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The chaos that ensued from the AT1 wipeout at Credit Suisse’s point of failure has raised questions about the future of the asset class, writes Tim Skeet.
Well, here we all are again. A big bank has been wound up, people have lost money, and everyone is shouting. It feels like another crisis is in the offing, markets are nervous, and the banking community is wringing its hands. The fall of Credit Suisse has sparked strong emotions. What we are also seeing, however, is fallout from some unfinished business from the financial crisis.
At the heart of today’s polemic is the fate of the holders of a series of arcane instruments, referred to as AT1 (additional Tier 1) bonds or CoCos (so-called ‘contingent convertibles’). The financial press has been scrutinising, in particular, the experience of the holders of Credit Suisse’s $17.5bn of AT1s and, more broadly, the implications for the rest of the $280bn AT1 market.
The Credit Suisse AT1 bonds were designed to be a part of the bank’s core capital stack – there to absorb losses if things went badly wrong for the bank. As we know, things did go badly wrong and investors in the bank’s capital instruments were wiped out. Followers of this unhappy story were surprised to see that shareholders, however, were not entirely zeroed. The question is: were these AT1 instruments really supposed to rank behind the shares?
In a highly unusual development, regulators outside of Switzerland rushed to clarify that they would have respected the usual hierarchy of creditors, prompted by wider concerns these instruments might completely lose credibility. If faith in the hierarchy of creditors is broken, a valuable route for banks to top up their capital base might be compromised.
What the Swiss did may have been consistent with the fine print on these particular AT1 notes, but investors have cried foul. The key to understanding how this Swiss pickle might have happened may be found by looking at the way these instruments were designed in the first place.
These financial instruments were devised in the aftermath of the financial crisis to address the shortcomings of a previous generation of instruments, which failed to absorb losses. The post-2008 framework created the concept of a ‘point of non-viability’ for a bank, where regulators would intervene before a bank completely lost the confidence of its stakeholders and failed. A new line of AT1 bonds emerged to fit the new framework.
Work on engineering these hybrid tier 1 instruments dates back to 1988 when the first Basel Committee capital requirements divided capital into Tier 1 and Tier 2, setting rudimentary proportions for each. By the mid-‘90s, European banks were issuing capital notes into the US, where a market for ‘preferred stock’ had existed for decades. As the design evolved (helped partly by the 2005 Basel 2 reforms), most regulators came to embrace the use of this easily issued, cost-effective capital instrument.
AT1s, with their inherent contradictions and embedded compromises, faced their first real trial in Zurich
At the heart of the design of these AT1s was financial alchemy that allowed the transformation of debt in the hands of investors into capital in the eyes of regulators. It was a market developed in Europe, with the additional fudge of giving what appeared to be a maturity date to investors on what looked like perpetual capital to regulators (achieved by way of a step-up). Moreover, the ability to absorb losses was explicitly tied to a trigger set at the minimum capital ratio of the issuer. These mechanisms proved useless in the financial crisis as banks collapsed faster than the capital calculations could be made.
The tougher 2011 Basel 3, introduced after the financial crisis, introduced a rolling set of capital and liquidity measures along with the concept of non-viability. Furthermore, regulators redefined the status of all bank-issued debt, making it explicitly ‘bail-inable’, subject to a supposed order of creditor preference. A revamped generation of capital notes was conjured up to fit in with the new regime and provide a good source of much- needed capital to hit the higher ratios. This new regime had not been fully tested at scale until now.
Thus, the AT1s, with their inherent contradictions and embedded compromises, faced their first real trial in Zurich. Today, as investors pick up the pieces of their broken expectations, it is pertinent to ask what the outlook for this class of hybrid equity might be in the context of a regulatory framework that has found them most useful. As other regulators speak out, investors reach for the fine print in the bond prospectuses.
Meanwhile, beyond speculating on the future of the AT1 asset class, a broader set of stakeholders is trying to second-guess regulators on where the vague ‘point of non-viability’ might be set in other cases. This points to another contradiction at the core of the capital debate – markets want transparency but regulators dare not show their hand. When they do, we can expect surprises. The banking saga continues.
Tim Skeet has spent much of his 40-year career specialising in bank funding in the capital markets, including working on developments in these instruments from the earliest times. The views expressed here are his own.
