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FRM Part II · FRM Exam Part II · Capital Structure in Banks

A risk manager reviews a proposed AT1 instrument. Which feature would cause the instrument to FAIL Basel III criteria for inclusion in Additional Tier 1 capital?

A coupon step-up after year five would disqualify the instrument from Additional Tier 1. Basel III prohibits incentives to redeem because they undermine permanence. Discretionary non-cumulative coupons, perpetual maturity and loss absorption through write-down or conversion are all required features.

  1. ADiscretionary, non-cumulative coupons that the issuer can cancel without triggering default
  2. BPerpetual maturity with no step-up or other incentive to redeem
  3. CA coupon step-up after year five to incentivise the issuer to call the instrumentCorrect
  4. DA loss absorption mechanism through write-down or conversion to common equity at a pre-specified trigger

Explanation

Basel III AT1 criteria require perpetual terms, discretionary non-cumulative distributions, and loss absorption via write-down or conversion. Step-ups or other incentives to redeem are prohibited because they imply an expectation of a call, undermining permanence. The other three features are required characteristics.

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