Credit Suisse, Yes Bank legacy: Tense future for AT1 bonds

After the fall of Credit Suisse, a Global Systemically Important Bank (GSIB), the fate of yet another instrument put in place after the 2007-08 crisis to prevent bank runs now hangs in balance. Called Additional Tier 1 (AT1) bonds, this is a Basel III tool to generate adequate capital for banks to ensure they "absorb shocks" arising from financial and economic stress, reducing the risk of spillover from the financial sector to the real economy. This is meant to prevent the 2007-08-like massive taxpayer-funded bailouts.

But it may soon become irrelevant. In both the Credit Suisse and Yes Bank cases, the first response of their respective regulators and governments was to write it off by inversing the protocol laid down for their treatment in crisis – in which AT1 bond holders are protected (higher in the "order of seniority") ahead of equity holders. The contrarian action, which would be clear soon, is at the heart of current turmoil in AT1 bond markets of Europe and India.

On the one hand, the Credit Suisse's AT1 bond investors are preparing for a lawsuit, on the other, European market regulators (of which Swiss FINMA is not a part) and Bank of England have rushed to assure their AT1 investors that their interest would take precedence over equity holders in case of a similar crisis. In India, those of the Yes Bank, which collapsed and the RBI took over for its "reconstruction" in 2020, are currently challenging the write-off in the Supreme Court.

If the Supreme Court upholds their interest and strikes down the write off – as did Bombay High Court ("quashed and set aside") in January 2023 and put it on hold for six weeks, which the apex court extended further – AT1 bond may survive. If not, it is unlikely that banks would sell AT1 bonds or investors would go for it.

Before going further, here is a brief on AT1 bonds to understand what is happening.

What is AT1 bond?

AT1 bond is meant to shore up Tier 1 capital of banks – paid-up equity capital, disclosed reserves (like NPA provisioning) and surplus etc. which are used for regular banking operations "without triggering bankruptcy" (also called "going-concern capital"). Tier 2 capital (also a regulatory or mandatory requirement like Tier 1 capital) is a bank's supplementary capital to absorb losses "only in a situation of liquidation of the bank" ('gone-concern capital") – as the RBI explains.

AT1 bond is a perpetual (no maturity date) debt instrument, higher-interest yielding (for example, Yes Bank offered 9-9.5% interest on it when FD rate was 6.5%) and higher-ticket size (of ₹1 crore and above for Yes Bank). But it is also highly risky because it can be converted to equity (market determined return) or written down (value reduced) and is also not protected by deposit insurance.

Hence, the RBI discourages individual investors (HNIs) and put stiff conditions while permitting it in 2014, and market regulator SEBI completely banned it for individuals in October 2020 and allows only qualified institutional buyers (QIBs) to invest as they are capable of appreciating the high-risk better.

Turmoil over Yes Bank's AT1 write-off

The Yes Bank had collapsed in 2020 after a series of scandals involving questionable investments (including in the IL&FS and DHFL both of which collapsed too), high upfront charges, high and undisclosed NPAs and multiple banking frauds like money laundering.

The RBI announced a moratorium on the Yes Bank (stopping it from making any payment to any depositors or discharge any liabilities to any creditors) on March 5, 2020. The next day, on March 6, 2020, it appointed an "administrator" for the bank. It released a "draft" scheme of the bank's reconstruction on the same day (March 6, 2020). This "draft" provided for writing off the AT1 bonds. But the "final scheme" of reconstruction, notified later on March 13, 2020 with the Central government's approval, "deleted" this provision.

But a day later, on March 14, 2020, the Yes Bank's "administrator" wrote off the AT1 bonds valued at ₹8,415 crore (issued in 2016 and 2017).

The Bombay High Court "quashed and set aside" this write-off on January 22, 2023. It said (i) the "final scheme" of March 13, 2020 "did not authorise Administrator to write off the AT-1 bonds" and (ii) the administrator "exceeded his powers and authority...after the bank was reconstructed on March 13, 2020".

In fact, the judgement records that at one time the RBI had, in a note to the Central government, "proposed to balance the interests of all stakeholders and in fact proposed conversion of the said AT-1 Bonds and a decision was taken to write-down the same". Note, a "write-down" (value reduced) is different from "write off" (value reduced to zero).

So, why did the RBI not act against the administrator and undo the write-off? This will remain a mystery and the role of the Central government, directly or indirectly, can't be ruled out. Interestingly, the judgement notes that the "administrator" didn't write off the first tranche of ₹280 crore of AT1 bonds (at 10.5% interest) issued in 2013 and offered "no reason" to explain "this discrimination".

The Yes Bank's misdeeds extended to its AT1 bonds too.

On April 21, 2021, SEBI issued an order holding the bank guilty of (i) "fraudulent acts" in facilitating "down-sale" of AT1 bonds issued in 2016 and 2017, from the institutional investors to its own "hapless and unsuspecting customers" (ii) "lured" the customers through "misrepresentation and fraud", making some of them "to alter their position from FDs to these AT1 bonds" by presenting the AT1 bonds as "super FDs" yielding much higher interests. The SEBI further said this "devious scheme to dump the AT1 bonds" continued till 2019 (iii) despite knowing "that the financial status of YBL had become unviable", leading to "writing down of these AT1 bonds". It imposed heavy penalty, including ₹25 crore on Yes Bank.

The SEBI found 1,346 individuals had bought the AT1 bonds (₹697 crore), of which 1,311 (more than 97%) were "existing customers" of the bank (who invested ₹663 crore); 277 customers had their FDs "prematurely closed" for this (₹80 crore) and many of these customers were "of advanced age of more than 70/80/90 years".

Yes Bank has not challenged this SEBI order (Bombay High Court order said).

Write-off of AT1 violates RBI guidelines and Yes Bank protocol

Coming back to the write-off, the Yes Bank told the NSE and BSE in March 2020 that it went by the Clause 2.15 of the RBI's 2015 "Master Circular – Basel III Capital Regulations". But this Clause says: "If the relevant authorities decide to reconstitute a bank or amalgamate a bank…the AT1 instruments will be fully converted/written-down permanently before amalgamation/reconstitution in accordance with these rules." The RBI also provides the protocol for this "fully converted/written-down" (called the "order of seniority") in Clause 2.10, which says: "If a bank goes into liquidation before the AT1 instruments have been written-down/converted, these instruments will absorb losses in accordance with the order of seniority indicated in the offer document and as per usual legal provisions governing priority of charges."

The "offer document" here is the Yes Bank's "Information Memorandum" for AT1 bond offers – a statutory contract. The Bombay High Court says, Clause 4 of this document lays out that "the claims of the bond holders in the bonds shall be superior to the claims of the investors in equity shares and perpetual non-cumulative prescribes shares issued by the bank".

Thus, the AT1 bond investors should have got protection (conversion to equity or write down), not written off. Now the Yes Bank and RBI have challenged the Bombay High Court order, which is now being heard by the Supreme Court.

In this (SLP), the RBI has justified the write-off (contrary to its own "final scheme" of reconstruction and its 2015 guidelines) by arguing: (a) so that "the capital provided by the public sector is not diluted" (b) the SBI "may not have even agreed to invest the money if the loss absorbent bonds were not to be written off" and (c) there would be "dilution" of SBI's money. In an earlier affidavit to the Madras High Court, the RBI had said (d) the AT1 investors "reaped high financial rewards" earlier and hence, shouldn't "shift the onus of loss upon RBI".

At the time of its takeover by the RBI, the SBI and seven other banks had pumped in ₹10,000 crore, of which the SBI's share was ₹6,050 crore. The AT1 bonds written off were worth ₹8,415 crore.

Turmoil in Europe over AT1 bonds

A similar thing has happened in the Credit Suisse case.

The Swiss authorities turned the protocol upside down, writing off $17.5 billion of AT1 bonds but ensuring that the equity holders get $3.23 billion (UBS's acquisition price), that is 37% of $8.7 billion market value of Credit Suisse at the time.

The Swiss regulator FINMA, in its communication on March 23, 2023 said what was the protocol: "AT1 instruments in Switzerland are designed in such a way that they are written down or converted into Common Equity Tier 1 capital before the equity capital of the bank concerned is completely used up or written down." This is what is the case with Yes Bank too (a global practice).

And then it employed clever wordplay to justify the reversal: "The AT1 instruments issued by Credit Suisse contractually provide that they will be completely written down in a "Viability Event", in particular if extraordinary government support is granted. As Credit Suisse was granted extraordinary liquidity assistance loans secured by a federal default guarantee on 19 March 2023 ("viability event"), these contractual conditions were met for the AT1 instruments issued by the bank."

Seemingly unconvinced by its own argument, it added that the reversal could happen because of the Swiss government’s Emergency Ordinance of March 19, 2023: "The Ordinance also authorises FINMA to order the borrower and the financial group to write down Additional Tier 1 capital."

Expectedly, the move spooked the European AT1 bond market (valued at $250-275 billion), forcing the EU banking regulators and Bank of England to immediately distance themselves (although they welcomed the Swiss move to save the bank) and declared unequivocal support for their AT1 investors.

On the very next day, March 20, 2023, the EU regulators, of which the Swiss FNMA is not a part, said: "...common equity instruments are the first ones to absorb losses, and only after their full use would Additional Tier 1 be required to be written down. This approach has been consistently applied in past cases and will continue to guide the actions of the SRB (Single Resolution Board) and ECB (European Central Bank) banking supervision in crisis interventions."

The Bank of England too said the UK "has a clear statutory order" in which shareholders and creditors would bear losses in which AT1 instruments "rank ahead" of equity investments, adding that it had followed this process in the unwinding of SVB's UK unit.

True, neither the status of GSIB (tighter oversight and monitoring) nor the Basel III norms (tighter banking norms and higher capital mobilisation through AT1 bond) could save the Credit Suisse from collapsing. As explained earlier in the Fortune India article "SVB Bank crisis: India's vulnerabilities and the deep malaise in US banking system", the real causes lie in the broader (neoliberal) economic framework governing the world; mere tinkering like GSIB, Basel III, AT1 bond wouldn't help. The turmoil over AT1 bonds is more like a shadow-boxing.