Concerns that began in U.S. regional banking have made their way to Europe where Credit Suisse (CS) became the central focus for investors, adding to worries around systemic risks in the financial system. Troubles are not new to the Swiss bank which has been undergoing a difficult restructuring. Last week, investors and depositors ran out of patience given concern over the impact of rate hikes, the prospect of a slowing economy and the issues surfaced with the failure of Silicon Valley Bank. CS’s stock was already ravaged, with shares down 68% last year and price declines accelerating in recent weeks. Moreover, doubts over CS’s ability to service its debts surfaced as the cost of insuring against default, measured by credit default swap spreads, surged to more than four times the levels seen at the height of the European Debt Crisis and the Global Financial Crisis. Given its status as a systemically important financial institution, a solution for CS needed to be found quickly. Swiss National Bank intervened last week to provide near-term liquidity and late Sunday evening UBS agreed to take over CS.
An important aspect of the crisis at CS was the treatment of Additional Tier 1 (AT1) bonds, also known as contingent convertible bonds or CoCos. These bonds were created following the Global Financial Crisis as a way to help banks meet their capital requirements. If a bank runs into trouble, the CoCos could be converted into equity in order to shore up the bank’s balance sheet. Fixed income investors believed that in a wind-down scenario, these securities would be positioned between more senior debt and equity. However, in this particular case, Swiss National Bank placed the AT1 bonds behind equity, resulting in a 100% loss for the US$17 billion of CoCos issued by CS. Investors responded viscerally as this decision raised questions for the broader market about the riskiness of these AT1 bonds. This situation has since calmed significantly following a statement by European and UK banking regulators, reassuring investors that under normal circumstances equity securities would be the first to absorb losses, and only after equity is fully depleted would AT1 bonds be written down. While that is small comfort to the holders of CS CoCos, it appears that the instrument and the AT1 market will survive the current crisis.
Although the fear of contagion is proving difficult to suppress, the situation with respect to CS appears to have been resolved with the merger with UBS. While these events serve as a reminder of the instability and stresses that can appear from time to time, regulators are also showing that they have a broad set of tools available to them during these periods. Nevertheless, we recognize that markets are particularly skittish following a year of rapid rate increases and the resulting stresses in the financial system. Financial conditions have tightened in recent weeks, no doubt providing room for central banks to re-assess their policy options. We are maintaining our below-consensus view for economic growth and believe that a cautious approach to risk taking remains warranted.