The bankruptcy of Silicon Valley Bank, the end of Credit Suisse's several-year agony with the takeover of the bank by UBS amid unprecedented treatment of bondholders and concerns about the stability of not only the US but also the European banking system. In addition, drastic discounts on the financial market benchmarks. This is how the events of the past two weeks can be summarised in a nutshell. Is the emotional reaction of investors based on fundamentals and fears about the condition of the banking sector justified, or was it a long-awaited correction of the hurricane-like growths of mid-October, and were the banks merely the spark that fell on a powder keg that had been swelling for almost six months?
SVB - the genesis of the problem in a nutshell
On Friday 10 March, Silicon Valley Bank, the 16th largest bank in the US, declared bankruptcy. This is the largest US bank failure since the collapse of Lehman Brothers in 2008. As a result, the bank's management was fired and shareholders lost their money. What was the reason for SVB's bankruptcy? The bank's customers were mainly start-ups. Two years ago, in an environment of low interest rates and an over-liquid financial sector, investment funds invested "lightly" in US technology start-ups. These in turn deposited their cash surpluses with banks such as SVB. The banks in turn invested their cash surpluses largely in bonds. And the whole process worked flawlessly until the Fed, in response to rising inflation, was forced to start a cycle of interest rate rises. This in turn led to two negative phenomena in the context of the described procedure.
- Firstly, rising interest rates caused the prices of bonds held in banks' portfolios, including SVBs, to fall. This has resulted in a difference between the book and market value of the bonds, which is expertly referred to as the so-called unrealised loss. This is a 'paper' loss, which is harmless if the bank is not forced to sell its bond portfolio before maturity.
- Secondly, rising interest rates have driven up the cost of capital, with the result that start-ups have struggled to raise new funds from investors. In order to cover the costs of day-to-day operations, they started to withdraw deposits en masse from banks, including SVB.
As a result, SVB was forced to sell a USD 21 billion bond portfolio in order to maintain liquidity and recorded a loss of USD 1.8 billion, which led to its insolvency.
So what happened with Credit Suisse?
After the turmoil of last week's SVB bank collapse, the financial markets were expecting a normalisation. Not only did the situation not stabilise, but the already tense situation in the financial sector escalated. Over the weekend, news circulated through the markets that Credit Suisse's agony of several years was finally coming to an end and the entity would be acquired for US$ 3 billion by UBS.
As part of the deal, existing CS shareholders will receive 1 UBS share in exchange for 22.48 Credit Suisse shares. This is a big loss for shareholders, but worse for AT1 bondholders, a type of bond issued in the wake of the 2008 global financial crisis. These bonds were created so that, in the event of a bank failure, the costs of the procedure would be borne first by creditors rather than taxpayers.
CoCo's problem
It is not this "promotional sale of Credit Suisse shares" that has caused panic in the financial sector. The reason is the redemption of AT1 bonds, the so-called CoCo's (contingent convertible bonds) issued by Credit Suisse worth USD 17 billion, bypassing the usual order of creditors. The reason was to stabilise the bank's financial position. In practice, this means that bondholders will be left with nothing. As mentioned above, unlike bondholders, shareholders were not 'wiped out' in the sale of Credit Suisse to UBS. According to some investors, the above action is a clear "breach of the hierarchy of claims". As a result, the market price of AT1 bonds has seen a drastic drop. The financial sector has realised that, should another bank fail, history could repeat itself and AT1 bondholders could once again be left with nothing. Which European banks are potentially most exposed?
UBS Group is more dependent in its capital on the type of risky bonds that were redeemed during the acquisition of Credit Suisse Group AG than any other major lender in Europe. Additional Tier 1 bonds, or AT1s, are equivalent to about 28% of the Swiss lender's top-quality regulatory capital, according to Bloomberg calculations. This is only slightly more than Barclays Plc, while the average exposure among Europe's 16 largest banks is around 16%. The key issue again is liquidity preservation. This 'bond time bomb' is relatively harmless unless another bank fails.
Credit Suisse (green line) and UBS (blue line) share chart
Who's next?
At least two major European banks are analysing risk scenarios in the banking sector and are looking to the Federal Reserve and the ECB for more substantial statements of possible support, according to Reuters. Both banks have held their own internal consultations on how quickly the European Central Bank should take action to ensure the stability of the banking sector, in particular its capital and liquidity position. The directors of the banks in question said that the banks and the sector are well capitalised and liquidity is high. Again, liquidity is the key word.
Can banks count on governments helping hand?
Treasury Secretary Janet Yellen announced that the government is ready to provide additional deposit guarantees if the banking crisis starts to develop. She further clarified that, quote:"The action we took was not focused on helping specific banks or classes of banks. Our intervention was necessary to protect the entire US banking system. Similar actions could have been justified if smaller institutions had been affected by deposit runs that pose contagion risk [the crisis]." US Treasury Department and the Fed will do everything to prevent a repeat of the 2008 situation.
Relax, it's just panic
It seems that the financial market panic we witnessed was disproportionate to the scale of the phenomenon. The reason for SVB's failure was the poor diversification of the bank's clients and its reliance on unstable deposits from more or less successfully managed start-ups. Credit Suisse's problems had been building up for a dozen years, and its takeover by UBS was not a matter of a sudden entity failure.
The panic in Europe was triggered in Credit Suisse's case by the redemption of AT1 bonds bypassing the creditor hierarchy and the realisation that creditors could be left with nothing if another entity failed. The two cases were not related, the genesis of the problem was different and the key word in both cases was liquidity.
