SUNANDO ROY – On Banking, Finance and Society

 

Modern banking regulation increasingly relies on capital instruments designed to absorb losses before insolvency occurs. Among these, Additional Tier 1 (AT1) instruments occupy a particularly sensitive position within the creditor hierarchy. They are intended to function as going concern capital buffers — absorbing stress while preserving the institution’s continuity.

Yet an increasingly important question has emerged in modern banking structures: should shareholder-linked payments, intragroup service arrangements, or upstream economic transfers continue while AT1 investors face heightened loss absorption risk or coupon uncertainty?

This question becomes especially important in banking groups where shareholder parents provide operational services through Service Level Agreements (SLAs), investment proceeds or revenues are shared intragroup, or economic value continues flowing upstream during periods of capital stress.

The issue sits at the intersection of creditor hierarchy, prudential integrity, related party governance, capital conservation, and market confidence.

Creditor Hierarchy in a Going Concern Institution

Creditor hierarchy is often associated with insolvency or liquidation. In reality, hierarchy continuously shapes market behaviour even while a bank remains a going concern. Investors constantly assess who absorbs losses first, whose claims are protected, and whether value extraction remains equitable under stress.

A simplified hierarchy within a bank generally appears as follows:

1. Secured creditors
2. Depositors and operational obligations
3. Senior unsecured creditors
4. Tier 2 capital holders
5. AT1 investors
6. Common equity shareholders

AT1 instruments therefore sit just above equity in the loss absorption waterfall. Under the framework developed by the Basel Committee on Banking Supervision, AT1 instruments are specifically intended to absorb losses before the institution becomes non-viable. Their role is not liquidation support alone. They are designed to preserve resilience while the institution is still operating.

The Central Tension

The hierarchy challenge emerges when a bank remains operational but faces weakening capital buffers, deteriorating profitability, market stress, liquidity concerns, or rising supervisory pressure. In such circumstances, AT1 coupons may become discretionary or restricted, capital conservation expectations tighten, and subordinated investors increasingly absorb uncertainty.

At the same time, shareholder-related economic flows may continue through dividends, intragroup management fees, SLA payments, revenue-sharing arrangements, treasury allocations, or investment proceeds transferred to the parent group.

This creates a critical prudential question: can shareholder-linked entities continue benefiting economically while subordinated capital investors absorb escalating going concern risk?

AT1: Debt in Good Times, Equity in Stress

AT1 instruments possess a hybrid nature. They behave like debt during stable conditions, but increasingly like equity during stress. AT1 investors accept coupon cancellation risk, conversion risk, write-down risk, and deep subordination. Because of this, regulators expect banks to preserve capital prudently once stress indicators emerge.

The controversy surrounding the resolution of Credit Suisse demonstrated how sensitive markets have become to hierarchy integrity. The write-down of AT1 instruments while equity retained residual value triggered widespread debate regarding consistency of treatment and investor expectations.

The lesson was clear: hierarchy credibility matters even before insolvency occurs.

Intragroup SLAs and Economic Subordination

Many banking groups operate through extensive intragroup Service Level Agreements. Under these arrangements, shareholder parents may provide IT systems, cloud infrastructure, compliance functions, treasury operations, HR support, cyber services, or centralised risk management.

Where these services are genuine, operationally necessary, and priced at arm’s length, payments under the SLA may legally rank as ordinary operating expenses. In practical terms, a bank may suspend AT1 coupons while continuing to pay critical operational vendors, including the shareholder parent acting as service provider.

Legally, this may be defensible. However, prudential concerns emerge where the parent is simultaneously the controlling shareholder, fees appear excessive, revenue sharing exists, or economic value continues flowing upstream despite capital stress. At that point, regulators begin asking: is the arrangement truly operational, or effectively a mechanism for shareholder extraction?

When Shared Investment Proceeds Become Problematic

The concern intensifies where intragroup arrangements involve investment income sharing, excess spread allocation, performance-linked transfers, or profit participation structures. These flows may economically resemble dividends, synthetic equity returns, or disguised capital distributions.

From a prudential perspective, such arrangements may undermine the intended role of AT1 capital. If AT1 investors face coupon cancellation, market spreads widen sharply, or capital conservation measures activate, yet substantial economic value still flows to shareholder affiliates, markets may perceive that hierarchy discipline is being weakened.

This becomes especially sensitive in closely held banking groups where governance independence is limited, the parent exercises dominant influence, or intragroup dependency is operationally entrenched.

Economic Hierarchy vs Legal Hierarchy

A major distinction therefore emerges between legal ranking and economic fairness. Legally, operational payables may rank ahead of AT1 distributions. Economically, however, markets may view shareholder-linked upstream transfers during stress as inconsistent with the spirit of subordinated capital absorption.

This distinction is critical. Financial stability increasingly depends not merely on contractual legality, but on perceived fairness, transparency, and credibility of loss allocation. Once investors believe that shareholders continue extracting value while subordinated investors disproportionately absorb stress, confidence can deteriorate rapidly.

Related Party Transaction Risks

These issues also intersect strongly with related party transaction governance. Supervisors may examine board independence, conflict-of-interest management, benchmarking of SLA pricing, transfer pricing methodology, and approval processes involving related parties.

Questions likely to arise include whether service fees are commercially justified, whether independent third parties would accept similar pricing, whether the arrangement is draining capital from the regulated entity, and whether shareholder interests are being prioritised over prudential resilience.

For regulators, the concern is not merely accounting treatment. It is whether the structure weakens going concern resilience, market confidence, and creditor protection discipline.

The GCC and Emerging Market Dimension

The issue carries particular relevance in GCC banking systems where family ownership, sovereign-linked ownership, and group-centric structures remain common. Many regional banks rely heavily on centralised parent infrastructure, intragroup outsourcing, and shared operational models.

At the same time, AT1 markets in the region have expanded significantly. This creates growing importance around investor protection, disclosure clarity, governance transparency, and consistency between capital conservation and shareholder economics.

Where implicit support assumptions remain strong, markets may underprice hierarchy risk until stress suddenly reveals structural weaknesses.

Resolution and Supervisory Perspective

Modern resolution frameworks increasingly emphasise operational continuity, separability of critical services, and prevention of value leakage during stress. Authorities may therefore scrutinise intragroup service arrangements, upstream transfers, and shared income structures, particularly where capital adequacy weakens.

Supervisors are increasingly likely to ask:

• Should shareholder-linked payments continue while AT1 coupons are suspended?
• Are SLA payments operationally essential or economically distributive?
• Do shared investment proceeds undermine capital preservation?
• Is the hierarchy functioning credibly under stress?
• Are subordinated investors being treated consistently with prudential expectations?

These questions are becoming central to modern supervisory assessments.

 

Key Concerns — Sum up

• AT1 instruments are designed to absorb losses while the bank remains a going concern.
• Shareholders sit below AT1 in the formal hierarchy but may continue benefiting economically through intragroup arrangements.
• Genuine operational SLA payments may legally rank ahead of AT1 coupons.
• Excessive or profit-linked SLA payments may resemble disguised shareholder distributions.
• Shared investment proceeds flowing to parent shareholders can weaken the credibility of capital conservation.
• Economic hierarchy may diverge from legal hierarchy during stress.
• Markets increasingly assess fairness of loss allocation, not just contractual enforceability.
• Related party transaction governance becomes critical in shareholder-parent structures.
• Supervisors may challenge upstream value extraction during periods of capital weakness.
• GCC banking structures with centralised parent dependencies may face heightened scrutiny.
• Weak hierarchy discipline can damage AT1 investor confidence and increase funding stress.
• The ultimate prudential issue is whether shareholder economics are being prioritised over resilience and subordinated capital protection.