Reshaping Bank Capital: The Evolving Role of Additional Tier 1 Instruments

On 11 December 2025, the ECB’s Governing Council endorsed recommendations from its High-Level Task Force on Simplification to streamline the EU’s prudential regulatory, supervisory, and reporting framework for banks. These proposals aim to reduce complexity while maintaining financial resilience, including fewer elements in risk-weighted asset and leverage ratio calculations. They also introduce a materially simpler prudential regime for smaller banks, expanding on the existing EU framework. Additionally, the ECB published a report titled “Streamlining supervision, safeguarding resilience,” outlining ongoing initiatives to enhance the efficiency, effectiveness, and risk-focus of European banking supervision. These recommendations will be presented to the European Commission ahead of its 2026 report on the EU banking system. The Governing Council also urges swift completion of the Banking Union and the Savings and Investment Union to eliminate national fragmentation and foster more efficient capital markets across the EU.

Current Challenges in Bank Capital Structures

Banking regulations impose two main types of capital requirements:

• Going-concern: To maintain bank solvency during normal operations.
• Gone-concern: To absorb losses and facilitate recapitalization in case of failure.

Each type includes risk-based requirements (tied to risk-weighted assets, RWA) and non-risk-based requirements (based on total unweighted assets). This results in a complex capital stack that combines going/gone-concern and risk/non-risk-based elements, each comprising different components, buffers, and requirements.

Moreover, the effectiveness of Additional Tier 1 (AT1) bonds as a source of crisis capital is debated. Designed to absorb losses early—via triggers like low capital ratios—to protect taxpayers and senior creditors, they often trigger too late in practice or are bypassed by regulators, yielding unpredictable outcomes. A major criticism is the inversion of creditor hierarchy: in Credit Suisse (2023) and Yes Bank (2020), regulators fully wrote down AT1 bonds (CHF 16 billion/~USD 17 billion for Credit Suisse; ~₹8,400 crore for Yes Bank) while shareholders received value or compensation, violating the norm that equity absorbs losses first. This discretionary approach in emergency resolutions has damaged investor confidence, triggered lawsuits—including a 2025 Swiss Federal Administrative Court ruling deeming Credit Suisse’s write-down unlawful (currently under appeal)—and underscored AT1s as riskier than intended. More importantly, AT1 has not been effective in preventing banks from transitioning from going-concern to gone-concern status.

EU Proposals to Simplify Capital Requirements

One recommendation from the governing council seeks to simplify banks’ capital requirements and buffers—known as the capital stack—by consolidating multiple existing buffers into two layers and streamlining the leverage ratio framework. The proposed changes include:

• Merging current capital buffers into two main layers:
  • Non-releasable buffer: Combines the capital conservation buffer (CCB; 2.5% of RWA, CET1 quality) with the higher of the G-SII buffer (up to 3.5% of RWA, CET1) or O-SII buffer (up to 3% of RWA, CET1). This buffer is fixed and cannot be reduced in crises.
  • Releasable buffer: Combines the countercyclical capital buffer (CCyB; 0–2.5% of RWA) and the systemic risk buffer (SyRB; jurisdiction-dependent). Authorities can reduce or release it during downturns.
• Streamlining the leverage ratio framework from four elements to two: a 3% minimum requirement and a single buffer (potentially set to zero for smaller banks), while preserving supervisory powers.

Pillar 2 guidance remains separate, non-binding, and sits atop the releasable buffer.

The four elements of the EU’s current leverage ratio framework are:

1. The 3% minimum leverage ratio requirement (Pillar 1, the Basel-standard binding minimum).
2. The G-SII leverage ratio buffer (an additional requirement for global systemically important institutions, set at 50% of their risk-based G-SII buffer).
3. Pillar 2 Requirement for leverage ratio (P2R-LR, a supervisory add-on to address excessive leverage risk).
4. Pillar 2 Guidance for leverage ratio (P2G-LR, non-binding supervisory expectation).

These extra EU-specific layers (particularly the P2R-LR and P2G-LR add-ons) make the framework more complex than the Basel III standard, which has only two: a minimum requirement and a G-SIB buffer.

The ECB proposes streamlining to two elements of the leverage ratio: 1) the 3% minimum requirement and 2) a single consolidated buffer (potentially set to zero for smaller banks, with a floor for G-SIIs), by merging or adjusting the EU-specific add-ons while preserving resilience and Basel compliance.

To boost bank capital quality while staying Basel-compliant and preserving resilience, the council proposes to:

1. Strengthen Additional Tier 1 (AT1) instruments, so they better absorb losses during normal operations, or
2. Remove non-equity elements (like AT1) from the going-concern capital requirements, provided overall capital levels and Basel rules remain unchanged.

In the first option, the council suggests improving the features of AT1 instruments to better ensure their loss-absorbing capacity in going-concern scenarios and to provide clearer information to banks and investors about these features. This approach would stay Basel-compliant without changing the role of AT1 (or Tier 2) instruments, thus maintaining the overlap with gone-concern requirements.

However, many details remain pending on how the regulator will implement this simplification, creating uncertainty—particularly for AT1 instruments. As AT1 is already going-concern capital, it will be interesting to see what additional features or adjustments the council proposes.

Global Perspectives: Australia’s Reform Path

Australia leads in reforming bank capital quality. In December 2024, the Australian Prudential Regulation Authority (APRA) confirmed plans to phase out Additional Tier 1 (AT1) instruments—also known as hybrids or contingent convertible bonds (CoCos)—with the new framework effective from 1 January 2027 and all existing AT1 expected to be replaced by 2032.

Australian banks must replace AT1 with more reliable capital forms: 1) Larger, internationally active banks: Replace the 1.5% AT1 allocation with 1.25% Tier 2 and 0.25% CET1. 2) Smaller banks: Fully replace AT1 with Tier 2 capital, along with reduced Tier 1 requirements.

APRA justifies the phase-out for the following reasons:

1. Enhanced crisis management, with more reliable capital that absorbs losses effectively and reduces risks of contagion, complexity, and legal challenges.
2. Lower capital and compliance costs for smaller banks, including reduced Tier 1 requirements.
3. Simplified regulations by eliminating a complex instrument that imposes high design, issuance, and marketing costs, particularly on smaller institutions.

Australia stands out due to the material ownership of AT1 instruments by retail investors. This structure heightens regulators’ concerns about triggering write-downs, given potential public backlash and broader systemic impacts—complicating crisis decision-making and undermining the bail-in mechanism’s intended purpose.

Future Outlook for AT1 and Bank Capital Quality

Phasing out AT1 instruments or materially reducing their role in going-concern capital would likely create significant supply pressure on Tier 2 bonds, as banks seek to replace them with higher-quality alternatives—such as CET1 or Tier 2—to meet regulatory capital requirements.

Australia’s APRA phase-out serves as a practical example: it requires approximately A$22 billion in new Tier 2 issuance to partly replace around A$38 billion in outstanding AT1, significantly increasing annual Tier 2 supply from major banks and shifting greater reliance onto these instruments. Similarly, under the ECB’s proposed reforms, the more radical option of eliminating AT1 could drive increased Tier 2 usage. However, the primary focus remains on enhancing rather than removing AT1, and no immediate market reaction has been observed.

AT1 bonds have long been a compelling option for yield-seeking investors, offering superior returns relative to other capital instruments. Recent regulatory developments have not prompted any downgrades from credit rating agencies. Despite their inherent structural complexities and subordinated status, hybrid securities issued by highly rated banks have continued to perform strongly in secondary markets, delivering attractive risk-adjusted returns.

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