The Credit Suisse takeover has shaken the European banking chessboard. In the heart of the Old Continent — although outside the jurisdiction of the European Central Bank as Switzerland is not part of the eurozone — the sale of a Swiss symbol was formalized last week. The sale to rival bank UBS upset the usual order of priority: the shareholders recovered part of their investment, while the holders of bonds known as contingent convertibles, or CoCos, have lost everything. In practice, it has made these bonds, which reinforce a bank’s capital cushion in times of crisis, more expensive for lenders, since their holders are now demanding higher returns. In other words, banks will now pay more to finance themselves, which raises the risk that they will restrict lending to their own customers.
Investors in Credit Suisse convertible bonds, also known as Additional Tier 1 bonds (AT1), lost $17 billion, which were fully written off. The shareholders, however, received the three billion Swiss francs ($3.25 billion) that exchanged hands in the deal, which in any case was far below the 7.5 billion that the bank had been worth before the operation. “Switzerland has crossed a red line whose immediate consequence has been to make bondholders nervous,” explains Joaquín Maudos, deputy director of the Valencia Institute of Economic Research (IVIE) and a professor at the University of Valencia in Spain. The markets have significantly pushed up the required return on investment, almost doubling it in some cases.
To avoid a bigger disaster and stem the bleeding, the ECB on Monday stated that, in the event of a crisis, losses will be assumed first by shareholders and creditors and, only later, by these bondholders. The European Banking Authority (EBA), the ECB supervisor and the Single Resolution Board (SRB), the body in charge of shutting down failed banks, have all spoken out about the order of priority that applies in Europe, where “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,” according to a joint statement by all three institutions.
The announcement somewhat soothed the markets, although the tension had already percolated in a sector where CoCos account for an estimated $260 billion of the debt market. “If it is not able to completely restore confidence that the rules of the game will be respected in the order of loss absorption, the cost of financing for banks will be higher. And, logically, they will transfer these costs to their customers,” says Maudos.
Convertible contingent bonds are a hybrid instrument: they have characteristics of debt (they pay interest to the investor) and also of equity (they can be used to absorb losses). If a series of requirements are met, these bonds can be converted to stock and counted as additional capital. In addition, they do not have a specific maturity but are perpetual, although banks reserve the right to redeem the bond once a certain period has elapsed since its issue (usually five years).
“They were created during the previous crisis to reinforce bank capital because it is practically comparable to the highest quality equity and can be converted when capital falls below a certain level,” says Ángel Berges, vice president of International Financial Analysts (AFI). Regulators require these internal bailout buffers so that they can take losses in times of bankruptcy, although other instruments would take a hit first: the highest quality capital, CET1, plus the reserves generated by the profits of previous years. Then would come the AT1s and subordinated bonds.
For banks, it is an attractive tool, since it allows them to convert the bonds into shares or reduce their value if the entity is in trouble. But after Credit Suisse bondholders were wiped out in the UBS takeover, investors may have reservations.
“A greater than expected risk has surfaced with the CoCos. This makes financing more expensive: investors will ask banks for greater profitability to take on this risk and, therefore, banks will grant more expensive loans,” says Leopoldo Torralba, an analyst at Arcano Economic Research. In this context, financial groups will have to choose between issuing new AT1 debt at a higher cost or look for other ways to raise capital, which will not be easy in a scenario of uncertainty like the current one.
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