Design features, market practices and loss absorption of AT1 instruments. Is there anything to fix?

The Credit Suisse case, where Additional Tier 1 (AT1) instruments absorbed losses only at the bank's point of non-viability, has reignited discussions about the ability of these instruments to serve as going-concern capital. Based on the lessons learned from this and previous bank crises for which almost no instances of loss absorption of AT1s on a going-concern basis have been observed, this paper examines the different features of AT1s, with a specific focus on Contingent Convertible bonds (CoCos). Areas of analysis include: the effectiveness of current Principal Loss Absorption Mechanism (PLAM) triggers, particularly in liquidity crises; the reluctance of banks to cancel AT1 coupon payments, irrespective of their financial condition; the lack of permanency of these instruments, due to the banks' practice of redeeming them at the first call date; and the seniority of AT1 holders over shareholders in all circumstances. The paper then discusses policy options to address a number of observed weaknesses, also considering the potential effects on issuers and investors' behaviour. While a number of changes to the current framework of AT1s seem necessary to enhance the loss absorption features on a going-concern basis (a principle stated in the Basel Accord for Tier 2 hybrid debt capital instruments since 1988), such changes should be carefully assessed against potential unintended effects, including in terms of regulatory complexity. In this respect, as an alternative, a more radical rethinking of the regulatory capital stack may be considered, also taking into account the requirements introduced in the meantime regarding loss absorption and the recapitalization capacity of banks in resolution.