The Credit Suisse bailout shook the European banking chessboard. In the heart of the Old Continent, although outside the ECB’s jurisdiction, the sale of a Swiss symbol to UBS bank was formalized last week. An operation in which the usual order of priority was broken: the shareholders recovered part of their investment, while the holders of the coconuts (acronym for contingent convertible bond) lost everything…

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The Credit Suisse bailout shook the European banking chessboard. In the heart of the Old Continent, although outside the ECB’s jurisdiction, the sale of a Swiss symbol to UBS bank was formalized last week. An operation in which the usual order of priority was broken: the shareholders recovered part of their investment, while the holders of the coconuts (acronym for contingent convertible bond) lost everything. In practice, it made these securities more expensive for banks, which reinforce the capital cushion in times of crisis, as their holders began to demand higher returns. That is, entities will pay more for their financing and, therefore, there is the threat of an even greater restriction on granting credit to customers.

Holders of Credit Suisse’s convertible bonds, known as AT1, lost $17 billion (about 16 billion euros), which were written off in full. Shareholders, however, went to the exchange of 3,000 million. A value, yes, far from the 7,500 million at which the entity was valued before the operation. “Switzerland crossed a red line whose immediate consequence was to make creditors nervous,” explains Joaquín Maudos, deputy director of the IVIE and professor at the University of Valencia. In fact, markets have increased the required return sharply, nearly doubling it in some cases. “Bank financing is now more expensive and banks lend less,” Gordon Shannon, fund manager at TwentyFour Asset Management, told Bloomberg.

To avoid a bigger disaster and stop the bleeding, the ECB went out on Monday to try to break this vicious circle: it issued a statement warning that, in the event of a crisis, in Europe the losses will be assumed first by shareholders and creditors and, only later , by the holders of these bonds. “The EBA [Autoridad Bancaria Europea]the ECB as supervisor and the SRB [Junta Única de Resolución] They have been specific about the order of priority that is applied in Europe”, emphasized these institutions in a joint note. That is, it guarantees that your investment will have priority.

The announcement calmed the markets, both on the Exchange and on trading requirements for the coconuts, which stopped falling. Although nervousness had already permeated a market valued at more than 250,000 million euros (in Spain, listed banks have more than 20,000 million). “If you fail to fully restore confidence that the rules of the game are respected in order to assume losses, the cost of financing that banks support will become more expensive. And that, of course, they will pass on to their customers”, counters Maudos.

Contingent convertible bonds are a hybrid issue: they have features of both debt (they pay interest to the investor) and equity (they can be used to absorb losses). In fact, if a number of requirements are met, emissions known as AT1 can be computed as additional capital. Furthermore, they do not have a specific maturity, but are perpetual, although the entities reserve the right to redeem the bond once a certain period has elapsed since its launch (usually five years).

“They were created in the previous crisis to reinforce bank capital because it is practically comparable to the highest quality and can be converted when it falls below a certain level,” says Ángel Berges, vice president of International Financial Analysts (AFI). Regulators require these built-in bailout buffers so they can be freed up to take losses in times of bankruptcy. Of course, before the previous steps must be performed: the highest quality capital, CET1 fully loaded, plus reserves generated by benefits from previous years. Then he would pull coconuts and then the subordinate titles. The idea, after all, is that taxpayers are not the first to foot the bill.

The People’s Precedent

For banks it is also attractive, as it allows converting them into shares or even their value can be reduced if the entity is in trouble. There is a paradigmatic case that serves as an example in European organizations: the resolution of Banco Popular, which ended up being absorbed by Santander for one euro in 2017. Afterwards, everyone saw their money disappear: shareholders and debtors (both convertible bond contingent and the subordinate). At the time, investors got nothing back and taxpayer protection and financial stability prevailed.

“A greater-than-expected risk arose with the coconuts. This makes financing more expensive: investors will ask banks for more profitability for this risk and, therefore, will grant more expensive loans”, says Leopoldo Torralba, economist at Arcano Economic Research. In this context, financial groups will have to choose in future maturities whether to issue new AT1 debt at a higher cost or seek other ways of raising capital, something difficult in a context of uncertainty such as the current one.

According to JPMorgan, the need to refinance convertible bonds could be a problem in the short term. An idea that abounds at Standard & Poor’s: “AT1 investors risk taking large losses as part of any bailout, whether as part of a formal resolution or a market solution to help a troubled bank.” A headwind for a financial sector that still fears a return from the stock market panic.

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