Case 014Capital and regulationCore

A bank's AT1 bonds are written down if its CET1 ratio falls below a trigger. A large fraud loss is announced. Compute the new ratio and explain what the AT1 holders now face.

The situation

Zorvenna Bank has common equity tier 1 capital of Rs 4,000 crore against risk-weighted assets of Rs 50,000 crore. Its additional tier 1 bonds are written down if the CET1 ratio falls below a trigger, illustrative for this case, of 6.125%. The bonds' terms also allow write-down if the regulator declares the bank non-viable.

Zorvenna announces a fraud loss of Rs 850 crore, charged straight to CET1 with no tax relief. Assume risk-weighted assets do not change on the day. For the coupon question, use an illustrative combined minimum and buffer of 8.0% of CET1. Confirm the current trigger, buffer and non-viability rules with the regulator before relying on any of them.

Your task

What is Zorvenna's CET1 ratio after the loss, how close is the trigger, and what should AT1 holders worry about?

Quick check

The ratio is still above the 6.125% trigger. Are the AT1 bonds safe from write-down?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Zorvenna's CET1 ratio falls from 8.00% to 6.30%, only Rs 87.5 crore of loss above the 6.125% trigger. AT1 holders face three risks: coupons can be cancelled because the bank is inside its buffer, any further loss or rise in risk weights hits the trigger, and the regulator can write the bonds down at the point of non-viability before the trigger is reached.

Step 1How far does the ratio fall?

Take the loss off the top of the ratio. Rs 4,000 crore less Rs 850 crore is Rs 3,150 crore of CET1, and over Rs 50,000 crore of risk-weighted assets that is 6.30%. The trigger is 6.125%, a gap of only 0.175 points. In rupees, a further loss of Rs 87.5 crore, or a rise in risk-weighted assets of about Rs 1,429 crore with no new loss, would hit it.

Zorvenna's CET1 ratio falls from 8.0% to 6.30% after the Rs 850 crore fraud, just above the 6.125% write-down trigger, and the regulator's non-viability power means the bonds can be written down without the trigger being reached.

Step 2Why is being above the trigger not enough?

Think of a smoke alarm set to go off at a certain temperature, and a fire officer who can order the building evacuated whenever he sees smoke. AT1 bonds carry both: a mechanical trigger on the ratio, and a point of non-viabilityA regulator judgement that a bank cannot continue without a capital injection or public support; at that point AT1 and similar instruments can be written down or converted. clause that lets the regulator act on its own judgement. A bank that has just disclosed a large fraud is exactly where a regulator may decide the reported ratio no longer reflects reality.

Step 3What happens to the coupons?

AT1 coupons are discretionary and non-cumulative: a missed coupon is gone, not owed. With CET1 at 6.30%, Zorvenna is inside an illustrative 8.0% combined minimum and buffer, so rules restricting distributions can stop the coupon even if the bank wants to pay it. For an investor who bought AT1 as a high-yield bond, the first loss is likely to be income, well before principal.

Route to loss for AT1 holders	What sets it off	How close
Coupon cancelled	Ratio inside the combined buffer, or the bank's choice	Already inside
Mechanical write-down	CET1 below 6.125%	Rs 87.5 crore of further loss
Non-viability write-down	Regulator's judgement	Possible now

Zorvenna's AT1 holders face three separate routes to loss after the fraud, and only one of them depends on the trigger; the coupon risk is live already and the non-viability route needs no ratio at all.

Close with what you would check next: whether the fraud is fully counted or more is coming, whether provisions on related loans will raise risk-weighted assets, and whether the bank can raise equity quickly. The limitation of the arithmetic is that it treats Rs 850 crore as final. Frauds are often disclosed in instalments, and the second announcement is the one that tends to cross the line.

Where candidates lose it

Candidates compute 6.30%, see it is above 6.125% and declare the bonds safe. The interviewer is waiting for the point of non-viability, which is why AT1 holders have in past episodes lost everything while ratios were still above the trigger.

The second miss is forgetting the coupon. It is discretionary, non-cumulative and the first thing to go when a bank falls into its buffer.

What the interviewer asks next

What equity raise would restore the ratio to 8.0%?
Why might AT1 holders be written down while shareholders keep something, and is that consistent with the usual order of losses?
How would you price the extra yield an investor should demand for this risk?

Company names and figures are illustrative.