A regulatory capital instrument is a share or security issued by a bank that meets the legal conditions to count towards its regulatory capital. Under Basel III, eligible instruments fall into three tiers: Common Equity Tier 1 (CET1), mainly ordinary shares; Additional Tier 1 (AT1), mainly perpetual securities that can be written down or converted into shares; and Tier 2, mainly long-dated subordinated debt. Each tier has strict criteria designed to make sure the instrument really absorbs losses.
The instruments determine how much of a bank's balance sheet can be counted in its capital ratios, discussed under bank capital adequacy. They also matter to investors, because AT1 and Tier 2 securities pay higher yields than ordinary bank bonds in exchange for bearing losses before other creditors. The criteria are set internationally by the Basel Committee and applied in the EU through the Capital Requirements Regulation, and in other jurisdictions through national rules.
Regulatory capital instrument in plain terms
Think of the layers of padding in a crash helmet. The innermost foam takes the first impact; outer layers add protection if the blow is bigger. Each layer has to be made of material that actually cushions a fall, or it does not count.
A bank's capital works in layers in the same way. Shareholders' money takes losses first, special perpetual bonds take them next, and long-term subordinated bonds take them if the bank fails. A security only counts as capital if regulators are satisfied it will really take the hit when needed.
The three tiers
| Tier | Typical instruments | Main features |
|---|---|---|
| Common Equity Tier 1 | Ordinary shares, share premium, retained earnings | Permanent, most junior claim, fully discretionary dividends |
| Additional Tier 1 | Perpetual contingent convertible or write-down securities | No maturity, cancellable coupons, conversion or write-down at a trigger |
| Tier 2 | Subordinated bonds and loans | Original maturity of at least five years, ranks below senior creditors |
Before Basel III, banks counted a wider range of hybrid securities, including some preferred shares and instruments with step-up coupons, many of which failed to absorb losses during the 2007 to 2009 crisis. Basel III tightened the definitions and phased such instruments out of capital.
Eligibility criteria
To qualify as AT1, a security must be perpetual, deeply subordinated, and free of incentives to redeem, such as coupon step-ups. It may be called by the issuer only after five years and with supervisory approval. Coupons must be fully discretionary and non-cumulative, meaning a skipped payment is lost for good and is not a default. Most importantly, the instrument must absorb losses while the bank is still a going concern: when the bank's CET1 ratio falls below a set trigger, the security converts into shares or is written down. In the European Union, the minimum trigger for instruments accounted for as liabilities is 5.125 per cent CET1.
Tier 2 instruments must be subordinated to depositors and general creditors, have an original maturity of at least five years, and lose capital recognition gradually over their final five years. Since reforms agreed in 2011, both AT1 and Tier 2 instruments must also be capable of being written down or converted at the point of non-viability, when authorities decide the bank would otherwise fail. This links them to the bail-in powers of a bank resolution authority.
Loss absorption in practice
AT1 securities are often called CoCos, short for contingent convertibles, a type of convertible bond in which conversion is triggered by capital levels rather than chosen by the investor. Their loss-absorbing design was tested in March 2023, when Swiss authorities arranged the takeover of Credit Suisse by UBS and FINMA ordered the full write-down of about 16 billion Swiss francs of Credit Suisse AT1 bonds, while shareholders still received some value. The contractual terms of those bonds allowed this, but the outcome inverted the usual expectation that shareholders lose first. The European Central Bank, the Single Resolution Board and the European Banking Authority stated shortly afterwards that, in the EU, CET1 holders would absorb losses before AT1 holders, and the Bank of England made a similar statement. Legal challenges to the write-down followed in Switzerland.
Investor and issuer considerations
For banks, AT1 and Tier 2 are cheaper than issuing new shares and do not dilute existing shareholders unless triggered, but they cost more than senior debt. For investors, the risks include coupon cancellation, extension risk if the bank chooses not to call on the first date, conversion into shares at a low price, and full write-down. Rating agencies rate these instruments below senior debt, reflecting their position in the creditor hierarchy. In some markets they have been restricted for retail investors because of their complexity. Separate loss-absorbing debt that is not capital, such as senior non-preferred bonds counted towards resolution requirements, sits just above Tier 2 in the hierarchy and is often discussed alongside capital instruments.