Credit Suisse : Crisis throws up more questions than answers

Credit Suisse’s downfall was different to the recent Silicon Valley Bank (SVB) default and those bank resolutions of the Global Financial Crisis (GFC). Typically, bank resolutions stem from problems with their assets: the loans they make (eg mortgages and corporate lending) or financial instruments they own (eg government and corporate bonds, asset-backed securities and mortgage-backed securities). When a bank’s assets become impaired – meaning they are lower in value than what they paid for them – and they are forced to sell such assets at a realised loss, problems can ensue.

A bank “unwind” often follows a typical script. “Asset-side” problems become apparent to depositors and other banks alike. Depositors withdraw their savings and other banks withdraw their lending – or at least require additional “good” collateral to be posted against the lending provided to the problem bank. The bank is then required to sell assets, often quickly in a fire-sale scenario, which crystallises these losses and generates a black-hole on its balance sheet. SVB had a typical asset-side problem where its liabilities (company deposits, many of which were uninsured and more flighty) were invested in long-duration assets which had subsequently fallen, a victim of the US Federal Reserve’s 2022-23 hiking cycle. Where SVB differed from the bank resolutions of the GFC was the speed of its decline. Social media means that news and information – sometimes speculative or with little substance – moves more quickly today. Concerns about banks can spread like wildfire, as was the case for SVB. Technology allows deposits to be withdrawn (almost) instantly via an app, meaning bank-runs involving slow-moving queues outside bank branches are now a thing of yesteryear. At face value, Credit Suisse was different to SVB as it did not exhibit an asset-side problem. Core Equity Tier 1 (CET1) – a measure of a bank’s risk-based capital and overall financial health – was last reported at 14% with a comfortable buffer to regulatory minimum requirements. Assets held were perceived to be “clean”, partly due to a more conservative risk management approach attributable to heightened regulatory scrutiny following recent high-profile scandals (Archegos, Greensill). The Swiss National Bank (SNB) also provided CHF50 billion in available liquidity – a move that should have provided confidence that Credit Suisse’s assets were sound. Even in the days prior to the announcement of UBS’s takeover, the SNB stated that Credit Suisse “meets the capital and liquidity requirements imposed on systemically important banks”.

Credit Suisse appears to be a domino knocked over by problems at SVB and other US regional banks. Commentators worried about contagion and questioned whether any European banks could be vulnerable. Credit Suisse – with its recent issues and need to restructure its investment bank – was targeted and in common with SVB such concerns caught the imagination of the masses in an incredibly short space of time. Credit Suisse depositors, wealth management clients and lenders could maintain existing exposure to the bank – something that may be reasonable given the bank’s apparent clean bill of health – or they could withdraw deposits and reduce their exposure just in case the speculation was right. If everyone else withdrew their deposits but they did not, this could result in an unfortunate outcome, particularly where deposits were uninsured.

Controversy over AT1 instruments
As part of the UBS-Credit Suisse solution, the SNB took the controversial decision to permanently write-down to zero CHF16 billion in Additional Tier 1 (AT1) instruments. AT1 provides banks with additional equity-like capital and can be written down or converted into equity in the event that a bank’s CET1 ratio falls to a certain level (generally 7%, but for some instruments as low as 5.125%) or is declared non-viable. The fact that the AT1 instruments were written down is not necessarily controversial. This is what they are designed to do. However, the fact there was no mention of a capital shortfall or balance sheet losses, and Swiss authorities had to amend the law over a weekend to define a bank needing the provision of government backed liquidity as a non-viable bank, has been controversial.

This also has ramifications because it is commonly thought that the non-viability test is based on capitalisation, not the provision of liquidity by the central bank. Here equity holders also received CHF3 billion as part of the deal. AT1s are senior to equity holders in the creditor waterfall and this controversial decision has sparked  a strong reaction among many bondholders. So, if CET1 at 14% comfortably exceeded the trigger level and Credit Suisse’s assets were sound, why were AT1s written down to zero? And if AT1s are senior to equity and worth zero, surely the equity value is also zero?

Unanswered questions
What seems clear is that Swiss authorities found there was a need to find a resolution quickly and that a Swiss solution (ie UBS) was preferrable. Many questions remain unanswered: if Credit Suisse’s capital was fine, as the SNB had claimed days earlier, and given SNB’s willingness to provide Credit Suisse with liquidity (cash provided in exchange for Credit Suisse’s assets), then why didn’t Credit Suisse weather the storm and meet depositor outflows with the ample liquidity available? Maybe a capital hole was discovered? While possible, this seems strange given the tight regulatory oversight and the clean bill of health the SNB had given Credit Suisse only days earlier. Were there concerns around wealth management outflows leading to a permanent impairment of its wealth management business? Could this cause damage to Switzerland’s reputation as a safe wealth management hub, one which is an extremely important contributor to the Swiss economy? Would UBS be unwilling to buy Credit Suisse unless the terms were too-good-to-be-true? Was the write-down of CHF16 billion of CET1 plus the promise of additional backstops in exchange for CHF3 billion the required solution to get the deal done? Could Credit Suisse’s board only accept UBS’s takeover if some value was available to shareholders? Did the authorities just get spooked?

Moves to ease broader AT1 concerns
Following the AT1 write-down, other European countries and the UK have distanced themselves from the actions of Swiss authorities, with the European Banking Authority stating that “common equity instruments are the first ones to absorb losses, and only after their full use would Additional Tier One be required to be written down.” However, credit spreads on AT1s at the time of writing remain materially wider (the Bank of America Contingent Capital index is +168bps or +43% wider during March) and pricing on most AT1 instruments now assume a low likelihood of being called at their first call date, indicating the market does not consider Swiss actions a one-off decision made independently by Swiss authorities with no read across to other jurisdictions.

The price action raises further questions about the future of AT1s as an asset class. If the instruments did not trigger due to a capital issue (as was intended) but for other reasons in a resolution scenario, are the instruments fit for purpose and can investors be confident in owning them in the future, and at what price will they be willing to do so? Assuming the answer is no, this means we may see a higher cost of capital in the banking sector in future and banks may be required to hold more common equity instead.

Investors to demand a higher risk premia?
At the very least, the Credit Suisse situation suggests future bank unwinds will follow a different script. In a world where information is widespread and technology enables money to be moved quickly, maintaining confidence around a bank’s health is paramount. In today’s world a sound capital position and access to central bank liquidity may not be enough to save a bank. Given this, a higher risk premia may be required for investors providing funding to the sector.