The Swiss Avalanche That Ended With A Shotgun Wedding
The dramatic banking events of the past two weeks in the US (SVB and Signature Bank) and Europe (Credit Suisse) have highlighted once again the pivotal historical role that confidence, or more correctly, the loss of confidence, has for banks.
The Swiss Government mandated takeover of Credit Suisse by UBS is a salient reminder of the need for fixed income wealth managers to construct client portfolios which appropriately balance the desire to earn attractive yields whilst navigating potential tail risks.
Banking continues to be a confidence sensitive industry
Of all industries banking remains acutely confidence sensitive.
Whilst banks do many things, their major function is to take in funds – primarily by way of customer deposits from those with money, pool them, and then make loans to those who need them.
Banking gives rise to an inevitable asset/liability maturity mismatch – their chief regulatory function of making loans inevitably means they will have a longer asset maturity profile when compared to their liabilities, which is usually majority funded by customer deposits.
Most of the time the system works well. Even though most deposits are on demand and can usually be withdrawn on no or minimal notice, customer deposits typically provide in aggregate terms a stable source of (relatively) cheap reliable funding.
Unfortunately, when a bank loses the confidence of its depositors the outcome is rapidly fatal and appeals to adequate balance sheet solvency metrics usually fall on deaf ears.
Credit Suisse’s recent error prone record and its wealthier deposit base made it more vulnerable to a fatal loss of deposit holder confidence
Credit Suisse has been the most error prone of European banks in recent years. In 2021 the bank experienced two massive own goals. It absorbed a $10b loss as a result of the bankruptcy of Greensill Capital. It also lost a further $5.5b from the collapse of Archegos Capital, the US hedge fund. These events led to CS announcing a major business restructuring strategy and necessitated it raising equity capital in 2H 2022.
Whilst CS had adequate Common Equity Tier 1 (CET1) and Tier 1 ratios of 14% and 20% at financial year end (FYE) 2022, the bank had clearly lost a lot of trust with market participants. Indeed, in the second half of 2022 CS’ publicly traded debt regularly traded several hundred basis points wider than UBS, with CS also trading materially wider than two other European rivals, Deutsche and UniCredit. Ominously, CS had also started losing deposit holder confidence, with its Liquidity Coverage Ratio materially dropping from 192% at 3Q 2022 to 144% at FYE 2022 as a result of material deposit outflows.
The dramatic collapse of SVB and Signature Bank over 11-13th March and the imprudent comments from the Saudi National Bank representative (March 15th) provided a reminder to nervous CS depositors of the theoretical risk of having large uninsured deposit balances with a distressed bank. Consequently, the cost to hedge CS debt via 5-year credit default swaps (CDS) rose dramatically to distressed levels above 1000 basis points.
Although it is highly unlikely that the Swiss authorities would ever allow any loss on customer deposits even in the event of a messy CS credit event, only the first CHF 100,000 of a client’s deposit is explicitly guaranteed by the Swiss government.
Faced with an awareness of the limit on the deposit guarantee, many of CS’ financially news sensitive depositors understandably decided they were not interested in taking any chances or experiencing any uncomfortable uncertainty on their deposit access.
Instead, they collectively withdraw up to CHF 10b of deposits per day, a situation that rapidly depleted CS’ liquidity, thereby requiring an emergency arranged CHF 50b Swiss National Bank funding facility (March 15th evening), and the inevitable announced takeover of CS by UBS on March 19th.
Total Loss-Absorbing Capacity End-4Q2022, in CHF bn
FINMA ignored traditional seniority principles – a 100%write down was imposed on more senior Additional Tier 1 (AT1) debt investors whilst CS equity investors retained some equity value.
AT1 bonds are the most junior debt issued by European and UK banks. The AT1 market is a $275b asset class – Credit Suisse is only the second time that AT1 investors have experienced credit impairment in the last decade (the other occasion was in 2014 when Banco Espirito Santo (BES) collapsed and$1.7b of BES AT1 were written off).
In the UBS takeover CS shareholders were spared full economic loss. Instead, CS equity was assigned a merger value of CHF 3b. Unusually, FINMA (the Swiss banking regulator) chose to impose a permanent 100% write down on Credit Suisse’s CHF 14.7b of AT1 bonds on the basis that the Swiss government support provided as a deal sweetener (in the form of Government indemnities and funding support) warranted a “completed write-down” of the bank’s AT1 bonds.
Although FINMA had broad powers to apply loss sharing in an unconventional way it is most unusual to impose a more severe loss on a more senior part of the Bank Debt Capital Structure (AT1), whilst enabling more junior equity investors (CET1) to retain some value in their financial investment.
FINMA’s actions in favouring equity investors surprised the AT1 market and other banking regulators. In recent days the European Banking Authority (EBA) and the UK Prudential Regulation Authority (PRA) have been quick to stress that, in contrast to FINMA, normal subordination loss principles will apply to EU and UK banks. Accordingly, AT1 investors, who are more senior in the debt capital structure, will not be treated more severely than more junior CET1 investors in the event of regulatory intervention affecting a EU or UK bank.
Source: Arbion, Credit Suisse.
Data as at 31/12/2022.
It seems to us that AT1’s have a risk profile which has parallels to that of a catastrophe bond. In the event of bank failure, loss experience on AT1 is likely to be very severe as the actions of a national bank regulator are discretionary, hastily made, and will inevitably err on the side of conservatism in calculating the amount of fresh equity that is needed to be created from write-downs.
It is therefore vital that credit investors employ great discernment in their AT1 issuer credit selection.
Source: Arbion, Bloomberg. Data as at 22/03/2023.
European banks remain investable
Investors should not mistakenly conclude that the events at Credit Suisse are a sign of European bank ill-health. CS’ problems arose from a combination of factors, many of them idiosyncratic.
Since the Global Financial Crisis (GFC) there has been a concerted global push to make banks safer. European banks have been progressively subject to more stringent rules on liquidity, risk taking, asset risk weightings and capitalisation. On a broad range of measures such as CET1, Tier 1 Capital, Asset Quality (annual cost of risk) and Liquidity Coverage (LCR), Europe’s banks are in sound financial health.
For AT1 investors we expect to see some silver linings out of recent events. Along with higher entry yields on AT1 paper it is likely that EU and UK banking regulators will encourage issuers to be bond holder friendly on the calling and refinancing of existing AT1 bonds.
Signia Invest’s approach to global credit
We have largely avoided AT1 debt as opportunities for attractive yields in other parts of the Bank Debt Capital structure (Senior, LT2) provided superior risk adjusted returns. Higher yields in corporate credit compared to a few years ago also meant that there was little portfolio need for AT1.
Signia Invest’s approach to issuer credit selection remains bottom up and is tailored to the varying risk profile of our clients. We invest in sectors that we readily understand and choose credits (issuers) that are subject to higher levels of public disclosure and which we have followed for many years.
At Signia Invest we adopt our own credit due diligence and construct portfolios that are bespoke for our clients. We are active in spotting and taking advantage of attractive cross-currency opportunities (on a currency hedged basis) and also invest when appropriate in different parts of an issuer’s debt capital structure.
Global credit markets are simply too big to be efficient. The move to higher yields has burned many large institutional investors and made some too timid to take advantage of compelling investment opportunities. Many of these same players are also hamstrung by uneconomic motivations and internal institutional rigidities which impede performance.
As a result, market conditions now provide attractive portfolio construction opportunities for experienced, flexible, non-benchmarked investors.
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