AT1: There is life beyond Credit Suisse

The resolution of the Credit Suisse case, with the forced sale of the bank to UBS by FINMA, the SNB and the Swiss Federal Council last Sunday, triggered strong selling in the AT1 segment and questions about the future and evolution of the instrument.

As part of the deal, the Swiss regulator wrote off the value of Credit Suisse’s AT1 bonds for CHF 16bn amount, instead allowing shareholders to limit the loss on their investment (UBS valued the bank at CHF 0.76 per share, 59% lower than the closing value on Friday 17 March, for a total valuation of CHF3bn).

With this decision, FINMA effectively inverted the creditor hierarchy with respect to the Basel rules, favouring shareholders at the expense of the AT1 bondholders. Although AT1s are clearly riskier than other debt instruments, they have always been and should be considered less risky than shares. But this has not happened.

The FINMA decision: some details

AT1 instruments absorb losses through three different mechanisms, chosen by the bank when the instrument is issued: nominal write-down (permanent or temporary, in case the bank becomes solvent again) or conversion into equity.

There are essentially two cases in which loss absorption is triggered:

• Contractual trigger (when capital, as measured by the CET1 ratio, falls below a certain threshold of 5.125% or 7%);
• Activation of ‘PONV’ (Point of Non Viability, i.e. when the regulator deems the bank to be close to failure). In this scenario, the participation in the losses of shareholders and bondholders is the basic prerequisite before public support can be activated.

The FINMA press release shows that Credit Suisse had not breached the capital ratios but that ” “there was a risk of the bank becoming illiquid, even if it remained solvent”. We therefore fall into the second case: FINMA, as the press release points out, linked the liquidity assistance backed by Swiss Confederation (amounting to CHF 9bn) to the impairment of AT1.

“The extraordinary state support entails a full write-off of the nominal value of all Credit Suisse’s AT1 bonds in the amount of approximately CHF 16 billion.”.

By applying the writedown only on the AT1s, FINMA has thus distorted the creditor hierarchy, causing a major shock in the markets and with implications that we believe are negative not only for Swiss AT1s, but in the long term for the entire architecture of Swiss resolution.

It is no coincidence that, the following day, both the ECB and the Bank of England[1] wasted no time in reiterating, via an official press release, the creditor hierarchy and that, for institutions under their supervision, equity is always written down before AT1s.

Five considerations

1. The European BRRD (the Directive regulating bank resolutions in the EU) clearly stated that if a bank is deemed ‘unviable’, the authorities may impose losses on AT1 and T2 holders. However, unlike in Switzerland, in the EU and the UK it is explicitly stated that if authorities decide to impose losses on AT1/T2, they must first write down equity, thus respecting the creditor hierarchy.
2. The devaluation of Credit Suisse’s AT1s highlights the riskiness of the instrument and the possibility that the regulator may impose losses on its holders, so an increase in the premium required by investors to subscribe AT1s can be expected in the future.
3. As of June ’22, the Tier 1 capital of European banks amounted to about €200bn (on average about 200 bps in terms of RWA). Although banks could be pushed to gradually replace some of these instruments with equity, we think it is difficult to assume a complete replacement, as the market would hardly absorb capital increases of this size. Moreover, even if the market had the capacity to do so, capital increases of this size would have a significant dilutive effect on shareholder returns with a net reduction in the RoE and thus the attractiveness of the industry.

4. The mechanism of permanent write-down of AT1s is essentially active only in Switzerland, since in Europe about 50% of the AT1s issues provide for a temporary nominal write-down and the remaining 50% for conversion into equity, which is slightly positive from the point of view of the recovery rate.

5. Since the scheme adopted in Switzerland for Credit Suisse cannot be replicated in the EU, we do not believe that there will be permanent damage to the AT1 market in Europe.