand environment. The next quarter's ECB announcements will be a decisive catalyst for this segment.