The impact of the Credit Suisse/UBS merger, driven through as it was by the Swiss regulators and with serious question marks hanging over the legality of some of its terms, is expected to have long-lasting repercussions on the industry: from the structure of bank funding to the liquidity profile of the bond markets to the potential weakening of the dollar as US banks struggle amid a broader market sell-off.
Equity implosion
“It is a mixed bag,” says Valerie Noel, head of trading at Syz Group.
“On the one hand, the market welcomes the fact that a systemic bank has been rescued through a last-minute weekend deal. A fallout of Credit Suisse would have had major implications for global financial markets, given their derivatives exposure and their ties with other banks.
Read More – UBS’ Credit Suisse takeover: What you need to know
“On the other hand, the deal is sending two negative messages to the market. First: that minority shareholders in systemic banks do not have much to say (the deal is going through without shareholders’ approval). And second, that CoCo bondholders are getting fully wiped out despite the fact that CoCos are supposed to be senior to equities. These two points are lowering the market confidence in systemic banks and towards Switzerland.”
The new UBS/Credit Suisse entity will become a giant in the European banking industry, with more than $5 trillion in assets. Once the investment banking restructuring is behind them, the growth opportunities in asset and wealth management and synergies could mean that the new giant Swiss bank may become profitable.
Economic impact
However, Noel warns that the immediate market reaction, especially in the equities space, could be seen as complacent.
“The reason for the market resilience mainly stems from the trust in the capacity of central banks to run two different monetary policies at the same time. On one hand, they are fighting inflation by hiking rates (see ECB last week). On the other hand, they are rescuing the financial system by providing banks with ample liquidity and a backstop (SNB support, etc.). The latter is even seen by some as a ‘stealth quantitative easing’.
“While this looks feasible on paper, running these policies at the same time carries important execution risks and creates a vicious circle: injecting liquidity is inflationary, which would force central banks to hike rates even more, which could create more issues for banks and lead to further liquidity injections and so on. In other words, the disinflationary impact of this financial crisis might not happen as it used to. Which means that central banks’ job is not done. And this is not necessarily good news for risk assets.”
Contagion fears
“Markets clearly see the UBS takeover of Credit Suisse as a sticking plaster over someone who has lost their arm, so expect to see a bigger sell-off over the coming weeks,” said Muhammed Demir, head of capital markets at City-based multi-asset broker Swiss Finance Corporation (SFC), speaking to The TRADE.
“But it is not just the stock markets that have been hit. Events in Switzerland also spell trouble for troubled US banks more exposed than their European counterparts. It seems like we are on the cusp of weaker US dollar territory against the euro.”
Astonishingly, in its delayed annual report, released on 14 March, Credit Suisse admitted “certain material weaknesses” in its internal control over financial reporting. This related to the “failure to design and maintain an effective risk assessment process to identify and analyse the risk of material misstatements in its financial statements” – an unexpected admission that highlights the crucial importance of robust financial reporting.
Bond chaos
But it’s the bond markets where the complexities of the Credit Suisse merger have really hit home – with the shock write-down of the bank’s AT1 bonds sending the market into an initial freefall.
“It’s a nightmare for the bond markets as investor confidence is falling sharply,” said Demir. “It will be difficult for the investors to go in new deals until we see a proper solution for the banking crisis and/or rate cuts, and we expect it to begin in Q3 23. The only winner is gold just as like any other financial crisis, it tends to go higher.”
AT1 bonds were introduced in Europe after the global financial crisis to serve as shock absorbers when banks start to fail. They are designed to impose permanent losses on bondholders or be converted into equity if a bank’s capital ratios fall below a predetermined level, effectively propping up its balance sheet and allowing it to stay in business. AT1 bonds have been very popular with qualified investors over the last decade, as they were paying fat coupons in a world of negative or zero interest rates.
Read More – Lone CoCo bond escapes the Credit Suisse carnage
But with reward comes risk. According to the Swiss bail-in regime, AT1 debt sits above equity in the loss absorption waterfall – but in a surprise emergency decree announced post-merger on 19 March, the government allowed FINMA special powers to circumvent this hierarchy in order to write the bonds down to zero (a value of around CHF17 billion) whilst still recompensing shareholders – a deeply unpopular decision that prompted outrage across some parts of the market and has sparked calls for litigation against both Credit Suisse, FINMA and the Swiss government.
“This is an arresting development, given that even unsecured bondholders usually rank above equity holders in the capital structure. So for equity holders to get “something” and CoCo bond holders to get “nothing” raises serious questions about the real value of CoCo bonds,” said Noel.
Future concerns
The subsequent impact saw the value of Credit Suisse bonds collapse, and had a negative impact across the $250 billion European AT1 bond market, with prices being knocked in some cases up to 20-30bps.
“AT1s being marked to 0 was a shocker (bonds went through mid 20s on Sunday), but the market was reassured on Monday following the ECB statement saying we are not the Swiss and we will not behave in the way they have because AT1 is important to our market/sector,” said one senior fixed income trader, who asked to remain anonymous. “After that, the market turned from sellers to buyers, and continued to see better buying when the US got in. Prices were everywhere on Monday though, and screen prices in the AT1 space have been totally unreliable.”
The broader bond market is now on the road to recovery, but while the AT1 market has slid back up slightly (around 5%) on hopes of potential legal redress, the question now is what the longer-term impact might be.
Read More – investors gear up for litigation over Credit Suisse writedown
“There is now a risk for the entire CoCo bonds to face a crisis of confidence and be shunned by investors,” said Noel. “A collapse in demand for CoCo bonds would mean that banks would need to raise capital through other means.”
This means that the whole future of bank funding in its current form could be at risk – with central banks needing to find an alternative product through which to raise capital. Another issue is that in the current state of uncertainty, the status of AT1 bonds remains in flux – and that makes pricing them almost impossible. “It’s just incredibly difficult to price these instruments right now, because no one knows where we are,” said Mark Leahy, chief business officer at LedgerEdge.
“A certain type of capital, which has been very comfortable with these instruments for a long time, is now either less available, or only available at a higher price than it was a week ago. That means you’re going to see higher costs, and you’re going to see investors depart the market. It’s going to be very hard to replace that pool of capital overnight.”
This means that not only could the bank funding structure transform, and liquidity temporarily dry up, but the whole investor profile of the segment could shift – away from the usual asset managers and private banks and towards those with a higher appetite for risk and a greater capacity for more sophisticated analysis.
The Credit Suisse crisis might have been concluded with the UBS merger, but its long-term consequences look set to be far from over…