The European Banking Authority (EBA) has raised concerns that banks in the European Union may be overstating the value of high-risk debt used to bolster capital buffers, potentially compromising their ability to withstand financial crises.

In a report published on Thursday, the EBA scrutinised the issuance of Additional Tier 1 (AT1) bonds, also known as contingent convertibles or CoCos. These financial instruments, introduced after the global financial crisis, are designed to convert into equity or be written off if a bank's capital falls below a specified threshold.

The EBA's investigation revealed discrepancies between the "carrying" value of AT1 bonds recorded on banks' balance sheets and their "nominal" value. The watchdog emphasised the importance of accurate valuation, stating, "Measuring non-CET1 capital instruments for prudential purposes using the carrying amount (accounting value) is necessary to prevent overestimation or underestimation of the total capital available to cover losses."

The report comes in the wake of the Credit Suisse debacle, where approximately $17 billion of AT1 debt was written down to zero during the bank's forced merger with UBS, triggering legal disputes. This event has prompted global regulators to reassess the role of AT1 bonds in capital buffers.

Chris Woolard, a representative from accountancy firm EY, commented on the EBA's findings: "The industry can almost certainly expect further probes in the short-term, and investors and regulators will be looking for greater standardisation across the banking sector."

To address these concerns, the EBA has introduced new templates aimed at standardising information on AT1 bonds and more accurately reflecting their worth. The guidance seeks to limit banks' ability to introduce bespoke modifications when issuing these instruments.

"Some provisions could be worded in a better way because, as originally proposed, they may be the cause of uncertainty in relation to regulatory provisions — for instance on the effectiveness/implementation of the loss absorption mechanism — or they may increase the already high complexity of the instruments," the EBA explained.

The watchdog's report also clarified that the prudential valuation of capital instruments should reflect their actual loss absorbency capacity. This means such instruments should be measured based on the amount of Common Equity Tier One (CET1) capital that would be generated in the event of a write-down or conversion.

As regulatory scrutiny intensifies, the banking sector can expect continued focus on capital adequacy and the transparency of financial instruments. The EBA has committed to ongoing monitoring of the quality of AT1, Tier 2, and TLAC/MREL instruments, promising additional guidance where necessary to ensure the stability and resilience of the European banking system.

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