So-called AT1 bonds, also known as CoCos, were in focus on Monday as shares of European banks showed significant declines in the wake of the rescue of Credit Suisse engineered by Swiss authorities by merging it with UBS.
The merger package announced late on Sunday means that some 16 billion Swiss francs in Credit Suisse’s AT1 debt will be written off to zero at the orders of the Swiss regulator Finma, which said this move would help bolster the bank’s capital. Several European banks, notably from Germany and France, hold Credit Suisse AT1 debt.
AT1 as seen as the riskiest form of bank debt in Europe. The announcement has already triggered a sharp sell-off in Asian bank debt and shares overnight. It is now feared that the market for new AT1 bonds will freeze and the cost of risky bank funding will jump.
“The troubling part of the deal is the decision to completely write down CHF15.8 billion in Credit Suisse additional tier one (AT1) debt that risks spreading contagion through the European/global banking system via the repricing of bail-in debt and equity at other banks,” said Lee Hardman, currency analyst at MUFG Bank, in a note to investors. “It meant that Credit Suisse’s AT1 debt holders lost more than its shareholders and has cast doubt on the hierarchy of claims in the event of a bank failure. AT1s were viewed as senior to stocks.”
The exact exposure of other banks to Credit Suisse’s bonds is not yet clear. Statistics on foreign bond holdings in Switzerland point to significant general exposures for German and French banks in particular. German banks held $11.5 billion in Swiss debt at the end of September, and French $8.0 billion. Japanese banks held $6.7 billion; Belgian $2.0 billion. Dutch banks had no such exposure at the end of September.
Contingent Convertibles
AT1 stands for “Additional Tier 1”. This type of debt is part of a family of bank capital securities known as Contingent Convertibles or “Cocos”. AT1’s are bonds issued by banks that contribute to the total level of capital they are required to hold by regulators.
As part of the merger deal between UBS and Credit Suisse, the Swiss authorities acted in line with Switzerland’s bank resolution framework, which is aligned with global bank resolution standards adopted in the wake of the 2008 financial crisis. The framework sees to it that taxpayers are shielded when banks get into trouble, forcing bondholders to be the first to incur losses when a bank goes into resolution.
CoCos and AT1s are seen as the lowest rung of bank debt. While they can generate attractive returns in good times, they’re set up as the first to feel the pain when a bank gets into trouble. This type of debt that banks issued also counts as “regulatory debt” and thus can count towards the banks capital ratios. A bank can bolster its ratios, for which minimum requirements are set, by issuing such debt.
The end result of the UBS-Credit Suisse merger now is that investors are now more concerned about credit risk alongside ongoing funding concerns at banks, although the purchase of Credit Suisse by UBS has taken an important financial stability risk off the table. “In current circumstances, we continue to recommend a short USD/JPY trade (click here) which is benefitting from the pick-up in risk aversion and less favourable financial market conditions,” said MUFG’s Hardman.