Opinion: Why the Credit Suisse drama matters

Among the reasons central bank regulators exist is to ensure a fair playing field in financial markets and so that investors know what to expect from the system, before they take risk. That is why this week has been an interesting one, after one of the rule-makers seemingly departed from the rulebook.

The Bank of England published a short statement on ‘UK creditor hierarchy’ on 20 March. The day before, the European Central Bank (ECB) made a similar but less specific statement.

Both missives welcomed the actions of Swiss authorities without mentioning Credit Suisse specifically. The statements came after Credit Suisse was sold to UBS at just over $3.15bn (£2.6bn), far short of its previously estimated $8bn worth on Friday.

This shotgun wedding between these two giant financial institutions brokered by Swiss regulator FINMA is reminiscent of the global financial crisis. However, while the deal avoided the disorderly collapse of a major bank, it has almost immediately created a row about creditor hierarchy, which is what triggered the Bank of England statement.

“The UK’s bank resolution framework has a clear statutory order in which shareholders and creditors would bear losses in a resolution or insolvency scenario,” said the Bank of England.

“Additional Tier 1 (AT1) instruments rank ahead of CET1 and behind T2 in the hierarchy. Holders of such instruments should expect to be exposed to losses in resolution or insolvency in the order of their positions in this hierarchy,” the UK central bank added.

This statement was necessary because the Swiss authorities, led by regulator FINMA, decided on a “complete write-down” of Credit Suisse’s AT1 investments.

These AT1s are a relatively new invention. They are hybrid bonds – sometimes known as contingent convertibles (Cocos) – and were a creation of the credit crisis. Functioning as bonds, Cocos are designed to be triggered and transformed into common stock in the event of a credit crisis, boosting a bank’s capitalisation by turning debt into shares.

There are carefully composed rules for the structure and hierarchy of banks’ capital – set out in Basel III, which took years to agree in the wake of the financial crisis. In a default, bondholders typically get paid before shareholders, who are therefore more likely to end up penniless in the event of a bankruptcy.

The issue of fairness and credit hierarchy is that FINMA’s complete write-down of Credit Suisse’s AT1 holders left the Coco holders penniless, while the bank’s common shareholders, including sovereign wealth investors, such as the Saudi government, were compensated with CHF 0.76 (£0.67) per share.

This is the reason for the urgency of the Bank of England’s ‘creditor hierarchy’ statement. The statement also reminded readers of its approach used for the recent resolution of SVB UK, in which all of its AT1 and T2 instruments were written down in full and the whole of the firm’s equity was transferred for a nominal sum of £1 – which is too bad for affected investors, but the central bank was making a point that, by its actions, the credit hierarchy was held intact.

The Swiss example messes with the hierarchy. Investors who bought Cocos sold by other banks around Europe may have been left feeling uneasy at FINMA’s decision about who would face the chop in the case of Credit Suisse. Clearly, the ECB felt the need to say something in response, and the Bank of England felt the need to restate the credit hierarchy more specifically.

Switzerland is a country famously sensitive about its banking laws. Swiss authorities have historically been averse to washing linen in public. Now, having upset the apple cart so publicly, FINMA will be watching closely for what happens next, but where this investor mess leaves Credit Suisse’s AT1 investors could become a matter for their legal representatives.