Why We Don’t Think Credit Suisse’s ‘Co-Cos’ Signal a Paradigm Shift

Editors’ Note: MarketMinder Europe doesn’t make individual security recommendations. Any reference to specific securities herein is incidental to our higher-level discussion.

Here is a thing we have observed about bank crises: It isn’t necessarily the actual bank failures that pose economic risks. We have seen enough banks fail during bull markets and economic expansions to indicate there is nothing inherently, automatically bearish about them for broader markets.^[i] No, our research finds problems often arise when officials respond in a way people perceive as inconsistent, making it difficult for investors to identify and price risks. And so we come to Credit Suisse, which was sold to UBS for centimes on the franc Sunday after flirting with failure last week. The manner in which regulators imposed losses on Credit Suisse’s investors seemingly caught a lot of observers off guard—giving equity investors some (small) compensation whilst wiping out holders of a particular kind of bank bond. Bondholders usually outrank stocks in the event of a firm’s failure, so some claim this establishes a new and curious scenario across Europe. But we see good reason to think the Credit Suisse situation isn’t a new blueprint for European banks, not least because Switzerland isn’t in the EU and Credit Suisse therefore wasn’t subject to the EU’s strict (on paper) bank resolution rules. Nor would it logically be a blueprint for the UK, where the Bank of England (BoE) has its own procedures. However, we think the fear could impact banks’ funding costs in the near term, which could in turn slow lending and economic growth. More volatility wouldn’t surprise us as markets price this in.

To explain all of this, we will have to get a bit technical and use terms like additional tier one capital and contingent-convertible bonds. The former refers to a class of banks’ regulatory capital buffers, and most outlets abbreviate it as AT1. The latter refers to a specific type of bond banks will sell to raise AT1 capital. It is a bond that can convert to equity if certain conditions are triggered, and those conditions are typically laid out in the bond’s prospectus—and occasionally mandated by regulators. Its abbreviation is co-co.

Credit Suisse is one of a few large, long-suffering European banks that regulators have seemingly been trying to solve since 2007 – 2009’s global financial crisis. It is in a class regulators call Globally Systemically Important Financial Institutions—aka G-SIFIs—whose sheer size or deep interconnectedness with the global financial system makes outright failure problematic economically in government officials’ opinions. Hence, despite many years of apparent mismanagement, regulators kept it afloat and bond investors—seemingly seeing the bank as too big to fail—continued capitalising it.^[ii] One big means of doing so? Co-co bonds. They are classified as AT1 capital, which is one rung below Common Equity Tier 1 (CET1)—the highest rank—because they can become equity capital in times of stress.

Last week, Credit Suisse released its delayed annual report, which contained some dismal results.^[iii] This hit its already-battered stock price hard. Depositors, seemingly seeing this as a case of US regional banking problems going global, fled.^[iv] The Swiss National Bank offered liquidity, but it couldn’t stem the outflows.^[v] Enter rival UBS, which purchased Credit Suisse Sunday in a deal most observers we follow described as a forced marriage arranged by regulators.

This is where many analysts’ surprise kicks in. In the most recent instances of a big, solvent bank buying out a failing institution, the sale price was a token. HSBC bought Silicon Valley Bank’s UK subsidiary for £1 last weekend, for instance.^[vi] When Spain’s Banco Santander bought the failed Banco Popular in 2017, it paid €1.^[vii] But UBS paid 3 billion Swiss francs in stock, which will give Credit Suisse shareholders 1 UBS share for every 22.5 Credit Suisse shares they owned.^[viii] Ordinarily this wouldn’t be such a big deal, considering Credit Suisse hadn’t actually failed yet, but it happened after Credit Suisse wrote its co-co bonds down to zero, wiping out those creditors.^[ix]

Typically, it doesn’t work this way. Longstanding practice is that shareholders take the first round of losses, with losses imposed on creditors only after common stockholders are wiped out. We think this makes sense in the real world. Shareholders own the business. When the business is no longer a business, its value goes to zero. But that business still owes people money, so its assets are sold and the proceeds used to pay off that debt. The order in which creditors get their money is generally determined by a pre-set pecking order, typically enshrined in bankruptcy law—or in banks’ case, bank resolution procedures set by regulators.

If Credit Suisse had failed outright with no buyer, we would generally expect it to go like this:

1. Bank fails.
2. Regulators divide bank in two—a good bank and a bad bank. The good bank contains everything that still works and makes money as intended. The bad bank contains everything that doesn’t work and is racking up losses.
3. Depositors and senior bondholders (meaning, creditors who own bonds with high-ranking claims on the company’s assets) go with the good bank.
4. Junior bondholders (meaning, creditors with lower-ranked claims on the company’s assets) and shareholders go with the bad bank. Shareholders get wiped out. Co-co bonds convert to equity, which is used to cover losses, and co-co bondholders get wiped out.
5. Regulators recapitalise the good bank, change the name, do some rebranding and eventually return it to the open market via a stock market flotation.
6. Regulators slowly sell the bad bank’s assets and use the proceeds to pay off remaining creditors, many of whom take partial losses—known as a haircut in industry jargon.
7. People write long articles and books on what went wrong and how to fix the financial system.

That is the European blueprint, based on our reading of all the relevant EU regulations. Whenever it has been tested, shareholders and co-co bondholders have been on the hook for losses. When Santander bought Banco Popular, both classes were wiped out.^[x]

So letting Credit Suisse’s shareholders avoid a total loss has caused some confusion amongst commentators we follow. Like the US Federal Reserve (Fed) and US Treasury’s decision to guarantee all of Silicon Valley Bank and Signature Bank’s uninsured deposits—regardless of pre-existing limits—it is a change from established procedures. It seemingly changes the pecking order that determined how banks’ various debt instruments were priced. It makes investors wonder, is this now a thing that can happen at all European banks? Can bondholders take losses whilst shareholders don’t? Has precedent changed? These questions appeared to ripple through European co-co bond markets this week, which saw sharp volatility.^[xi]

Trying to predict how officials will act in the heat of the moment is always perilous, in our view. But we see some mitigating factors. One, again, Switzerland is a metaphorical island. It isn’t in the EU or eurozone, so its banks aren’t regulated by the European Central Bank (ECB) and aren’t part of the EU’s banking union. That means they aren’t subject to the EU’s bank resolution framework. In the wake of the move, reports noted the peculiarity of Swiss rules and that the bond prospectus outlined this risk.^[xii]

For the UK, EU and eurozone, Swiss regulatory quirks don’t seem too relevant. A decade ago, in the wake of Cyprus’s bank crisis and sovereign bailout, the EU rewrote its bank rules in hopes of avoiding taxpayer-funded bailouts.^[xiii] In doing so, they formalised bail-ins, in which shareholders and bondholders take a certain percentage of losses when a bank fails. Only when enough creditors have been bailed in can a failing bank take state money to assist with its resolution process (i.e., Step 5 in the above hypothetical process).^[xiv] These rules create a very strict pecking order. Shareholders take the first losses, followed by junior or subordinated bondholders—which includes co-co bonds—and then senior bondholders. Next on the hook are uninsured deposits, starting with large corporations with deposits above €100,000, followed by small and midsized business and individual deposits above €100,000.^[xv] These entities get bailed in until they have collectively covered at least 8% of the bank’s liabilities, at which point the bank can get a state capital infusion. If the bank seeks capital above 5% of liabilities, all creditors must be wiped out.

These rules are enshrined in EU law and mirrored in member-states’ laws and their local authorities’ bank resolution processes. The BoE similarly has its own procedures. Both entities announced Monday that what happened at Credit Suisse won’t change how they approach failures.^[xvi] In time, as the dust settles, we think markets will likely reflect this. That said, we do think officials’ behaviour in the event of a failure is worth watching. Inconsistent actions by regulators, most notably the Fed and US Treasury, were a key cog in 2008’s financial crisis, in our view.

Beyond the regulatory response, the Credit Suisse saga could incentivise banks to reduce lending, especially if co-co debt becomes more expensive and difficult to issue for a while. Banks have used it above and beyond regulatory minimums in recent years to avoid diluting shareholders’ stake in the companies through issuing more equity capital.^[xvii] We doubt banks will have much appetite for raising equity capital now, as it would imply some weakness, perhaps scaring off depositors in this environment. Therefore, we can envisage banks deciding to take less risk for the time being. Even if they don’t outright shrink their balance sheets, they could reduce the pace of new lending, which could slow economic growth. As in the US, it will take time for this to show in the data, making it an area to watch.

For now, though, the fear evident in financial commentary seems much greater than reality. Even if reality doesn’t go terribly well from here, we think anything shy of abject disaster probably qualifies as positive surprise. We will continue monitoring the situation, but currently, we don’t think recent banking issues present a fresh, lasting, large negative development for global markets.