AT-1 Bonds

Recently, the private lender YES Bank additional tier 1 (AT1) bonds worth Rs. 8,415 crore have been written down to zero by the Reserve Bank of India(RBI) under the scheme of reconstruction of Yes Bank.

AT-1 bonds are unsecured perpetual bonds — with no maturity — issued by banks to shore up their capital base to meet Basel III requirements.The RBI is the regulator for these bonds.
The concept of Additional Tier-1 (AT1) Bonds was introduced by Basel III post the 2008 financial crisis, to protect depositors of a bank on a going concern basis. These bonds are also commonly known as Contingent convertible capital instruments (CoCos).
Under the Based III framework, bank’s regulatory capital is divided into Tier 1 and Tier 2 capital. Tier 1 capital is subdivided into Common Equity (CET) and Additional Capital (AT1).
In simple terms, equity and preference capital is classified as CET and perpetual bonds are classified as AT1. Together, CET and AT1 are called Common Equity.

Tier 1 capital is a bank's core capital and includes disclosed reserves—that appears on the bank's financial statements—and equity capital. This money is the funds a bank uses to function on a regular basis and forms the basis of a financial institution's strength.
Tier 2 capital is a bank's supplementary capital. Undisclosed reserves, subordinated term debts, hybrid financial products, and other items make up these funds.
In India, banks are required to maintain capital at a minimum ratio of 11.5 per cent of their risk-weighted loans.
Of this, 9.5 percent needs to be in Tier-1 capital and 2 percent in Tier-2.

AT1 are a special category of debt designed to absorb losses in case the bank’s equity capital dips below a certain threshold.
These are quasi-equity instruments. These are meant to be like equity, but are structured as bonds.
These bonds are listed and traded on the exchanges.So, if an AT1 bondholder needs money, he can sell it in the market.
Banks cannot use conversion or write down of AT1 instruments to support expansion of balance sheet.

As these bonds are perpetual and carry no maturity date, they carry call options that allow banks to redeem them after five or 10 years.
Banks can stop paying interest on them and also write off their value.
In case, if the RBI feels that a bank is tottering on the brink and needs a rescue, it can simply ask the bank to cancel its outstanding AT-1 bonds without consulting its investors. This is what has happened to YES Bank’s AT-1 bond-holders.

According to the RBI’s Basel III capital regulations, if the relevant authorities decide to reconstitute a bank or amalgamate it with any other lender under Section 45 of Banking Regulation Act, 1949, the bank will be deemed as non-viable or approaching approaching non-viability.
The RBI has also added an additional trigger in Indian regulations, called the ‘Point of Non-Viability Trigger’ (PONV), which gives power to the RBI to 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 and 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.
The PoNV condition requires all AT1 and Tier 2 instruments to be capable of being converted into common equity or written off.

It is an international regulatory accord that introduced a set of reforms designed to improve the regulation, supervision and risk management within the banking sector.
It was published in 2009, largely in response to the credit crisis associated with the Great Recession.

Objectives

Improve the banking sector's ability to absorb ups and downs arising from financial and economic instability
Improve risk management ability and governance of banking sector
Strengthen banks' transparency and disclosures

Impact on Investors

RBI’s write-down of Yes Bank AT1 bonds will not only be detrimental to the financial interests and may cause panic redemptions in situations where it is not warranted, it will severely affect investor’s confidence in debt markets and financial institutions.
This could also result in the contraction of the investor base in these bonds, as many would seek to avoid these bonds in future.

Impact on Banking and Financial System

Any write-down on existing AT1 bonds will set a wrong precedence as it may lead to drying up of the AT-1 market in India completely for all issuers, especially in light of the fact that the banking system seems to be under stress.
Any negative impact on these bonds could also increase the credit spreads across the assets classes and would have a detrimental impact on RBI’s objective of transmission of rate cuts to the larger economy.