What Happened in Zürich This Weekend?

Author: Joel Montin 

UBS absorbing Credit Suisse…

As you will have seen in the news the last couple of days, UBS is acquiring (some would say at gun point) all shares in Credit Suisse (CS). As a result of the deal, the existing shareholders become shareholders in UBS (at a fraction of the value of their shareholding in CS as at last Friday.) The deal is accompanied by, among other things, a SFr 50bn (USD 54bn) credit line from the Swiss National Bank (SNB). This looks and feels a lot like a bail-out, which is likely to spark a debate around government (and tax payers’) support and the resulting increase in moral hazard. The key objective of the overall deal is of course to restore (or avoid an overly adverse decline in) the confidence in the wider banking industry. And since UBS takes on a great risk by not knowing exactly what it is buying, an element of government support (the deal includes separate credit lines to UBS as well) was likely necessary, at least in order to complete the deal before the market opened on Monday.

…while some capital bondholders were left with nothing

Concurrently with yesterday’s takeover, the outstanding sums under all additional tier 1 capital instruments (AT1s) issued by CS were written down to zero. This resulted in SFr 16bn (USD 17 bn) worth of debt being wiped out and CS’s balance sheet being equally strengthened. Looking at this from a general perspective (without regard to specific Swiss features, as the case may be), the AT1s are deeply subordinated instruments that rank senior only to the share capital of the issuer. The terms of such instruments will also include, at least as a matter of Union law, loss-absorption mechanisms that enable the instruments to be written down (or converted into ordinary shares) upon certain pre-defined trigger events. As we understand, the instrument may also be written down by the regulator by operation of mandatory Swiss law (similar to the BRRD in the European Union). The write-down, if done by the regulator exercising its mandate provided by law, will (at least in the context of European Union law) need to respect the so-called ‘no creditor worse off’ principle (NCWO). This means that the investors should not be worse off as a result of the write-down than they would have been if the issuer had gone into bankruptcy. In this instance, where more junior creditors (the shareholders) get an allocation in the deal (the reason for which some say has political dimensions), whereas more senior creditors (the holders of AT1 instruments) get nothing, it will be difficult to square this write-down with the principle of NCWO. However, if the write-down is effected under the terms of the AT1s, the regulator will not be restricted by the NCWO principle (unless the terms provide otherwise).

Raising fears for the wider banking industry

Looking at the statements made by the relevant Swiss regulator and the terms of (some of) CS’s AT1s, it appears that the extraordinary government support in the form of the SNB credit line triggered a contractual write-down of the AT1s. While this may thus be technically permissible, it still raises many concerns about the status of corresponding AT1 instruments of other institutions. Looking at the CS debacle as a precursor for how other regulators would treat AT1 investors in a similar bank-saving exercise, it seems as if AT1 instruments are more risky than shares. It is likely that this may adversely affect the valuation and pricing of such instruments in the secondary market and reduce the depth of the global AT1 market overall, thus impairing banks’ ability to secure this type of funding (which is required under European Union law) going forward. As a result, it may be that the Swiss regulator traded the concern for the viability of CS against a concern for the ability and costs for the wider banking industry to raise capital.

This may seem a minor issue for the wider economy, but if banks struggle to raise the capital they need, this may ultimately affect banks’ risk appetite and their ability to finance the real economy. The repricing of capital instruments may hurt other types of capital instruments as well, even if issued by corporates and other non-banking institutions.

The EBA putting on a band-aid

Yesterday, possibly prompted by these potential effects on the capital market for banks, the European Banking Authority (EBA) issued a separate announcement in response to the Swiss regulator’s actions. The statement reads: “In particular, 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. This approach has been consistently applied in past cases and will continue to guide the actions of the SRB and ECB banking supervision in crisis interventions. Additional tier 1 is and will remain an important component of the capital structure of European banks.”

It will be interesting to follow the aftermath of this weekend’s bail-out. It is not unlikely that this will include many different types of disputes, such as mis-selling claims and objections against the write-down itself. In any event, the overall questions about the reputation of banks and their respective capital position are all but over.