ADDITIONAL tier-1 (AT1) or contingent convertible bonds (CoCos) were designed in the wake of the 2008 global financial crisis to provide sufficient capital to banks, reduce their risk of failure and ensure that investors rather than taxpayers bear the costs of rescuing a failing lender.

They are thus a hybrid instrument with both equity- and debt-like features.

Three critical features distinguish them from bonds — a perpetual tenor, non-cumulative, discretionary coupon payments and loss-absorption features that require either a conversion into equity in times of stress or a simple write-down of the bond’s value, ensuring that investors incur the costs of bailing in (as opposed to governments and ultimately taxpayers bailing out) distressed lenders.

Therefore, they have the acronym of ‘CoCo’ as conversion is contingent on specific capital triggers being breached.

AT1s are also deeply subordinated instruments being senior only to outright equity holders and therefore, given all of the above-mentioned risks, priced far wider than senior unsecured debt issued by the bank.

In return for raising such expensive money, banks’ balance sheets benefit by central banks and rating agencies treating such debt as part of tier-1 capital. The latter represents a bank’s core capital and is comprised primarily of its equity stock, retained earnings, disclosed reserves and minority interests.

Additionally, AT1 is a way of raising non-dilutive capital which would be the case if common equity were issued, and in jurisdictions where debt issuance benefits from tax shields (Asia and Europe), it can be classified as long-term debt.

Therefore, despite the costs, AT1s add balance sheet brawn, can potentially enhance ratings as a source of long-term capital and can preserve shareholding structures owing to their non-dilutive nature.

The added advantage of transferring the burden of financial rescue to investors has made these instruments well liked by regulators until recently. Since their introduction in 2012, their issuance in Europe has ballooned to almost 100 billion euros ($122bn), while the Asia-Pacific region led by China, Japan and India has aggregated $142bn out of the global issuance of $331bn.

Interestingly, there has been no issuance in the United States since these instruments are treated as equity rather than debt and therefore do not benefit from any tax advantage.

Pakistan is likely to witness a spate of AT1 issuance in the wake of the successful combined placement of Rs14 billion from two commercial banks. It is therefore important that all stakeholders are cognisant of the issues that have arisen in the aftermath of sustained issuance in developed markets.

Regulators need to better define the events where a bank could suspend coupon payments. Currently in Pakistan, there is a ‘going concern’ trigger when a bank’s tier-1 capital falls below 6.625 per cent of its risk weighted assets (RWAs) and a ‘gone concern’ trigger which is to be determined by the State Bank of Pakistan (SBP).

Given that all banks in Pakistan are required to maintain combined capital (inclusive of tier 1 and tier 2) of 11.9pc in 2018 and on average maintain tier-1 capital at 12.7pc of RWAs, it is most likely that regulatory action will be pre-empted much before the trigger levels are reached.

In cases where institutions have reached a ‘point of non-viability’, such triggers remain undefined. In retaining maximum flexibility, central banks have inevitably created uncertainty about exercising triggers and any singular activation for a systemically important bank could precipitate a mass withdrawal of capital, destabilising the wider banking system.

The European Commission has recently drawn up proposals to clarify the ‘maximum distributable amount’ that also govern when a bank can pay coupons on such instruments. The dilemma is to balance greater pay-off predictability, which in turn benefits more accurate valuation, with regulatory discretion that treats each bank on an individual basis and improves management of systemic risk.

However, uncertainty appears embedded into the instrument. In February 2017, fears about Deutsche Bank’s viability prompted a sell-off in their AT1s, heavy declines in their share price and stalled issuance in the entire market for CoCos.

Even though the market has subsequently recovered, investors have become more aware of the instruments’ true nature which combines the limited upside of a bond with the potentially unconstrained downside of equity.

It is, therefore, imperative that investors that still comprise institutional buyers in Pakistan’s nascent market conduct robust due diligence on what they are buying. In a developing market, it is also incumbent upon regulators to ensure that robust disclosure standards are met.

Rating agencies also have a critical role to play in effectively determining credit risk and ultimately pricing.

Given the deeply subordinated nature of the instrument and the inherent risks explained above, CoCos represent a form of mezzanine debt or quasi-equity and are therefore in more mature markets, commonly rated significantly below the issuer’s senior, unsecured securities. Consequently, investors in such markets have come to expect near equity-like returns.

Finally, the SBP needs to sensitise its regulation to cater to issuance by Islamic banks which remain one of the most under-capitalised segments of the market and therefore potentially heavy users of the instrument. In particular, the requirement for non-cumulative profit payments causes Sharia issues and a way forward that balances such concerns with regulatory pre-requisites needs to be found.

The writer is a financial sector expert with the World Bank

Published in Dawn, The Business and Finance Weekly, March 5th, 2018