European banks: steadying the ship?

Simon Outin

Director of Financials Research, Global

In our opinion, the acquisition of Credit Suisse by UBS is sufficient to provide visibility for the Credit Suisse group. Credit spreads and credit default swaps on the senior debt issued by the Credit Suisse holding company and operating companies should stabilise in the coming days and weeks, avoiding the disorderly failure of one of the 30 globally systemically important financial institutions.

In many respects, the deal looks favourable for UBS, although may not be without risks:

• Scope – Credit Suisse’s valuable Swiss bank is included in the deal, and antitrust considerations are not considered relevant given financial stability concerns.
• Liquidity – Includes a liquidity line of up to CHF 100 billion plus the CHF 50 billion provided to Credit Suisse last week.
• Capital –CHF 16 billion worth of AT1s written down and badwill of more than CHF 30 billion, ie, the common equity tier 1 (CET1) of Credit Suisse minus the CHF 3 billion price.
• Tail risk – Also includes up to CHF 9 billion second-loss insurance from the federal Swiss government.

The consequences for additional tier 1 (AT1) bond holders are significant.

The deal to rescue Credit Suisse involved the write-down of USD 17 billion of AT1 debt to zero. This represents the largest loss in the AT1 market to date.²

AT1 bonds were created in the wake of the global financial crisis to absorb losses in a going-concern scenario. The goal was to facilitate the rescue of banks while avoiding using too much public money – in contrast to the banks’ hybrids issued before the crisis. Also known as contingent convertibles, AT1s help banks meet their capital requirements, because they can be converted into equity or written down if the issuing bank’s capital strength falls below a pre-determined level.

Concerns about the wider prospects for AT1s led to negative price action varying from 5-20 percentage points across the board for European banks on Monday morning.

But it seems the markets have drawn some limited reassurance from the statement by the European banking regulators, and subsequently the Bank of England, reiterating that – despite what happened in the case of Credit Suisse – AT1 debt holders should suffer losses only after equity investors have been fully wiped out.³

In addition, we believe banks will do the maximum to pay coupons as due and to reimburse on the first call date with a view to bolster much-needed confidence. Banks can also replace AT1s with pure CET1 capital – a decision, we believe, they are likely to take on a unilateral basis, if the supervisor agrees, as the banks estimate their cost of equity versus cost of funding.

In the case of Credit Suisse, senior creditors (preferred or not) have been fully protected.⁴ We think that, after the initial shock reaction on Monday, this will likely be reflected in positive price actions on AT1s, which are critical for financial stability in Europe.