UBS buys Credit Suisse: What happened?
Over the weekend, Switzerland’s largest bank — UBS — acquired the country’s second-largest bank — Credit Suisse. After 166 years of operations, this former global banking giant met its unceremonious end.
Its ultimate downfall began last week, as investors became apprehensive of the company’s long term outlook following general uneasiness of the banking sector.
On Wednesday, though, the problems accelerated as the bank’s biggest shareholder — the Saudi National Bank — announced that it wouldn’t be providing any additional investment.
That announcement sent the bank’s customers into panic as they withdrew their deposits en masse. Both the Swiss National Bank (the central bank) and Credit Suisse rushed in to assure shareholders, depositors and the market that everything was fine.
For the central bank, that meant providing Credit Suisse with a 50 billion CHF (or 53 billion USD) credit line.
Credit Suisse, meanwhile, went on a communications offensive to show markets that:
- It had enough cash to cover expenses
- they held enough Tier 1 capital to cover any losses (more on that below)
It wasn’t enough to calm the frenzy and Credit Suisse’s share price tumbled to never-before-seen lows.
By the time Friday rolled around, rumors of an imminent closure or takeover were consuming both the financial news and the social media space.
Over the weekend, the Swiss government had seen enough. With seemingly lightning speed, the Swiss National Bank and the markets regulator FINMA brokered a deal for UBS to take over its beleaguered rival for just 3 billion CHF.
Credit Suisse and a long history of scandal
Despite the sudden turn of events, Credit Suisse has been under stress for the better part of a decade.
While coming out of the 2008 financial crisis from a position of strength, the years since have been rocky and disappointing. The bank made a series of bad bets that both culminated in ugly losses and exposed poor management decisions and risk control failures.
Credit Suisse had multiple business divisions, including its retail bank, investment arm, and lucrative wealth management services. Unfortunately, the losses and poor performance from the investment arm couldn’t offset the gains it made in wealth management, which caused the bank to underperform its peers.
These reputational damages ultimately caused the downfall as, despite having enough capital and almost no exposure to interest rate risk*, bank customers and investors alike fled almost all at once.
* Silicon Valley Bank failed because it had too much of its capital invested in long-term government debt. Normally, if they held it until maturity, there would’ve been no risk. However, once depositors wanted their money back, they had to sell these bonds at a steep loss due to mismatched interest rates. Credit Suisse, on the other hand, managed this risk well, having almost no exposure to interest rate fluctuation.
Tier one capital, AT1s and cutting in the creditor line
Tier 1 capital and its role in Credit Suisse’s selling price is perhaps the most interesting story to come out of this saga.
To prevent a catastrophic bank failure, financial institutions around the world need to hold a certain amount of capital in reserve. The rules on how to do so and what type they need to hold come from what’s known as the “Basel Accord” which is an ongoing agreement between global central banks.
The last big update in effect is Basel III (there’s a 4th one that just came out, but banks haven’t implemented it yet). Basel III states that all banks should have:
- 8% of their total risk-weighted assets (so loans they’ve made and other investments) backed up by different types of capital
- 6% should be in “Tier 1” capital which includes:
- Equities (shares), retained earnings, and cash. (known as CET or “common equity tier 1)
- Alternative Tier 1 (AT1) which are convertible bonds the bank makes with investors.
- The rest is Tier 2 and Tier 3 capital which can be a mix of stocks, bonds, commodities and currencies.
Banks sell Tier 1 capital when there’s market pressure so that they can continue to pay out depositors. (We call this “going concern”).
Tier 2 and 3 capital is for whenever the bank might fail and acts as assets that can be sold to cover liabilities like deposits.
Credit Suisse and the AT1 controversy
Unlike the other tier assets, AT1s (alternative tier 1) are a bit unique in that they are convertible bonds.
A convertible bond is a loan that can convert into equity or another asset based on a set of conditions.
AT1s are what’s known as “convertible contingent” bonds or “CoCos.” The idea of a CoCo came directly out of the last financial crisis.
The rules for AT1s work like this:
- If the bank that issued them is under duress, it can convert the bond into equity of the bank.
- It can also, at the will of the regulator, be made worthless or written off.
In the first case, CoCo holders will receive some form of shares when the AT1 converts from debt.
In the second, the CoCo holders lose the entirety of their investment — which is exactly what happened over the weekend.
As part of the merger, FINMA and the Swiss National Bank forced Credit Suisse’s AT1s to liquidate to zero. This conversion created a controversy as:
- Borrowers have higher priority to assets in the event of a bankruptcy or takeover
- Shareholders generally get whatever’s left (if anything)
- Investors like CoCos as they prefer to get equity for the risk they’re taking since bank mergers give the shareholders of the acquisition bank stock of the acquiring bank.
Institutional investors in Europe are concerned right now since the Swiss National Bank devalued their CoCo holdings.
That raises questions as AT1s were an easy way for banks to meet their Tier 1 capital requirements. Now, with investors not willing to purchase AT1s, a serious bank security measure could be in jeopardy (even if it isn’t the only one available).
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What Credit Suisse’s failure means
Credit Suisse going under is raising questions and concerns across the board. Here are the ones we’re looking at the most.
Nervousness from central bankers
It’s been a nerve-wracking few months for central bankers. Even before Credit Suisse fell, there was concern for the global banking industry.
The liquidity window opens again.
Just yesterday, major central banks around the world announced that they’d re-open an emergency liquidity window to borrow US dollars.
Last used at the onset of the pandemic three years ago, this tool allows investors to buy and sell government debt directly with central banks in the US, UK, Eurozone, Japan, and Switzerland.
The goal is to ensure that government bond markets continue to function as they’re crucial for keeping cash flowing through the economy. Why?
If cash stops flowing, then business activity stops and banks can’t meet depositor demands. When that happens, the economy will come to a halt, creating a true crisis.
(We definitely don’t want that).
It’s important to remember that adding cash to an economy doesn’t necessarily create inflation. Inflation happens when supply for money exceeds the demand for money. Right now, there’s lots of demand for money, which is why central banks temporarily opened this window.
Will central banks continue to raise interest rates?
Over the past year, many central banks have been hiking interest rates to cool off inflation. (The higher the rate, the more expensive it is to borrow, which means companies and people invest less).
They’ve done so at a record pace. Now, though, banks are the ones showing the most stress. Cooling inflation is a noble goal, but crashing the banking industry will cause more problems than it solves.
With that, we could see central banks either pause or lower their pace of rate hikes this month.
Interest rates are an enormous part of our economy. If the central banks stop hiking now (or even cut), then it will change the economic outlook from today and beyond.
What’s the value of AT1s now, anyways?
The AT1 controversy might be the largest one out of Credit Suisse’s failure, at least for the banking sector. By not recognizing the debtholders’ desire to receive shares, the Swiss National Bank raised serious questions about the 275 billion USD market.
Of course, the bond investors knew getting nothing was a risk. It’s also worth pointing out that this is only the second time a CoCo conversion took place since their inception in 2014. Still, this episode might kill the AT1 as we know it, which will only create more pressure on banks to have adequate tier 1 capital in place.
The social media and fintech age give rise to rapid volatility
We’re in the social media age where brand reputation is becoming far more important than underlying fundamentals.
After all, Credit Suisse had plenty of Tier 1 capital with a CET 1 ratio of 14.1% by the end of 2022. (Banks should have a ratio of at least 6% CET 1 to meet Basel III requirements). On paper, they were fine. Yet, that didn’t really matter to customers and investors.
Financial technology (AKA Fintech) might have played a role as well. Banking apps make it incredibly easy to withdraw funds from an account at a moment’s notice. Fintech has only accelerated in the past few years, which makes it easier than ever to react to fears and market conditions.
Obviously, neither social media nor fintech are directly responsible for these failures. However, banks can no longer rely on their balance sheet to calm the nerves of investors and customers.
It’s not 2008, even if there are similarities
It’s tempting to look at the 2008 global financial crisis and believe we’re back in the same spot. Even if bank failures were a hallmark of the great recession, there’s a major difference between now and then.
Mainly, banks are under pressure for having mismatches between their deposits and their investments. Their mismatched investments, this time, are mostly in government debt. In 2008, the banks got into massive trouble as they held mountains of debt linked to toxic mortgages. As those home prices plummeted, the banks took enormous losses.
At the same time, millions of people lost their homes as they had bad mortgages they could no longer afford. The entire system came crashing down, taking the banks, the housing market, and peoples’ homes with it.
Today, it’s far different. Housing markets are mostly stable. Homeowners switched from having primarily variable-rate mortgages to fixed ones. There are certainly still risks right now, but central banks should be able to contain them far better than before; at least as it currently stands.
In any case, we can all take solace that the memes are continuing to produce. Unlike in the GFC, we didn’t have such quality sh** posting. For that, we can all be thankful it’s not 2008.