As the effects of the coronavirus wreck economies, banks are facing increased loan-loss risks and prioritizing capital conservation. Their additional Tier 1 (AT1) securities should survive a short bout of the virus. But even in a prolonged pandemic, the risk/reward trade-off might be better than perceived.

Revenue shortfalls are spreading across industries, forcing lenders to increase their loan-loss reserves. Mounting realized losses threaten subordinated credits, and European banks’ AT1s are seen as most at risk. Even so, we believe AT1s issued by stronger European banks can earn attractive returns.

How Banks Prepared for the Next Crisis

The COVID-19 pandemic is both a human tragedy and a huge and unpredictable problem for businesses worldwide. Banks are facing complex risks that are unusually hard to model.

But lenders have stronger balance sheets today than they had a decade ago. As a result of tougher regulation following the global financial crisis (GFC), banks have greater financial flexibility to cope with unpredictable events. In Europe, for example, capital ratios have improved significantly since the GFC, and nonperforming loans represent a much lower proportion of total loan books (Display).

To help delever, European banks also shrank their balance sheets, judiciously limiting lending and new credit. Even those banks with lower asset quality, such as Italian banks, improved their banking books—particularly systemic Italian lenders—creating a more robust banking system.

Balance-sheet structures have changed too. Regulators want greater resilience as well as higher capital. Consequently, AT1s have become popular as a flexible buffer to help absorb shocks.

For regulatory capital purposes, Tier 1 capital absorbs losses immediately when they occur on a “going concern” accounting basis. Tier 1 capital comprises common equity—termed common equity Tier 1 (CET1)—and AT1, which ranks higher than does CET1. Rising bank losses erode equity capital. Ultimately this may reduce CET1 below the minimum level required to pay the AT1 coupon.