The collapse of Credit Suisse was a blow to the segment of contingent convertibles. However, banks, investors, and regulators still see many advantages in this instrument. A detailed analysis by the finews.com editorial team reveals more.
For years, Additional-Tier-1 (AT1) bonds issued by banks were considered a niche product, included in the portfolios of specialized funds and particularly savvy institutional investors. Naturally, financial market regulators and the banks issuing AT1 bonds were interested in this complex instrument with equity-like characteristics.
Since the Swiss Financial Market Supervisory Authority (Finma) wrote off Credit Suisse’s (CS) AT1 bonds with a nominal value of 16 billion francs as equity in March 2023 – rendering them worthless for investors – these often-called Contingent Convertibles (Cocos) have not lacked attention.
Challenging Legal Questions
They regularly make headlines, most recently with a law firm suing Switzerland in a New York district court. The main stage, however, remains the Federal Administrative Court in St. Gallen, where most plaintiffs have turned.
Aside from the challenging legal questions of whether the provisions and clauses in the prospectus allowed the write-down of CS’s AT1 bonds and whether the intervention in property rights was proportionate: What is the basic idea behind Cocos? Has the concept proven itself, and how has the market evolved after the «accident»?
A Child of the Global Financial Crisis
The Coco concept was developed with significant input from regulatory authorities and is a child of the 2008 global financial crisis. At that time, banks had to make large write-downs on their assets, which affected their equity. This further eroded confidence in the banks' solidity and their assets, creating a vicious cycle that threatened to drag the entire modern financial system into the abyss.
The very first Coco was issued by Lloyds Bank in 2009, followed by CS in 2011, and many other large banks. Crisis experiences show that raising equity capital is difficult and costly, especially when it is most needed.
Sweetening the Credit Suisse Takeover
Cocos solve this problem: They allow systemically important banks to raise large amounts of funds relatively cheaply in normal times. When everything runs smoothly, Cocos remain debt instruments, but in a crisis, if the conditions in the prospectus are met, they can be converted into equity (shares) or written off to absorb losses, as in the case of CS.
At least in theory, this instrument increases the stability of the bank and the overall financial system. Was this the case with CS? The write-off of the corresponding debts ordered by Finma was certainly a factor that sweetened UBS's takeover.
Before the Storm
Considering the Swiss government's chosen path of a forced merger between the two major banks, accompanied by extensive liquidity commitments and state guarantees, AT1 bonds have at least partially fulfilled their purpose.
After the financial crisis, there was also great hope, including from the Swiss National Bank, that the instrument would have a preventive effect. It was supposed to improve incentives for risk-aware behavior among investors, sending corresponding signals through the market. This would enable bank managers and regulators to take timely measures before a bank hits the storm.
Signals Alone Are Not Enough
Indeed, according to an article by Professors Heinz Zimmermann and Pascal Böni published in «Schweizer Monat» (in German only) in early April 2023, the markets sent very clear signals before the CS debacle – not only the AT1 bond market but also CS shares, regular CS bonds, and CS credit insurance premiums. Bank management and regulators were aware of these signals, but the expectation that this would prompt them to act in time (whether they didn't want to, couldn't, or weren't allowed to remains debatable) was not met in reality.
The Coco market quickly recovered after the CS shock and is once again open for Swiss banks like UBS. However, there have been no new Coco issuances denominated in Swiss francs since then. It remains true that Cocos are cheaper for issuing banks than raising equity through stock issuance and that supervisory authorities can use them to strengthen the stability of the banking system.
Investors Continue to Buy
Why do investors continue to buy despite the CS trauma? The ongoing demand is because Cocos yield significantly better returns than regular senior bank bonds. These bonds usually have a perpetual maturity but are typically repaid at a pre-determined call date set by the bank (subject to regulatory approval).
So far, including CS, only about 5 percent of the volume of European banks' AT1 bonds has defaulted. The market is not lightweight: Since 2011, European banks have issued AT1 bonds worth approximately 370 billion francs.
A Hotly Debated Topic
From the outset, the influence of regulatory authorities on Cocos has been a hotly debated topic among experts. How strongly could and would authorities curtail bondholders' property rights in a crisis, and how extensively would they interpret their discretion?
We can expect clarifications regarding Cocos in Switzerland from the Federal Administrative Court's ruling in St. Gallen, though it will likely take some time.
Need for Action by Authorities and Banks
After the CS case, authorities worldwide are reviewing the rules for AT1 bonds. A critical point is the definition of the trigger for write-downs or conversion into equity. Banks also see a need for action.
At its last general meeting, UBS ensured through a statutory amendment that new AT1 bonds will be converted into shares of the major bank in the event of a crisis, rather than being written off. This prevents a situation like CS, where the creditor hierarchy was inverted, and shareholders were less financially impacted than bondholders.
