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European Banks: Potential Fallout from Credit Suisse's AT1 Bonds Wipeout

SGAnalytics_Blog_European Banks: Potential Fallout from Credit Suisse's AT1 Bonds Wipeout
Published on Mar 23, 2023

Negative headlines undermined confidence in Credit Suisse…

Credit Suisse Group AG's bonds, stocks, and credit default spreads plummeted last week due to increasing concerns about the company's future and the possibility of contagion from the collapses of two US banks - Silicon Valley Bank (SIVB) and Signature Bank. The sell-off in Credit Suisse's stocks and bonds was mainly sparked by the recent announcement from its major shareholder, Saudi National Bank, who reiterated that it would not increase its stake beyond 9.9% due to regulatory and accounting challenges associated with higher shareholding. This news came at an inopportune time as Credit Suisse was already grappling with various controversies related to its financial reporting and its connections with investment firm Archegos and supply chain financing firm Greensill Capital. It's worth noting that Saudi National Bank has been conveying similar messages since October 2022.

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…UBS Group AG and the Swiss National Bank came to a rescue…

Nonetheless, after a long negotiation over the weekend, on 19 March 2023, UBS Group AG (UBS) agreed to buy Credit Suisse Group AG for CHF 3 billion in a government-brokered deal aimed at containing a crisis of confidence that is spreading across global financial markets. The Swiss National Bank (SNB) provided additional incentives to the deal, including ample liquidity support. This assistance included unrestricted access to SNB's facilities, a CHF 100 billion loan for UBS and Credit Suisse with preferred creditor status, and an additional CHF 100 billion liquidity assistance loan supported by a federal default guarantee. Further, the Swiss government offered a guarantee of CHF 9 billion to cover potential losses that may arise from certain assets that UBS acquires as part of their transaction, should any future losses exceed a particular threshold.

…however, holders of Credit Suisse Group AG bonds suffered a historic loss…

While Credit Suisse shareholders unexpectedly managed to recover some of their investment (1 UBS share for 22.48 Credit Suisse's shares, which is equivalent to CHF 0.76 or around 40% of Credit Suisse's stock price on Friday's close), the holders of Additional Tier 1 (AT1) or contingent convertible (CoCo) bonds saw their credit written down to zero.

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In the event of a bank's bankruptcy, AT1s usually hold a higher ranking in the claim hierarchy than common equity. However, AT1s are typically considered as "going concern" capital, meaning they can be written down in certain cases and jurisdictions even without bankruptcy. This leaves it up to banking authorities to determine whether they should be ranked lower than equity or not. Until recently, investors had assumed that for AT1 bonds to be converted into equity, the equity would need to be completely eliminated first. Still, this assumption was proven incorrect as Swiss market authority Finma decided to wipe out Credit Suisse's AT1 capital.

Credit Suisse's prospectus for its AT1 bonds contained provisions allowing Finma to deviate from the standard hierarchy of claims in certain situations, such as when the bank receives an "irrevocable commitment of extraordinary support from the Public Sector." Given that such support has been provided, Finma announced a complete write-down of the nominal value of all AT1 bonds of Credit Suisse, amounting to approximately CHF 16 billion. While this action is legally permissible, the timing of this choice looks ill-advised given the current angst about banks' liquidity, solvency and funding environment across both sides of the Atlantic.

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SGAnalytics_Blog_European Banks

What next? Will this event trigger risk for other European banks?

Credit Suisse's CHF 16 billion (USD 17 billion) AT1 bond wipeout is the biggest loss recorded in Europe's USD 275 billion AT1 market. This loss is significantly greater than the EUR 1.35 billion loss incurred by junior bondholders of Banco Popular in 2017. It's important to note that Banco Popular's equity had also been written off, and the bank was sold to Santander for EUR 1, which is a different scenario from Credit Suisse's situation, where their shareholders were offered CHF 3 billion.

The event has triggered a sell-off in the European banks' AT1 bonds as Finma's action seems to have sent a message that AT1 bonds can be junior to common equity and offer inadequate risk compensation. While the consequences of the events in the European banking sector are unclear at the moment, it would be fair to assume that the funding costs will be higher. It would be difficult for the European banks (especially the smaller size banks already facing the brunt of the economic slowdown in Europe) to raise funding through the mandatory AT1 bonds substantially below the cost of equity. Higher funding costs would imply lower profitability, liquidity and lending growth. Additionally, the weaker growth prospect or non-linear recession in Europe would make the situation more vulnerable, and hence the overall outlook for the European bank's AT1 bonds remains negative.

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