March 29, 2023
Quick Guide to CoCos After Buying Credit Suisse
In the past two weeks, markets have experienced not seen volatility since the pandemic with the Silicon Valley Bank default, which subsequently led to the decline and purchase of Credit Suisse by UBS AG.
During the weekend of March 18, UBS AG agreed to buy Credit Suisse for $3.2 billion (less than $0.8 per share) with considerable facilities and guarantees from the Swiss regulator, the Swiss Financial Market Supervisory Authority (FINMA). Although the market widely discussed the terms of this purchase, what generated the most controversy was FINMA’s treatment of Jr. subordinated bonds or Contingent Convertibles (CoCos).
What are CoCos, and why are they relevant?
Contingent Convertibles (CoCos), also called Additional Tier 1 Bonds (AT1), are Jr. subordinated bonds that act as buffers if a bank’s regulatory capital levels fall below a certain threshold. If this happens, they can become capital or be canceled.
These instruments are part of the capital buffer regulators require banks to hold to support in times of market turbulence. In other words, banks are required to maintain a determined level of CoCos in their capital structure. And the essential point for this commentary is that CoCos rank higher than stocks in a bank’s capital structure. If a bank is in trouble, the bondholders will be ahead of the shareholders to get their money back. That’s why these bonds have more correlation with the movement of the bank’s action.
What happened to Credit Suisse’s CoCos?
During that weekend, FINMA decided to change the capital structure hierarchy, granting some recovery to Credit Suisse’s shareholders but canceling all the CoCos of this bank, which reached a value of $ 17 bn.
What reaction did the market and other regulators have?
The Monday following these events, the market entered a risk-off mode towards these bonds, as they considered that the precedent of this operation could be generalized to the other CoCos of other banks. On average, these fell between 10-15 percentage points on the same day, and credit risk premiums on the US treasury increased by about 200 basis points (bps).
Given this, European regulators, such as the European Central Bank, the Bank of England, and the Federal Reserve in the United States, spoke out before the market. The regulators made it clear that FINMA’s procedure would not apply in these jurisdictions and that the hierarchy of the banks’ capital structure would be respected in case of non-viability of the banks, but that the financial system for these regions was solid and with sufficient liquidity. These announcements have helped to provide certainty to the market.
Can the case of Credit Suisse’s CoCos be generalized?
No, it is essential to consider that Switzerland is a different jurisdiction from the rest of Europe, such that the ECB cannot act or interfere in Switzerland and vice versa. In addition, in Europe, there are precedents that the hierarchy in the capital structure was respected during bank liquidations. First, in 2017, when Santander SA acquired Banco Popular, and recently, with the sale of Silicon Valley Bank UK to HSBC. In both cases, the first line of defense to absorb losses was common stock and later CoCos.
Another critical point is that triggers for CoCos are different in Switzerland compared to the ones issued in the rest of Europe. Swiss CoCos are canceled permanently once the capital ratio falls below the threshold. In contrast, CoCos of German, Spanish, and French banks are temporarily revoked until the bank’s capital ratio is again above the threshold. In the case of British CoCos, they are converted into shares once they exceed this threshold.
Our Committee has always recommended CoCos from banks with solid credit profiles and systemically important globally, in very manageable proportions, in the construction of portfolios. In addition, we recognize a somewhat irrational market reaction towards this sector, so we closely follow different metrics that help us react on time to relevant market events.