22 March 2023

Credit Suisse impact on EU market: regulators on alert - consolidation not ruled out

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In this article, we briefly discuss the impact of recent Credit Suisse events on the EEA banking landscape and signal potential trends for further consolidation to protect banks and bond holders.

What happened with Credit Suisse?

Credit Suisse experienced a quick loss in confidence, driven by identified material weaknesses in its financial reporting and accelerated by the turbulent events in the US financial markets last week. In the final days leading up to its acquisition by UBS Credit Suisse had a daily outflow of more than CHF 10 billion in funds. This outflow was on top of the CHF 111 billion that had disappeared during the last quarter of 2022 after a social media post questioned the bank's financial health.

Following the Basel standards, Credit Suisse qualifies as a "global systematically important banking group". This means that it is subject to increased capital and liquidity requirements, as well as certain rules for recovery and resolution. The banking group had been generally deemed too big to fail, and the Swiss regulator FINMA, the Swiss National Bank and the Swiss Federal Council stepped in to prevent further harm to the financial system and scale back market unrest. On Sunday, 19 March 2023, this culminated in the announcement that UBS planned to acquire all shares in Credit Suisse.

While the current shareholders in Credit Suisse will receive a share consideration in the form of UBS shares (albeit against a significant discount to their last market value), the biggest blow was dealt to the holder of AT1 capital instruments. The Swiss Authorities decided to write down AT1 capital instruments (CoCos) with an aggregate value of CHF 16 billion in full. This left the market with a bitter aftertaste due to the AT1 holders being impacted more than the shareholders of Credit Suisse, and also led to significant speculation about this potential precedent for EEA banks in financial difficulties.

Could it happen in the EEA?

Relevance for EEA banks and instrument holders

The Dutch Central Bank (DNB) is closely monitoring developments, stating that Dutch banks are resilient and can handle the turmoil in the financial sector. After those measures were taken and UBS took over Credit Suisse, share prices of Dutch bank stocks have remained relatively stable or even shown an increase. This could indicate a cautious return of trust in the sector.

The return of trust has been bolstered by a statement on the impact of the Credit Suisse precedent in the context of the European recovery and resolution framework (as set in the BRRD and SRM Regulation) – made by the European Banking Authority (EBA), the European Central Bank (ECB) and the Single Resolution Board (SRB, the European body responsible for recovery and resolution planning related to all EEA significant banking groups). While in their joint statement the SRB, EBA and ECB welcome the comprehensive set of actions taken by the Swiss authorities to ensure financial stability and thus acknowledge that these are aimed at preventing further contamination of the financial markets, they also reassert that the approach taken deviates from the guiding principles and corresponding legislative framework applicable in the resolution context within the EEA. In particular, the ECB, EBA and SRB are explicit that, in line with the European resolution framework, common equity items (CET 1 instruments held by shareholders and an institution's reserves) are the first to absorb losses and – in accordance with the EEA resolution framework - take the first hit. Only after the full use of the equity instruments will the holders of AT1 /T1 items come into play and may be impacted.

While the statement is supported by the mandatory application of the write-down and conversion order laid down in the EU resolution framework, the statement does not offer full clarity on the scenario that would have applied to Credit Suisse had it been located in an EEA jurisdiction. In the Credit Suisse example, authorities did not apply formal resolution powers. Instead, AT1-instrument contractual terms were used to procure the write-down. In brief, these terms stipulated that the AT1 bonds may be fully written down if deemed necessary by the Swiss authorities in a clearly defined trigger event. This includes situations in which: (i) Credit Suisse needs irrevocable or extraordinary support from the public sector with the aim to improve its capital position; and (ii) the Swiss regulator determines that without this support, Credit Suisse would become insolvent or in material default under part of its debt.

While unlikely, a similar situation could arise if an EEA bank were not resolved under the EEA resolution framework, but instead placed under a recapitalisation outside such context (Article 32(4) BRRD). We believe, however, that with their statement, the ECB, EBA and the SRB intend to signal that they – absent extraordinary circumstances – will respect the order in which shareholder and creditors of a troubled bank bear losses. This means that they would look to write down shares and other CET1 items before taking measures against AT1 or lower ranking instruments in all crisis interventions (with the broader term suggesting the intent is to uphold this order in non-resolution scenarios as well). The Bank of England issued similar communications, stating that the UK's bank resolution framework has a clear statutory order in which shareholders and creditors would bear losses in a resolution or insolvency scenario, proven by the recent resolution of SVB UK.

Potential actions for banks and investors

A similar succession of events is unlikely in the EEA due to the very specific nature of the terms governing the Credit Suisse AT1 instruments. At other major European banks, contractual bond terms generally include provisions that they can be temporarily written down or converted into shares, but do not include a full-stop write-down power for the banking institution or its authorities. Banks and their investors would benefit, however, from a fresh review of the contractual terms governing outstanding instruments to assess their respective positions, specifically in a distressed scenario.

What's to come?

The long-term effects of the Credit Suisse acquisition by UBS, and the impact of the decision by the Swiss authorities to fully write off AT1 capital instruments on the European markets, remain uncertain. A clear result of the recent SNB/FINMA decision has been the uncertainty on the status of the AT1 capital instruments in the resolution pecking order, triggering a sell-off in other bank debts. Despite reassurance by European authorities, the markets seem to have (at least for now) remained uneasy and cautious as they assess the risk of these types of instruments. This may make it more difficult for banks to attract AT1 funding or other bond market funding, which in turn may trigger a variety of accompanying consequences. These include: (i) bonds requiring a higher premium, (ii) downward pressure on prices of outstanding bonds and outstanding bonds being repurchased at a discount, or (iii) adverse impact on compliance with regulatory capital requirements by banks.

From a regulatory perspective, these recent events may speed up the implementation of a European deposit insurance scheme – one of the pillars of the banking union. While this has been in the making for years, finalisation has been stalled due to a lack of consensus between the member states.

We expect recent events to also trigger market parties to review opportunities for further consolidation in the banking sector. This could be done via: (i) absorption of banks that are at risk in terms of capital, liquidity or concentration, or (ii) (minority) investments into banks via additional capital raises to solidify their capital and funding base. After all, it has become clear that even significant groups such as Credit Suisse with apparent solid liquidity and capital balance are at risk if market perception and confidence turn.