BoE puts AT1 through its paces with most severe tests yet

By Alice Gledhill

LONDON, Nov 30 (IFR) - UK banks' Additional Tier 1 bondswould be fair game and converted into equity if they hit severeproblems, the Bank of England's most stringent stress tests yetshowed on Wednesday.

This year's test was the third annual healthcheck by theBank of England's Prudential Regulation Authority (PRA) and wasmore severe than in 2014 and 2015. It was the first based on thecentral bank's new approach to stress testing, which includespotential misconduct costs.

It is the first test in which the UK regulator theoreticallyconverted the instruments as a way of getting banks back to astronger footing, a clear reminder for investors of thepotential losses posed by holding this type of debt.

New regulation following the last financial crisis hasforced lenders across Europe to beef up their stock of lossabsorbing capital in recent years.

By end-2015, the seven participating banks had issued acombined £23bn of AT1, which in the case of UK lenders convertsinto equity if a bank's Common Equity Tier 1 (CET1) ratio dropsbelow 7%.

The CET1 ratios of RBS, Barclays and Standard Chartered allslipped below 7% in the stress scenario, forcing thehypothetical conversion of their AT1 bonds.

In the case of the latter two, that helped pushed their CET1ratios back over the hurdle rate, to 8.3% and 7.2% respectively.

RBS fared worse. Its CET1 ratio only clawed back to 6.7%even after its AT1 was converted, but the bank has alreadysubmitted an updated capital plan to the PRA.

"The conversion of AT1 was a positive development insofar asit reflected increased amounts of such loss-absorbing capacityon some banks' balance sheets," the Bank of England said.

"Banks for which AT1 converted in the stress were moreresilient, all else equal, than if they had not issued AT1instruments."

NAILED

The focus on AT1's ability to absorb losses serves as atimely reminder of the risks posed by the asset class, whichsuffered a violent sell-off earlier this year simply on fears ofcoupon suspension.

"To me it's pretty clear that as an AT1 holder, the BoE willnail you," said one investor. "Some people don't always thinkthat way. It's interesting because if you think about it, RBShasn't really been that volatile."

All three banks have already taken further action over 2016,not taken into account by the tests, which reduces theprobability of breaching the trigger. RBS has issued a further£2bn of AT1 since December 2015, for example.

AT1 bonds were narrowly trading up by late morning,reflecting that progress.

A Barclays US$1.5bn 7.875% callable in March 2022 ralliedfrom 97.75 to 98.2, while an RBS US$2.65bn 8.625% callable inAugust 2021 initially dropped half a point to 97.3 beforeclimbing to 98.2, for example.

The fact that its capital plan has already been approved bythe PRA, coupled with already depressed valuations across RBS'capital structure, means the impact on credit spreads is likelyto be very limited, BNP Paribas analysts wrote in a note.

But people "definitely forget" that the debt can be writtendown, said Filippo Alloatti, a senior credit analyst at HermesInvestment Management.

"It carries some weight if you see that in an officialdocument, within an exercise by the Bank of England. 7%, to someextent, is far away, but it's still pretty high."

UK AT1 bonds are more punishing for investors than themajority of European jurisdictions where bonds are structuredwith a 5.125% trigger, reducing the chance of conversion.

"I think it underlines the value of having high trigger AT1instruments," said Roberto Henriques, European credit analyst atJP Morgan. "I think that this might end up with the sectormoving to high trigger AT1 structures." (Reporting by Alice Gledhill, editing by Helene Durand, SudipRoy)