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Western EuropeMarch 23 2023

Is the UBS/Credit Suisse deal enough to protect Europe from US bank contagion?

The sale of Credit Suisse to UBS may have preserved market stability for now, but economists warn we are not out of the woods yet, writes Anita Hawser.  
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Is the UBS/Credit Suisse deal enough to protect Europe from US bank contagion?Image: Getty Images

Another week, another last-minute bank rescue deal hashed out over a weekend. In the past two weeks we have seen the resolution frameworks countries put in place following the 2008 financial crisis set in motion – some for the very first time – to try and stop the contagion from the collapse of Silicon Valley Bank (SVB) and Signature Bank in the US spreading to the other side of the pond. 

In the early hours of Monday, March 13, HSBC snapped up the UK operations of SVB for £1. To sweeten the deal, the UK government also made concessions, relaxing the ring-fencing rules to allow HSBC’s ring-fenced bank, which cost somewhere in the region of £1.5bn to set up, to take on the corporate deposits and high-quality loan book of SVB UK.

“HSBC got the deal of the century in being given a pass on ring-fencing requirements – that is massive,” says Anthony Watson, CEO and founder of the Bank of London (TBOL), a clearing, correspondent and wholesale bank, which also bid for SVB UK’s assets. “It’s a staggering benefit to them as the costs of ring-fencing are not insignificant.” Even though SVB UK had a high-quality loan book, Mr Watson says the massive concession on ring-fencing is worth its weight in gold and is something no other bank has.

This weekend it was UBS’s turn. It paid a much heftier price tag (more than $3.2bn) for its ‘shotgun wedding’ with Credit Suisse, although at SFr0.50 a share in its own stock, it was still much lower than what Credit Suisse’s shares were trading at (SFr1.86) on the Friday before the deal was brokered by the Swiss National Bank, Swiss regulator Finma and Switzerland’s finance ministry. 

HSBC got the deal of the century in being given a pass on ring-fencing requirements

Anthony Watson

Marco Troiano, head of financial institutions at ratings agency Scope Ratings, says the issues with Credit Suisse were very different from the US banks in the sense that it went into the weekend with good levels of capital. “It’s not obvious at all that it was a failure of regulation or supervision,” he says.

Credit Suisse was a systemic bank, continues Mr Troiano. If it was not sold to UBS, the alternative was to see it go into resolution or a disorderly type of liquidation that would have been a very serious scenario for global banks. “The sale to UBS preserves stability for a vast majority of the liability structure of Credit Suisse, from depositors to senior bondholders both of the holding company and of the bank. The only part of the capital structure which is really impacted is equity and near equity; that is, the AT1s [additional tier 1 capital].”

The fallout from Credit Suisse’s AT1 wipeout

The deal has proved controversial with investors, largely due to an unusual move by the Swiss authorities to wipe out or write down $17bn (SFr16bn) of Credit Suisse’s AT1 bonds. Usually, equity is the first instrument to take the losses in any kind of financial distress of a bank. But in a reversal in the case of Credit Suisse, AT1s took the first losses ahead of pure equity. 

“Did Finma break away from other regulators – the Fed, the ECB [European Central Bank] – and protect fortress Switzerland to the detriment of the rest of the world?” asked one former investment banker. 

Keith Thomas, head of securities litigation at UK law firm Stewarts, says Switzerland is not an EU member state and clearly its priority was stabilising the Swiss banking system. But he says it looks like there is a question of interpretation of the rules governing the Swiss bonds and whether the actions of the Swiss regulator and the Swiss National Bank with respect to Credit Suisse’s AT1 bonds conform to those rules or not. “It’s open to interpretation,” he says. 

But according to S&P Global Ratings, although many market participants had not anticipated that the Swiss authorities would enforce a 100% write-down of the AT1 instruments without also wiping out common equity shareholders, the AT1 documentation, combined with the authorities’ legislative powers, made this outcome possible.

European regulators (the European Banking Authority (EBA), the ECB and the Single Resolution Board) were quick to inform markets that the order according to which shareholders and creditors of a troubled bank should bear losses is that “common equity instruments are the first ones to absorb losses, and only after their full use would Additional Tier 1 be required to be written down”.

Mr Troiano argues that, given the Credit Suisse AT1 wipeout, the market will likely re-evaluate the risk for this asset class. This could make it more expensive for banks to issue, he says, which could have negative implications for banks’ profitability, in terms of them either having to pay more for these types of instruments, or replace them with equity capital. “For some smaller marginal lenders, it could be a matter of access to the market; for others it would be relative cost,” he says. “If you were already paying very high coupons, and with this you end up paying double-digit coupons, then maybe you’ll think it’s better to go with equity instead.”

Is it just Swiss [AT1] bonds which are going to be a lot more expensive, or is it something that’s going to ripple out across all the markets?

Keith Thomas

Mr Troiano says this is a learning curve for everyone, as there have not been many resolutions in Europe, or instances where AT1s were converted or written down. “This is an asset class that still needs some real-life experience for everyone to understand exactly how it will work in times of crisis.”

Mr Thomas says the market is still waiting to see how the AT1 situation pans out. “Is it just Swiss [AT1] bonds which are going to be a lot more expensive for the issuing banks, or is it something that’s going to ripple out across all the markets with a particular focus on Europe as it has 70% to 80% of the world’s AT1s?”

The AT1 wipeout and other issues pertaining to how the deal was structured by Swiss authorities means we are unlikely to have heard the last of Credit Suisse. “Given that UBS shareholders were not given a vote on the deal, that holders of AT1 bonds were wiped out, and equity holders were not, and that the loss guarantee provided by the Swiss government leaves taxpayers on the hook, this is not the end of the Credit Suisse story,” says Jack Allen-Reynolds, deputy chief eurozone economist at Capital Economics.

Credit Suisse investors are reported to be considering legal action over the deal. 

Now the hard work really begins 

The UBS/Credit Suisse deal may have been hashed out over a weekend, but the hard work lies ahead. The execution risk from the Credit Suisse acquisition saw global ratings agency S&P revise its outlook on UBS from stable to negative. “We see material execution risk in integrating CS [Credit Suisse] into UBS given the size and weaker credit profile of CS and particularly the complexity in winding down a large part of CS’s investment banking operations,” the ratings agency stated. 

“This could mean a weakening of the combined group’s competitive position or underperformance against its financial targets because of sizeable restructuring or litigation costs, pressure on revenue capacity, or setbacks in realising cost savings.”

While recent events have shaken investor confidence in the banking sector, Mr Allen-Reynolds says there are reasons to be cautiously optimistic at this stage about the European banking sector. “European banks are much better capitalised than they were before the global financial crisis, so if credit risks were to materialise, they’re much better placed to absorb losses,” he says. More banks are also subject to regulatory stress tests in Europe than they are in the US, he says, which includes EBA stress tests as well as those carried out by national authorities.

European banks have also been actively hedging their interest-rate risk, which SVB did not, and while the central banks have made dollar swap lines available daily instead of weekly, demand for dollars was almost zero this week.

“Having said that, we shouldn’t be complacent,” says Mr Allen-Reynolds. “Credit Suisse is far from being the only European bank with profitability problems. It’s also a globally systemically important bank so it is subject to more regulatory oversight than most banks. It looked like it had high levels of capital and liquidity and a big liquidity backstop from the central bank, and that hasn’t stopped it from getting into trouble.” Reports last week, says Mr Allen-Reynolds, suggest Credit Suisse was losing SFr10bn in deposits a day.

“While it doesn’t look like we’re in a 2008 scenario, that doesn’t mean all of these problems are going to blow over now that UBS has bought Credit Suisse,” he adds.

As markets digest the impact of UBS’s rescue of Credit Suisse, S&P says investors are asking whether a lack of market confidence could cause contagion in the European banking sector. S&P maintains its view that, overall, European banks stand to benefit in the rising interest rate environment.

“As we said last week, rated European banks do not exhibit a combination of large unrealised losses on securities portfolios and highly confidence-sensitive funding models,” says S&P Global Ratings credit analyst Giles Edwards. “Furthermore, we see the business and risk management deficiencies that led to Credit Suisse’s takeover by UBS as quite unique in nature and scope relative to the European banking sector.”

Too early to declare victory

We have a very different situation this time around compared with 2008, says Innes McFee, an economist at Oxford Economics. “Central banks immediately stepped in with a new facility for US regional banks. They’ve opened up dollar swap lines daily now rather than weekly. They’ve managed to resolve institutions very quickly, so all those signs are really positive. But I think it’s a bit early to declare victory.”

The key question now, says Mr McFee, is how much does this tighten bank lending and credit conditions. “Credit data is going to be really important over the next couple of months because we’ve de-risked the banking sector a lot, but a lot of that risk has supposedly gone into the non-banking sector, which relies on funds from banks.

“If I wanted to paint an adverse scenario, it would probably be around if credit lines from banks are pulled from private equity and other sources and that leads to a fire sale of assets. Then, ultimately, we may see the situation get worse, but we’re not in that situation at the moment.” 

Mr Watson of TBOL says he is encouraged by people getting in rooms and solving problems in real time. But moving forward, he believes there is room for firms that do not pose the same types of risks. “Certainly, we hope the lesson from the past few weeks will be that not all banks have to be risky, leveraged or lending institutions.”

Unusually, while TBOL has a full universal banking licence similar to the Big Four UK banks, it does not lend or leverage out any of its customers’ deposits. It has 100% reserve banking, which means all of its deposits are held at the Bank of England. “No other bank in the UK does this,” says Mr Watson. 

While regulators moved quickly to shore up banks’ capital and liquidity, Mr Troiano says the resilience of the sector in Europe can still be improved. “We don’t have common deposit insurance, right. We don’t have a solid enough risk framework for sovereign exposures, which are still risk-weighted at zero. Do we need to raise the threshold for insured deposits? And if that’s the case, who’s going to pay for that?”

 

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Anita Hawser is the Europe editor at The Banker. For the past 20 years, Anita has worked as a freelance journalist for a range of banking, finance and tech titles covering topics such as cybersecurity, financial crime, cryptocurrencies, payments, trade and supply chain finance. Before joining The Banker, Anita was Europe editor at Global Finance.
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