EU bank regulation under Basel III ensures bank solidity but often creates barriers to EU financial integration. Additional Tier 1 contingent convertible debt is designed to provide relief, but historically it has not been able to absorb risks. This column argues that AT1 debt needs to be reformulated. AT1 should have a much higher trigger for conversion, and conversion should be activated by a supervisory decision when the bank is deemed viable but undercapitalised. These interventions should be triggered on a timely basis to prevent forbearance, while respecting property rights of investors against excess conversion.
EU bank regulation under Basel III established norms and buffers that ensured bank solidity in the face of large shocks such as COVID, rising interest rates, and war. Yet these rules are quite complex and often create barriers to EU financial integration. The EU ambition (and political necessity) for a common capital market, combined with the recent US deregulation drive, has led to strong momentum to reduce the regulatory burden.
A recent ECB review frames the main issues (ECB 2025). Some capital buffers are designated for specific risks, others are aimed at resolvability, yet ultimately they serve similar purposes. There are too many detailed norms and disclosures, some providing rarely used low-quality data. There is a legitimate need to streamline overlapping norms, disclosures, and approvals to support economic performance.
Is it possible to reform bank regulation without weakening our hard-won stability, in an historical phase of larger, hard-to-assess risk?
How to enhance bank resilience
At a time of large shocks, legislation needs to provide a second line of defence besides buffers and rigid norms, defining a mandate and contingent tools for a prompt and flexible response capacity. The key insight is that bank stability depends on both ex-ante solidity (its capital buffers) as well as ex-post resilience, the capacity to respond promptly and recover from large shocks that cannot be fully anticipated or absorbed (Brunnermeier 2022, Perotti 2024).
Under Basel III there is a single capital tool targeting bank resilience, namely Additional Tier 1 (AT1) contingent convertible (CoCo) debt designed to provide relief in bad times when it is impossible to raise new equity (Kashyap et al. 2008). CoCo bonds are supposed to convert into equity or absorb losses once a bank has high leverage but is still basically viable (going-concern conversion). By promptly reducing leverage, AT1 conversion supports the recovery of viable banks, avoiding the distress spiral leading to runs, default, and inevitable bailout.
Yet as the ECB review recognises, European AT1 bonds are currently not a credible source of relief. Not once since their creation has a CoCo bond absorbed risk outside bank default. In other words, they have proven to be pure debt. As such, they do not belong to core CET1 capital. The reasons are evident: EU norms allowed AT1 debt conversion only once bank equity falls to 25 basis points above default. This is a laughable standard: no bank could survive long enough to make use of this stunted tool.
The ECB review thus concluded that banks ought to substitute CoCo bonds with real CET1 equity; or else, their format must be reformed to become a credible recovery tool. While the first option creates more solidity (Borio et al. 2025), there is little appetite among EU banks to raise so much equity (around €400 million). Thus, the time has come for a proper reformulation of AT1 towards its original purpose of enhancing bank resilience.
Reforming CoCo debt
What are the necessary changes to the AT1 format to ensure a credible role in supporting bank recovery? In brief: a higher equity content combined with a reliable and timely mechanism for risk absorption.
Some lessons can be learned from two past experiences with AT1 debt. First, consider the 2016 upheaval around a Deutsche Bank CoCo bond that may have had to miss a single coupon, as the bank reported negative earnings. The markets responded strongly, as they were unprepared for any form of going concern losses. In other words, the original regulatory purpose was not credible.
The episode forced an adjustment in legislation and further deepened the market belief that CoCo bonds were never meant to take any risk ahead of default. One lesson that may be drawn is that coupon suspension may not be worth the drama. It may simply be best to simplify the instrument, also reducing the number of automatic triggers and normative thresholds around conversion. In the end, the real contribution of AT1 to risk absorption is full conversion from debt to equity capital when the bank is worth saving but ‘almost gone’ unless recapitalised.
An even more significant lesson can be learned by the troubled experience of CoCo conversion in the Credit Suisse case. The Swiss legislator had imposed a high trigger and added a second conversion trigger to be activated by supervisors once bank distress may have caused fiscal costs. Indeed, the conversion of these CoCo bonds avoided a default, protecting Swiss taxpayers from a brutal experience such as the 2008 UBS bailout.
Yet the conversion happened chaotically and way too late, due to legal ambiguity causing supervisory timidity (Martino and Perotti 2024). At the time of the March 2023 runs, Credit Suisse satisfied capital requirements; yet its business model and governance had long lost the confidence of investors. The bank had suffered large runs a year earlier, at a time when CoCo conversion would have been useful to enable a new direction for the bank, or at the very least a more orderly acquisition. The delay led to further deterioration and forced a rushed sale on disastrous terms, creating extreme market concentration.
Confusingly, the bonds were entirely wiped out rather than converted into equity, an outcome that appeared to violate priority rules. This is not a flaw in regulatory design: in reality the full loss suffered by Credit Suisse CoCo bondholders reflected a market choice at the time of their issuance (Perotti 2023a). Markets have since adjusted their approach, and recent CoCo issues are designed to convert into equity rather than losing all value.
These experiences should guide EU reforms. First, admissible AT1 debt should have a much higher trigger for conversion: at least 7.5% (and ideally more), ensuring that the bank satisfies basic capital requirement (thus mandatory 4.5% CET1 plus the 2.5% conservation buffer) with some margin.
Second, conversion should be activated by a supervisory decision when the bank is deemed viable but undercapitalised. Book equity would serve only as an indication, as accounting values are static and unreliable measures of viability. Here supervisors must have clear discretion to act once the bank is deemed to be viable but ‘a going concern unless recapitalised’, provided the assessment is legitimised (and mandated) by relevant market and supervisory signals.
Balancing investor rights and prompt corrective action
How can we ensure a legitimate supervisory choice to trigger conversion on a timely basis and prevent forbearance, while respecting property rights of investors against excess conversion? This is a most delicate issue, requiring establishing the legitimacy and proportionality of the intervention.
Reliable and justifiable conversion ought to be supported by a legal protocol that assigns discretionary powers to supervisors upon salient signals that a bank is deemed ‘viable but compromised’, thus requiring an immediate recapitalisation. Here ‘salience’ implies both a reliable measure of risk and a signal of its immediate relevance, and thus the urgency of a prompt response.
Among the most salient indicators of likely distress are market signals such as prices (equity, credit default swaps, or bond prices) and quantities (outflows and redemptions). This notion has been advanced for years and would have been useful in guiding a prompter response in recent bank distress episodes (Acharya et al. 2023).
Yet market signals can be erratic or manipulable; they need to be filtered by assessments made by a plurality of supervisors, accountants, and central bank officers (e.g. stress tests, collateral assessment, and book equity criteria). Table 1 lists these indicators in terms of their accuracy in signalling risk as well as their salience. A final indicator is whether liquidity support by the central bank would need to come as emergency lending (ELA), implying that the bank has insufficient collateral for standard refinancing. As in the Credit Suisse case, this assessment implies that without some recapitalisation, the bank’s survival requires some (indirect) fiscal support.
Table 1 Market and supervisory signals in the conversion trigger
Source: Based on Martino and Perotti (2024)
As every distress situation is somewhat unique, conversion should not be mechanically triggered by specific indicators; rather, supervisory action should be based on the interpretation of a set of signals provided by a plurality of private, public, and professional entities. As a minimum, three indicators ought to be actively signalling distress, so that neither market nor supervisory triggers would dominate. This principle ensures that conversion could not be unilaterally forced either by market manipulation or by institutional assessments. See Table 2 for a classification of salient signals and their sources.
Table 2 Activation signals and participants in the assessment
Conclusion
In a context of rising risks and fewer norms, bank stability depends more than ever on ex-post resilience. At present there are no credible capital tools available to bankers and supervisors to shore up confidence at critical moments, aside from public support. Reform of AT1 capital thus emerges as an opportunity to improve a critical contingent tool.
Conversion of debt into equity ensures a sharp drop in leverage for viable but compromised banks. At a time when capital markets would not be willing to contribute new capital, timely conversion allows reducing risk incentives and granting a chance of recovery in place of resolution (Martynova and Perotti 2018). Reform needs to ensure adequate equity content for AT1 debt to qualify as a Tier I capital instrument, and a clear supervisory mandate to activate conversion. A higher activation threshold implies adding equity, improving the recovery capacity after conversion. Assigning (and expecting) clear responsibility to supervisors on the basis of salient signals is critical to contain risk incentives and avoid unnecessary delay in reversing bank degradation.
Source : VOXeu
