While many have praised the Swiss regulators, including the Financial Market Supervisory Authority (Finma), for their swift action in rescuing Credit Suisse (CS) by selling it off to its rival UBS over a weekend, they have been less positive about how Finma dealt with the distressed lender’s additional Tier 1 (AT1) debt.
As outlined in Tim Skeet’s article, AT1 bonds “were designed to be part of the bank’s core capital stack, there to absorb losses if things went badly wrong for the bank”. Also called contingent-convertible (CoCo) bonds, they were devised in the aftermath of the 2007–09 global financial crisis to bolster a bank’s capital ratio and avoid a bailout funded by taxpayers. As such, CoCos offer additional yield to compensate for their risk profile.
And most investors were well aware of the risk and rewards. But what got the market riled was when the Swiss regulator instructed CS to write down SFr16bn ($17.45bn) in CoCo bonds to zero, inflicting losses on its creditors while shareholders received compensation of CHF3bn. Customarily, shareholders incur losses before bondholders in the liability hierarchy.
Other regulators – including the European Central Bank, the Monetary Authority of Singapore and the Bank of England – quickly stepped in to reassure investors that they will abide by the conventional creditor hierarchy, with AT1 instruments ranking ahead of common equity Tier 1 and behind Tier 2. But this wasn’t enough to quell concerns in the European market, with Deutsche Bank seeing a sudden drop in share price on March 24.
But will the Swiss debacle have a broader impact on the European banking sector? Undoubtedly, the $250bn AT1 market remains important to banks’ qualifying capital, particularly in order to meet leverage ratio. And, according to Fitch, western European banks are more reliant on hybrid debt than in the US, for example, where CoCo bonds are not eligible as Tier 1 capital.
As a result of Finma’s action, many analysts predict that banks’ cost of capital will increase and issuance may prove more difficult in the near term. According to Moody’s Investors Service, “despite the anticipated treatment of AT1 bondholders in the EU and the UK, the specific treatment of Swiss AT1 bondholders will likely lead to higher funding costs for these capital instruments globally because investors will likely demand additional risk premia, at least in the short term”.
Likewise, S&P Global Ratings said: “In our view, an increased focus on downside risk could increase banks’ cost of capital and make new AT1 issuance more difficult and more expensive. Jittery investors will take some time to revise their perceptions of risk for individual banks and instrument structures.”
In the medium term, Fitch expects pressure on AT1 issuance to reflect further regulatory debate on the continued role as going-concern capital, and from pricing due to the higher yields that issuers may need to offer to the market.
However, overall S&P doesn’t believe that a lack of market confidence will cause contagion in the European banking sector and sees Credit Suisse as an outlier. According to its credit analysts, the European banks are benefitting from the rising interest rate environment, plus they don’t exhibit a combination of large unrealised losses on securities portfolios and highly confidence-sensitive funding models.
“Nevertheless, we remain mindful that the seismic shift in monetary policy will be a game changer for parts of the financial sector,” said the ratings agency. “We expect the market turmoil will take time to recede as investors come to realise that the macroeconomic environment brings nuanced but far from dire consequences for European banks, and that the banking sector remains solid.”
Joy Macknight is editor of The Banker. Follow her on Twitter @joymacknight
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