Thursday 11 July 2013 by Legacy

European bank Tier 1s - EBA clarification reduces call risk

There has been some uncertainty under European regulation regarding whether callable bank Tier 1 securities will or won’t be included as Tier 2 capital once they have stepped up at their call date. This is potentially important as it has implications for a bank’s call decision: if securities still have some capital weighting past their call date, this may give banks impetus to leave them outstanding.

This point has now been clarified. The European Banking Authority (EBA) released confirmation on 4 July that stepped up old style hybrid Tier 1 securities would not qualify as new style additional Tier 1 capital and goes on to exclude its eligibility as grandfathered or new style Tier 2 capital.

The confirmation of this point supports a relatively positive view of call likelihood on existing step up Tier 1 securities in Europe, since the only reason to leave them outstanding will be as cheap funding in cases where the stepped up cost remains low versus current senior new issue spreads. If left outstanding, they would remain legally subordinated and continue to provide a cushion to senior creditors in the event of bail-in or bankruptcy, but they would not be included in any form of regulatory capital.

The following is the full explanation taken from the EBA's website

Question: “What will be the treatment of an Additional Tier 1 (AT1) instrument structured with a first call date and one step up after 5 years prior to 1 January 2013, callable quarterly thereafter at every interest payment date without any step up (subject to supervisory approval)? Is the instrument eligible for grandfathering if not called at the first call date? If the instrument is derecognized as AT1 on 1 January 2013, can it be included into Tier 2 and, if so, what amount will be eligible (full amount or gradually phased out amount)?"

Answer: “The eligibility for grandfathering of both innovative and non innovative instruments is determined in accordance with the provisions of Regulation (EU) No 575/2013.

For instruments with an incentive to redeem, Article 489 applies. As a general principle, instruments formerly issued with an incentive to redeem shall be eliminated from regulatory own funds at their effective maturity date (the first call date) if they do not fully comply with the criteria of Article 52 after the effective maturity date. The fact that the instrument is not called does not mean that the instrument may be reclassified as an instrument without an incentive to redeem. Due to the existence of subsequent quarterly calls, the instrument does not meet fully the criteria of Article 52 and in accordance with the provisions of Article 489 (4) of Regulation (EU) No 575/2013, the instrument described above will be fully disqualified from AT1 after the first call date.

As an exception to the general principle outlined above, instruments where the first call date associated with an incentive to redeem took place before 31 December 2011 but the institution did not exercise the call on the instrument, will be grandfathered according to provisions foreseen by Article 489 (6) and phased out according to Article 486 (5) of Regulation (EU) No 575/2013. The same reasoning holds true for Tier 2 instruments with similar features (Article 490 (6) of Regulation (EU) No 575/2013).

In addition, because in particular of the quarterly call, the instrument would not meet the eligibility criteria for inclusion in fully eligible Tier 2 capital. It would also not meet the eligibility criteria for inclusion in grandfathered Tier 2 capital as foreseen under Article 484 (5) of Regulation (EU) No 575/2013.”