Swiss regulators broke the rules of the game

Swiss regulators broke the rules of the game

Peter Garnry

Chief Investment Strategist

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.

Quarterly Outlook

01 /

  • Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges

    Quarterly Outlook

    Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges

    Althea Spinozzi

    Head of Fixed Income Strategy

  • Equity Outlook: Will lower rates lift all boats in equities?

    Quarterly Outlook

    Equity Outlook: Will lower rates lift all boats in equities?

    Peter Garnry

    Chief Investment Strategist

    After a period of historically high equity index concentration driven by the 'Magnificent Seven' sto...
  • FX Outlook: USD in limbo amid political and policy jitters

    Quarterly Outlook

    FX Outlook: USD in limbo amid political and policy jitters

    Charu Chanana

    Chief Investment Strategist

    As we enter the final quarter of 2024, currency markets are set for heightened turbulence due to US ...
  • Macro Outlook: The US rate cut cycle has begun

    Quarterly Outlook

    Macro Outlook: The US rate cut cycle has begun

    Peter Garnry

    Chief Investment Strategist

    The Fed started the US rate cut cycle in Q3 and in this macro outlook we will explore how the rate c...
  • Commodity Outlook: Gold and silver continue to shine bright

    Quarterly Outlook

    Commodity Outlook: Gold and silver continue to shine bright

    Ole Hansen

    Head of Commodity Strategy

  • FX: Risk-on currencies to surge against havens

    Quarterly Outlook

    FX: Risk-on currencies to surge against havens

    Charu Chanana

    Chief Investment Strategist

    Explore the outlook for USD, AUD, NZD, and EM carry trades as risk-on currencies are set to outperfo...
  • Equities: Are we blowing bubbles again

    Quarterly Outlook

    Equities: Are we blowing bubbles again

    Peter Garnry

    Chief Investment Strategist

    Explore key trends and opportunities in European equities and electrification theme as market dynami...
  • Macro: Sandcastle economics

    Quarterly Outlook

    Macro: Sandcastle economics

    Peter Garnry

    Chief Investment Strategist

    Explore the "two-lane economy," European equities, energy commodities, and the impact of US fiscal p...
  • Bonds: What to do until inflation stabilises

    Quarterly Outlook

    Bonds: What to do until inflation stabilises

    Althea Spinozzi

    Head of Fixed Income Strategy

    Discover strategies for managing bonds as US and European yields remain rangebound due to uncertain ...
  • Commodities: Energy and grains in focus as metals pause

    Quarterly Outlook

    Commodities: Energy and grains in focus as metals pause

    Ole Hansen

    Head of Commodity Strategy

    Energy and grains to shine as metals pause. Discover key trends and market drivers for commodities i...

Disclaimer

The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website. This content is not intended to and does not change or expand on the execution-only service. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
Full disclaimer (https://www.home.saxo/legal/disclaimer/saxo-disclaimer)


Business Hills Park – Building 4,
4th Floor, office 401, Dubai Hills Estate, P.O. Box 33641, Dubai, UAE

Contact Saxo

Select region

UAE
UAE

Trade responsibly
All trading carries risk. Read more. To help you understand the risks involved we have put together a series of Key Information Documents (KIDs) highlighting the risks and rewards related to each product. Read more

Saxo Bank A/S is licensed by the Danish Financial Supervisory Authority and operates in the UAE under a representative office license issued by the Central bank of the UAE.

The content and material made available on this website and the linked sites are provided by Saxo Bank A/S. It is the sole responsibility of the recipient to ascertain the terms of and comply with any local laws or regulation to which they are subject.

The UAE Representative Office of Saxo Bank A/S markets the Saxo Bank A/S trading platform and the products offered by Saxo Bank A/S.