Rules of the game - from Swiss finish to finished

The ramifications of the actions of the Swiss authorities last night are likely to have consequences for bank debt markets for years to come. A Global Systemically Important Financial Institution has essentially failed to carry on as a going concern, and FINMA, the Swiss regulator, has overseen a payment to equity holders (bonuses also being paid, apparently), while AT1 debtholders are wiped out, which is unprecedented. The situation is very fluid, but our early thoughts are as follows;

Firstly, we believe that the Swiss regulators have ripped up the rules for investing in a company. Equity is obviously the most subordinated security in a capital structure, nevertheless, Credit Suisse equity holders got bailed out by UBS (along with government guarantees) while AT1 debtholders are written down to zero.  It has been reported that, apparently, the law was changed over the weekend, which allowed the liquidity facility, put in place last week, to be used as a reason to trigger a Viability Event. The most similar case that comes to mind is Banco Espirito Santo in Portugal some years ago where, in our and many market participant’s view, the Portuguese regulator failed to treat pari passu bondholders in an equal and fair manner – legal action was taken by bond holders and the process is still ongoing. The consequences for Portuguese banks were quite severe as they were in practice locked out of international capital markets for years.

Secondly, AT1 capital is supposed to be “going concern capital”. That means they would get triggered into equity at a given CET1 level (generally 7% for Swiss banks), giving the issuer an automatic capital injection thereby allowing it to continue to be “a going concern”. In a more severe case, where the entity completely failed to remain a going concern, then the AT1s would be written down, but also along with the Tier 2 bonds and other subordinated debt, given the latter are “gone concern” capital. In this scenario the equity is of course written down to zero. This is what happened with Spain’s Banco Popular some years ago, and in this case investors did not question the decision (it had non-performing assets of ~30% and full loaded CET1 of ~7.3%).

Thirdly, as a consequence of the aforementioned, we are seeing subordinated debt trade down this morning, but other regulators having been quick to highlight the differences in their own regimes. The ECB has just hit the tapes, saying “the Great Financial Crisis has established, among others, the order according to which shareholders and creditors of a troubled bank should bear losses”, “In particular, common equity instruments are the first ones to absorb losses, and only after their full use would Additional Tier One be required to be written down”. It seems very clear to us, they think the Swiss regulators got it wrong.

Finally, we wonder what long term consequences this has for the Swiss financial system, as this action from FINMA will very likely dent investor confidence in this regulatory regime. Other banks have seen significant contagion, but even allowing for the statement already from the ECB, the laws governing the write-down or conversion of AT1s is enshrined across Europe via the Bank Resolution and Recovery Directive (BRRD) which sets out, by rule, that equity holders have to be wiped out and a valuation must be carried out before this power is used; the same rules continue to apply in the UK. Given the complexities of the European system, with every country having a vote, it would be almost impossible to get agreement to change laws in this manner in a short space of time. 

It is very difficult to say how badly damaged investor confidence will be in the short term though. We do however think that it is important to keep in mind that this was a bank, in a specific regime, facing large deposit outflows, where we think the regulator made a highly questionable decision, and one that could end up in court – in some cases, bonds are now bid with a “Claim Transfer Agreement”, suggesting this option is open.  

It’s fair to say that we are shocked by the actions of the Swiss regulator and wouldn’t down play the significance of what happened, and in particular the fact that laws were changed over the weekend. However, we do think the read across to other banking regimes isn’t clear cut and the statement from the ECB has helped to calm frayed nerves. 

Investors’ trust will have been severely shaken, but banks still need investors to hold their debt for them to continue their normal operations and other bank regulators will be keen to emphasise the differences in their regimes to bolster confidence – the ECB statement is unlikely to be the last we hear on this.