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In this note, we address the following topics:
- Does the collapse of Credit Suisse’s AT1 CoCos cast a shadow over the whole asset class?
- Will Deutsche Bank be the next domino to fall?
- How can the situation of US regional banks be resolved?
1/ Have AT1 CoCos become “uninvestable”?
Following the collapse of CHF15.8bn of AT1 CoCos from Credit Suisse on Sunday 19th, March 2023, which represented c. 6.2% of the universe as at the end of 2022 (ICE BofaML CoCo index), several voices were quick to claim that AT1 CoCos were “dead” and that the segment had become “uninvestable”.
a) The breach of “creditor hierarchy” could not have happened in Europe or in the United Kingdom.
The handling of Credit Suisse’s takeover by UBS was particularly messy, as FINMA and the Swiss government had to change the law during the weekend in order for AT1 CoCos to be permanently written-down to zero without having to put first equity down to zero as well. This was a breach in what we call “creditor hierarchy”, and was used as an argument that AT1 CoCo bond prospectuses or regulations could not be relied upon.
The ECB’s regulatory arm, along with the Bank of England, as well as Singaporean, Canadian and Hong-Kong regulators each published statements reminding investors that they would have handled a similar case differently. The ECB explicitly stated that “common equity instruments are the first ones to absorb losses, and only after their full use would Additional Tier 1 be required to be written down. This approach has been consistently applied in past cases and will continue to guide the actions of the SRB and ECB banking supervision in crisis interventions. Additional Tier 1 is and will remain an important component of the capital structure of European banks.”
b) AT1 CoCos are still necessary for banks.
AT1 capital is a necessary layer of regulatory capital for banks from all over the world. In Europe & in the UK, AT1 capital forms a stack that usually has to stand between 1.5% to 2.5% of a bank’s risk-weighted assets.
Should banks be required by regulators of forced by investors to forego this capital stack, then, they would have to replace it with common equity, whose cost of capital is currently estimated at c. 15-16%. This would not be an efficient, nor a cost effective, replacement.
The AT1 CoCo format might evolve in the future, as the “CoCo” layer of complexity is made redundant by the fact that authorities can declare a bank as “non-viable” in order to trigger either the write-down of these instruments or their theoretical conversion to equity. We had written about this in April 2022 (“Does the ECB want to end CoCos?”).
c) AT1 CoCo investors will not disappear.
“Investors will never come back to the asset class or this issuer after such an event!” We have heard this several times on bond markets: after Greece’s debt restructuring in 2012, after the unequal treatment of bondholders from Banco Espirito Santo in 2015, after the nationalization of Banca Monte dei Paschi di Siena in 2016…
Yes, the collapse of Credit Suisse’s AT1s is significant for the AT1 market, but we do not really see why investors would be willing to leave altogether the space on AT1s from other banks, whose fundamentals were nowhere near those of Credit Suisse. AT1 buyers are (or at least are supposed to be) aware that these instruments can jump to default with no hope for recovery if the issuing bank is regarded as no longer viable. This story is a reminder that defaults rarely happen, but when they do, they come in with a bang. Again, Banco Popular Español was a similar case in 2017 and was eventually seen as idiosyncratic, while on a much smaller scale.
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