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Swiss regulators broke the rules of the game Swiss regulators broke the rules of the game Swiss regulators broke the rules of the game

Swiss regulators broke the rules of the game

Peter Garnry

Head of Equity Strategy

Summary:  The Credit Suisse takeover deal brokered by the Swiss government over the weekend broke all the rules, leaving money on the table for shareholders while wiping out additional tier 1 (AT1) capital holders. This move upsets the order in the capital structure and pushed the USD 250bn AT1 market lower this morning. The move by Swiss regulators could have longer term consequences for European banks with cost of capital going higher. In today's equity note we explain the AT1 market and why it is important for European banks.


Credit Suisse takeover design sends shock waves through AT1 bonds

The Swiss government’s shotgun wedding of UBS and Credit Suisse with shareholders of Credit Suisse receiving one share in UBS for 22.48 shares in Credit Suisse valuing the bank at roughly $2.8bn. While shareholders were left with something on the table the additional tier 1 (AT1) capital holders were wiped out on their outstanding notional value of CHF 16bn breaking with precedence in prior bailouts. The move also goes against the capital structure order as AT1 capital sits above equity which means that it should always be shareholders that absorb all losses before they flow to AT1 capital holders.

Markets did not like the takeover design sending AT1 bonds down as much as 17.5% at their intraday lows. In order to stem further confidence loss, EU banking regulators reiterated that common equity tier 1 (CET1) capital still takes losses before AT1 capital holders. This announcement has calmed the market with AT1 bonds rallying 8% off their lows.

The two biggest ETFs tracking CoCos (a part of the tier 1 capital structure) and all AT1 bonds

Source: Bloomberg

As we still do not know the longer term consequences of the SVB bailout, which included the full guarantee of uninsured deposits, we also do not know the longer term consequences of the Credit Suisse bailout. Last night’s event could create lasting damage to the AT1 capital market and thus long-term funding and cost of capital for European banks. In any case, the risk blow to banks the past two weeks will mean that risk-taking in the system will go down and thus cost of capital will go up for the economy.

What is AT1 capital?

The AT1 bonds framework was created after the Great Financial Crisis under the new Basel III rules as a new layer of capital to function as shock absorbers in case of banking stress and failures. The figure below shows a simplified capital structure of a financial institution and here it can be seen that AT1 bonds have the highest risk after the common equity tier 1 capital holders (shareholders).

One of the key criteria for an AT1 bond is that it is a perpetual, meaning that the bond does not expire, to ensure that it is permanent capital. Some of these AT1 bonds come with equity conversion in the case a bank’s leverage ratio dips below a certain threshold. These AT1 bonds are called contingent convertible bonds, or ‘CoCos’, and correspond to around 40% of the outstanding AT1 bonds. The AT1 market size is around $254bn with most bonds denominated with banks representing 97% of the issues and European banks representing 80% of the AT1 universe.

Source: VanEck
Source: Lazard Asset Management

One of the reasons why European banks have been the main issuer of AT1 bonds is that the return profile on common equity has been so disastrous that it has not been a viable capital source unless a bank has been willing to issue capital at a high cost of capital. AT1 bonds have functioned as a bridge and vehicle to create tier 1 capital. Investors have been keen on investing in AT1 bonds, and especially in global systemically important banks because there has been this implicit idea that governments would only allow shareholders to loss everything. The risk-reward ratio has thus been seen as quite good for AT1 bondholders. As the return chart from Lazard Asset Management shows is that the capital structure return profile has been distorted. Bank equity, as the most risky part of the capital structure, should have yielded a higher return than AT1 bonds but it did not, indicating that the European banking system is structurally unsound from an investor point of view.

For those that want to educate themselves even more on AT1 capital we can recommend these two short notes from Lazard Asset management:

Focus on the AT1 Market – Part 1

Focus on the AT1 Market – Part 2

It should be noted, that in May 2022, Fitch Ratings wrote a note about the existential crisis in Europe over AT1 bonds as European supervisors are leading discussions about a capital stack redesign with a focus on common equity tier 1 capital. In other words, the EU regulators are acknowledging that the current system is not optimal. But how to get increase the emphasis on common equity tier 1 capital when European banks’ return on equity is so low relative to the cost of equity?

European banks have the highest risk

Under the Basel III framework banks’ leverage ratio is defined as the capital measure (tier 1 capital) over exposure measure (risk-weighted assets). The total regulatory capital includes tier 1 (CET1 + AT1) and tier 2 capital and most be minimum 8% implying a maximum leverage of 12x, but this is under assumption of course that the risk-weighting framework is set correctly and work linearly across all risk scenarios; we would argue that it is not the case and thus the system has an implicit hidden risk.

Source: Bank for International Settlements

The whole Basel III framework is built on the layered regulatory capital and then a risk-weighted approach to the assets on the balance sheet. Government bonds have the lowest risk weighting under the current framework and it makes sense. But when you add an interest rate shock and held-to-maturity accounting, which only works under the assumption of stable liabilities, then regulators add a highly non-linear risk to the system. Because as we saw with SVB and other banks, the risk-weighting was clearly too low relative to a situation with unstable liabilities. This is the key risk in the banking system. If the wider population finds the utility value of deposits too low to other alternatives such as short-term government bonds, gold, Bitcoin, equities etc. then the banking system could easily extend its decline in aggregate deposits which will deplete banks of its cheapest funding source and potentially increase the pressure on forced asset sale.

We have updated our banking monitor with Canadian banks and also added the AT1 capital so our clients can see which banks have the most outstanding notional of AT1 capital. In addition we computed the lower bound on leverage by dividend the tier 1 capital with the total assets. This is naturally the most conservative risk measure on banks as it sets all assets to the same risk. Under this assumption it becomes quite clear that US banks are better capitalised than European and Canadian banks.

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