AT1 capital instruments issued by Swiss banks: recent developments and outlook

Additional tier 1 capital instruments (AT1 Instruments) are a form of regulatory capital that was introduced after the 2008–09 financial crisis to enhance the resilience of banks in times of financial distress. These instruments have features that distinguish them from other types of debt or equity, such as being perpetual, subordinated, and convertible or write-downable under certain conditions. Since the market for AT1 Instruments was rocked by the wipeout of $17 billion of Credit Suisse's additional tier 1 bonds in March 2023 that accompanied the government-brokered takeover of Credit Suisse by UBS, it has seen important innovations.

The Swiss Banking Act (Bundesgesetz über die Banken und Sparkassen, or BankA) provides the legal basis for imposing regulatory capital requirements on Swiss banks. These requirements, including the conditions that instruments have to fulfil to qualify as additional tier 1 capital, are then detailed in the Capital Adequacy Ordinance (Verordnung über die Eigenmittel und Risikoverteilung der Banken und Wertpapierhäuser, or CAO). The BankA and CAO implement the international criteria for AT1 Instruments set by Basel III into Swiss law, with certain Swiss finishes.

In accordance with Basel III, the CAO distinguishes between three categories of regulatory capital:

• Common equity tier 1 capital (CET1);

• Additional tier 1 capital (AT1); and

• Tier 2 capital (T2).

CET1 is the highest-quality and most loss-absorbing form of capital, consisting mainly of ordinary shares and retained earnings. AT1 is the second-highest-quality form of capital, consisting of instruments that, among other features, are perpetual, subordinated, and intended to be capable of absorbing losses while the bank is still a going concern. T2 is the lowest-quality form of capital, consisting of instruments that are subordinated and capable of absorbing losses in the event of liquidation or resolution of the bank (gone concern).

The CAO details the features that AT1 Instruments have to fulfil, including the following:

• The instruments must be perpetual – i.e., have no fixed maturity date and the issuer has no obligation to repay them – and the first possibility for the issuer to repay the instruments must be after at least five years;

• The instruments must not create any expectation of repayment, and holders have no right to demand repayment;

• The issuer has full discretion to defer or cancel interest under the instruments and interest payments may only be made if the issuer has sufficient distributable assets available;

• The instruments must contain contractual terms that specify a conversion into equity or a write-down of the principal amount in the event that either the CET1 ratio of the issuer falls below a predefined threshold or if the issuer reaches the point of ‘non-viability’; i.e., prior to the issuer receiving public support or if so ordered by the Swiss Financial Market Supervisory Authority FINMA (FINMA) to prevent insolvency of the issuer (each, a Trigger Event); and

• The instruments must not have any features that could hinder the recapitalisation of the issuer.

The CAO also sets the quantitative requirements for regulatory capital requirements, with more-stringent rules applying to systemically important banks, and sets out to what extent such requirements can be fulfilled with AT1 Instruments.

The takeover of Credit Suisse by UBS, which was brokered by the Swiss government after an acute crisis of confidence in Credit Suisse that resulted in many clients withdrawing their money, led to a wipeout of $17 billion of Credit Suisse's AT1 bonds in March 2023. Up to that day, Swiss AT1 Instruments were generally structured as so-called write-down instruments, exposing holders to the risk of their claims being permanently written down in full in accordance with the terms of the instrument, if a Triger Event were to materialise.

Following the March 2023 events, UBS decided to structure its newly issued AT1 Instruments in such a way that they would convert into equity of the holding company (UBS Group AG) if UBS's CET1 ratio falls below the threshold of 7%, or if UBS reaches the point of non-viability. This would ensure that, outside restructuring proceedings, holders of AT1 Instruments would receive shares in UBS Group AG instead of being fully written off. Accordingly, all AT1 Instruments that UBS Group AG has issued since March 2023 – including $3.5 billion issued in November 2023 in two series of $1.75 billion each, $1 billion in February 2024, and SGD 650 million in February 2024 (the New AT1 Instruments) – were issued under this new structure.

The US dollar instruments were issued on a Rule 144A/Reg S basis, with clearing through the Depositary Trust Company and with certain transfer restrictions applicable to shares received by holders upon a conversion of the instruments. The Singapore dollar instruments were issued on a Reg S-only basis, with clearing through SIX SIS Ltd.

To reflect a transition phase required to create the equity capital backing a potential conversion of the New AT Instruments by way of amending the issuer's articles of association (a so-called Conversion Capital Availability Event), the terms and conditions of the New AT1 Instruments included a ‘flip feature’:

• Prior to the occurrence of the Conversion Capital Availability Event, the terms and conditions of the New AT1 Instruments provided for a contingent write-down mechanism. Accordingly, if a Trigger Event had occurred prior to the Conversion Capital Availability Event, the New AT1 Instruments would have been written down to zero.

• After UBS Group AG's annual general meeting in April 2024 approved the creation of conversion capital (Wandlungskapital) and the amendments were subsequently registered with the commercial register, and, hence, a Conversion Capital Availability Event occurred, the write-down feature of the New AT1 Instruments is no longer applicable. Instead, upon the occurrence of a Trigger Event, the New AT1 Instruments now convert into shares in UBS Group AG at the conversion price set out in the terms and conditions of the relevant New AT1 Instrument.

UBS's new AT1 Instruments were received favourably by the markets, with the initial issuance of New AT1 Instruments in November 2023 being several times oversubscribed. The strong demand signalled a further sign of confidence returning to the market for AT1 instruments following the March 2023 events. Also, it confirms the viability and investor-friendliness of AT1 Instruments with a conversion feature. This does not, however, mean that AT1 Instruments with a write-down feature are a thing of the past. In fact, most Swiss banks issuing AT1s still use this structure. For example, Raiffeisen Schweiz Genossenschaft issued AT1s with a write-down feature in May 2023 and Vontobel Holding AG in September 2023.

On April 10 2024, the Federal Council (the federal government of Switzerland) issued a report that included a number of recommendations to enhance stability in the financial market (the Report). The Report analyses numerous areas, including ones affecting AT1 Instruments. Among others, it evaluates:

• The effectiveness of the Swiss regulatory framework;

• The role of AT1 Instruments in the Credit Suisse crisis:

• Potential changes in the regulatory treatment of AT1 Instruments; and

• Potential reforms of AT1 Instruments.

Acknowledging that AT1 Instruments are an important component of the regulatory capital framework and that Swiss regulations applicable to AT1 Instruments are aligned with the international standards set by the Basel Committee on Banking Supervision, the Federal Council evaluated, but does not propose to further pursue, the following measures:

• Limiting AT1 Instruments to instruments with an equity conversion rather than a write-down feature; this measure, however, would not improve the risk-absorbing capacity of AT1 Instruments; and

• Replacing AT1 requirements with corresponding CET1 requirements.

On the other hand, the Report also raises several criticisms and challenges of AT1 Instruments, such as:

• The instruments did not adequately contribute to stabilising Credit Suisse during its ongoing crisis as, due to market expectations (the disappointment of which could have had a fatal impact in a period of volatility), Credit Suisse did not suspend interest payments and replaced AT1 Instruments for which the first call date had occurred with newly issued AT1 Instruments without being obliged to do so;

• The instruments (and Credit Suisse's other regulatory capital) could not prevent or stop a bank run despite the bank meeting the regulatory capital requirements (as was also confirmed by FINMA and the Swiss National Bank) when investors and depositors lost confidence in the bank and withdrew their assets;

• The instruments created complexity and opacity in the capital structure and the risk profile of Credit Suisse, as investors in the instruments did not fully appreciate the features and terms of the instruments; and

• While, for Credit Suisse, the regulatory requirements of AT1 Instruments demanded a write-down or conversion if the CET1 ratio falls below 7%, markets had already lost confidence in the survivability of Credit Suisse prior to that threshold being reached.

The Report considers that AT1 Instruments should contribute more effectively to a bank's resilience in ongoing operations (going concern), rather than only in resolution (gone concern). The report considers a number of measures to strengthen the resilience and stability of systemically important banks related to AT1 Instruments, including the following:

• Strengthen the risk-bearing function of AT1 Instruments on a going-concern basis (e.g., clear criteria for suspending coupon payments) in line with international efforts;

• Increasing the trigger point for conversion or write-down in line with international efforts in order to ensure that AT1 Instruments can effectively absorb losses before a bank approaches the point of non-viability; and

• The continuation of the exemption of AT1 Instruments from the Swiss withholding tax regime to maintain competitive conditions for Swiss issuances, while monitoring international developments and the potential impact on the Swiss tax revenue.

The Report concludes that, in accordance with international endeavours, the primary focus in reforming the rules applicable to AT1 Instruments should be to strengthen the risk-absorbing capabilities of AT1 Instruments in a going-concern scenario; e.g., by way of prohibition of interest payments or issuer calls of AT1 Instruments if the issuer suffers going losses.

The market for AT1 Instruments has seen important innovations since the wipeout of $17 billion of Credit Suisse's AT1 bonds in March 2023 that accompanied the government-brokered takeover of Credit Suisse by UBS. In particular, newly designed AT1 Instruments providing for an equity conversion feature on the occurrence of a Trigger Event were received favourably by the markets, signalling a further sign of confidence returning to the market for AT1 Instruments.

The recent report by the Swiss Federal Council identified a number of potential measures to strengthen the risk-bearing function of AT1 Instruments on a going-concern basis. However, in the view of the authors, any potential changes to the current framework will need to be carefully evaluated, including considering their potential impact on the market for such instruments and compatibility with international standards.