The Basel III framework improved capital adequacy requirements, enhanced regulation, and bettered transparency to address the issues arising from the financial crisis 2008. In India, the RBI is responsible for regulating banks. It has been implementing the Basel III norms from 2013 in phases. This will ensure that Indian banks adhere to international standards. More importantly, it makes the banking system more resilient. It will be able to absorb losses, withstand financial/ economic stress, and continue operations.
Capital adequacy was a key feature in these norms. In simple terms, it measures the financial health of a bank. It is the ratio of the bank’s capital (funds) to its assets (i.e. loans and investments). Tier 1 Capital was dedicated to these requirements. Tier 1 Capital is further split into common equity capital and additional tier 1 Capital (AT1). Common equity capital consists of shares and reserves. AT1 consists of perpetual instruments.
AT1 Capital is further classified into PNCPS (Perpetual Non-Convertible Preference Shares) and perpetual debt. Preference shares are similar to equity shares, however, owners are given a specific payout instead of a portion of the profits. In an insolvency scenario, preference shareholders will be paid before equity shareholders.
Both AT1 instruments have no maturity. These instruments are issued by the bank directly and not through other entities. The interest rate/ coupon may be fixed or floating. Interest and dividend payments are non-cumulative, i.e. if the bank’s finances don’t support this outflow it does not have to pay. Further, when it’s financial position improves, it is not obligated to pay unpaid interest from previous periods. As far as the perpetual debt is concerned, even the repayment of principal is not guaranteed.
The purpose of Tier 1 Capital is to absorb losses, if any, from risky transactions. Therefore, debt instruments issued under AT1 Capital can be converted to equity in times of financial stress.
AT1 instruments offer higher returns. It is important to note that they are not pure debt instruments because they may be converted into equity shares. Interest/ dividends and even principal repayment are not guaranteed. These investments are suitable to aggressive debt investors, who are open to their investments being converted to equity.