One of the reasons why European banks have been the main issuer of AT1 bonds is that the return profile on common equity has been so disastrous that it has not been a viable capital source unless a bank has been willing to issue capital at a high cost of capital. AT1 bonds have functioned as a bridge and vehicle to create tier 1 capital. Investors have been keen on investing in AT1 bonds, and especially in global systemically important banks because there has been this implicit idea that governments would only allow shareholders to loss everything. The risk-reward ratio has thus been seen as quite good for AT1 bondholders. As the return chart from Lazard Asset Management shows is that the capital structure return profile has been distorted. Bank equity, as the most risky part of the capital structure, should have yielded a higher return than AT1 bonds but it did not, indicating that the European banking system is structurally unsound from an investor point of view.
For those that want to educate themselves even more on AT1 capital we can recommend these two short notes from Lazard Asset management:
Focus on the AT1 Market – Part 1
Focus on the AT1 Market – Part 2
It should be noted, that in May 2022, Fitch Ratings wrote a note about the existential crisis in Europe over AT1 bonds as European supervisors are leading discussions about a capital stack redesign with a focus on common equity tier 1 capital. In other words, the EU regulators are acknowledging that the current system is not optimal. But how to get increase the emphasis on common equity tier 1 capital when European banks’ return on equity is so low relative to the cost of equity?
European banks have the highest risk
Under the Basel III framework banks’ leverage ratio is defined as the capital measure (tier 1 capital) over exposure measure (risk-weighted assets). The total regulatory capital includes tier 1 (CET1 + AT1) and tier 2 capital and most be minimum 8% implying a maximum leverage of 12x, but this is under assumption of course that the risk-weighting framework is set correctly and work linearly across all risk scenarios; we would argue that it is not the case and thus the system has an implicit hidden risk.