Credit Suisse’s rescue crossed a consequential debt Rubicon
3 min read 21 Mar 2023, 11:50 PM ISTUBS Group AG, having subsumed Swiss Bank Corp 25 years ago, is now absorbing Credit Suisse Group AG, creating a single Swiss banking giant
PremiumUBS Group AG, having subsumed Swiss Bank Corp 25 years ago, is now absorbing Credit Suisse Group AG, creating a single Swiss banking giant. Credit Suisse’s shareholders get something and senior bondholders are protected—but that luxury does not extend down the capital stack. How banks are able to finance themselves is poised to become a lot more challenging.
To facilitate the deal and square up the numbers, the Swiss regulator Finma has ordered that about 16 billion Swiss francs ($17.3 billion) of Credit Suisse’s riskiest type of debt will now be worthless. Known as Additional Tier 1 (AT1) bonds, and also called contingent convertibles or CoCos, this debt can be converted into equity or written off if a bank’s capital falls below a prescribed level. Owners of the Swiss firm’s securities will get nothing. It was a lovely asset class while it lasted.
Weaker European banks will struggle even harder to find investors to commit capital that, not just in theory but in practice, really can be wiped out. The entire banking sector will end up paying for Credit Suisse’s myriad transgressions one way or another. The repercussions of the Swiss takeover structure may close off access to CoCos for all but the strongest banks—the definition of which will come under ever-closer scrutiny.
The ramifications could cause a world of pain for banking regulators. It is not a coincidence that over the weekend major central banks settled on a coordinated increase in dollar swap funding lines to keep liquidity greasing the wheels of the global financial system.
Additional Tier 1 bonds are meant only for sophisticated investors who truly understand the risks. However, even professionals face a rude awakening this week—and this specific zeroing of one asset class for the benefit of all others will send a seismic shock through the entire $275 billion European bank subordinated debt market.
This asset class is the building block that underpins the inverted triangle of all financial institutions’ equity capital base. Who’s going to insure basement flooding after this storm?
That highly subordinated bank capital can be ‘bailed in’ when a bank fails is a known known. American investors tend not to have any illusions about how risky this type of debt is, but the potential for a total loss on account of AT1 holdings was underappreciated in Europe. Many investors secretly felt it was one of those risks in life worth taking to clip a big fat coupon, as AT1 bond yields are so much higher than on senior preferred or covered bank debt categories. By only investing in highly-regarded banks—like perhaps a storied 167-year old Swiss institution that operated as the second part of a local duopoly—some may have hoped that their risks were minimal. After all, it worked a treat for the best part of the last 15 years.
The brutal reality is that it’s yet another cockroach crawling out from the fixed-income world as a consequence of central banks aggressively hiking their policy way up from below-zero interest rates.
Investing in Additional Tier 1 bonds made a lot of sense for big fund managers tracking an index. Higher income returns on AT1 bonds helped create ‘alpha’ in their diversification strategies.
Many private investors also could not resist the juicy yields available, although several countries either prevented or heavily regulated access to this asset class. It was the naughty but nice oasis in a desert of micro yields. But Credit Suisse;s AT1 debt not being honoured changes that dynamic drastically.
While this sudden bail-in is not a one-off, it is of a different scale. The collapse of Spanish retail lender Banco Popular, which was swallowed up by Banco Santander SA in 2017, really ought to have served notice. However, with a much smaller and localized subset of investors affected, it didn’t change the greed mindset. National champions like Credit Suisse are supposed to be too big to fail.
Regulatory changes since the global financial crisis have created new bail-in regimes across all major markets that carefully determine what can happen to subordinated bond holders in the event of a bank failure. In the Credit Suisse case, bondholders are helping bail out shareholders. Equity investors are getting about $3.2 billion of value, while equity-like capital bondholders get zero.
The Swiss regulator has clearly crossed a Rubicon here by foreclosing on this cornerstone of the capital structure of banks. While AT1 bond prospectuses clearly laid out their risks to investors, that doesn’t lessen the shockwave. The world of bank capitalization is about to become a lot more volatile. ©Bloomberg
Marcus Ashworth is a Bloomberg Opinion columnist covering European markets.
