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What are Additional Tier-1 bonds?

Topics Covered: Indian Economy and issues relating to planning, mobilization of resources, growth, development and employment.

What are Additional Tier-1 bonds?

What to study?

For Prelims: What are AT- 1 bonds, their key features.

For Mains: Significance and risks associated with these bonds.

Context: The Association of Mutual Funds in India (AMFI) has written to the Reserve Bank of India (RBI) and the Securities and Exchange Board of India (SEBI) to allow fund houses a temporary write down of additional tier 1 bonds of Yes Bank to avoid a huge hit on the net asset value of schemes that hold such bonds.

Implications:

This assumes significance as many fund houses stand to lose thousands of crores if the additional tier 1 bonds are completely written off.

Background:

Under the Based III framework, banks’ regulatory capital is divided into Tier 1 and Tier 2 capital.

Tier 1 capital is subdivided into Common Equity (CET) and Additional Capital (AT1). 

What are Additional Tier-1 bonds?

They are a type of unsecured, perpetual bonds that banks issue to shore up their core capital base to meet the Basel-III norms.

 Key features:

  1. These have higher rates than tier II bonds.
  2. These bonds have no maturity date.
  3. The issuing bank has the option to call back the bonds or repay the principal after a specified period of time.
  4. The attraction for investors is higher yield than secured bonds issued by the same entity.
  5. Individual investors too can hold these bonds, but mostly high net worth individuals (HNIs) opt for such higher risk, higher yield investments.
  6. Given the higher risk, the rating for these bonds is one to four notches lower than the secured bond series of the same bank. For example, while SBI’s tier II bonds are rated AAA by Crisil, its tier I long-term bonds are rated AA+.

However, it has a two-fold risk:

  1. First, the issuing bank has the discretion to skip coupon payment. Under normal circumstances it can pay from profits or revenue reserves in case of losses for the period when the interest needs to be paid.
  2. Second, the bank has to maintain a common equity tier I ratio of 5.5%, failing which the bonds can get written down. In some cases there could be a clause to convert into equity as well.

Given these characteristics, AT1 bonds are also referred to as quasi-equity.

Differences between Common Equity (CET) and Additional Capital (AT1):

Equity and preference capital is classified as CET and perpetual bonds are classified as AT1. Together, CET and AT1 are called Common Equity.

By nature, CET is the equity capital of the bank, where returns are linked to the banks’ performance and therefore the performance of the share price.

However, AT1 bonds are in the nature of debt instruments, which carry a fixed coupon payable annually from past or present profits of the bank. 

How RBI can take over the regulation of any bank?

There is an additional trigger in Indian regulations, called the ‘Point of Non-Viability Trigger’ (PONV).

  • In a situation where a bank faces severe losses leading to erosion of regulatory capital, the RBI can decide if the bank has reached a situation wherein it is no longer viable.
  • The RBI can then activate a PONV trigger and assume executive powers.
  • By doing so, the RBI can do whatever is required to get the bank on track, including superseding the existing management, forcing the bank to raise additional capital and so on.
  • However, activating PONV is followed by a write down of the AT1 bonds, as determined by the RBI. 

Insta Link:

Prelims Link:

  1. Basel Norms 1 vs 2 vs 3.
  2. CET vs AT1.
  3. Tier 1 vs 2 capital.
  4. ‘Point of Non-Viability Trigger’ (PONV).
  5. Role of RBI during bank crisis.

Mains Link:

Write a note on Basel norms.

Sources: the Hindu.