The collapse of Credit Suisse, bail ins and moral hazard

Welcome to Finance and Fury. This episode is about the banking system – the collapse of credit Suisse and looking at how bail ins, bail outs work and the moral hazard this creates. In in an effort to answer the question: Is having a back stop from letting banks completely collapse a good thing, or is making the financial system and your situation worse?

To explore this concept – we will be looking at the collapse of Credit Suisse – which as been sold to UBS –

1. This didn’t come as much of a shock to financial markets – Credit Suisse has been the problem child of EU banking for over a decade now – it has been plagued with scandals, losses and restructuring – it has been on life support for some time and finally died from the 1,000th cut – losing money every stage of the way
2. Back in October 2022, there were rumours that Credit Suisse was on the verge of bankruptcy – these were floating around online – this caused investors to start pulling roughly $10bn per day out of the bank, across deposits or investments
   1. Because of their financial troubles, there were talks about a merger between UBS and Credit Suisse last year – however regulations got in the way – anti-trust regulations specifically, which are in place to avoid a monopoly – where you get one giant company controlling any industry
   2. And up until last Wednesday, it was believed that the Swiss regulators were going to stick with a two bank model no matter what – being Credit Suisse and UBS
      1. Australia has a similar policy – 4 pillar policy – Government policy to maintain the separation of the four largest banks in Australia by rejecting any merger or acquisition between the four major banks – so CBA cannot buy out all of the other banks and become the monopoly provider
   3. What is interesting is that the Swiss Government has previously bailed out both banks in the GFC using taxpayer money to try and preserve this 2-bank model – they did this rather than allow these banks to be acquired by some other non-Swiss bank – like a JP morgan or Goldman Sacs – but now this anti-trust regulation has been ignored and UBS has been allowed to become what is closest to a monopoly bank in any western economy – this is actually at the regulators request
   4. Blackrock tried to swoop in and buy out Credit Suisse last week – but the deals were rejected by the Swiss regulators – So the Swiss regulators were set on UBS to buy out Credit Suisse – in a form of a financial shotgun wedding – this had two purposes – they would still regulate the bank that purchased Credit Suisse – and they would not get bad press for using taxpay funds to bail out a failing bank
3. Looking at the deal between Credit Suisse and UBS – not so much a deal, but more of a take it or leave it offer that regulators ended up pushing through
   1. The initial offer was a real low ball – $1bn – this was obviously rejected – but the regulators were annoyed that UBS wasn’t taking this seriously – as they didn’t want a Swiss bank to fail – which it likely would have if the negotiations dragged on – so they started applying pressure to both banks to come to a deal before markets opened on Monday last week – this was all done in record speed over a two day period – which if you are the destressed asset, never bodes well for you
   2. After some haggling – Credit Suisse was sold in a $3.2bn deal – where shareholders in Credit Suisse were paid in shares in UBS – This deal was agreed upon only if the banks assets could be purchased cheaply and if they would be indemnified from the legal issues facing Credit Suisse – but there were also some additional kickers to sweeten the deal
   3. Credit Suisse PR department sees this as a merger – not a buy out due to them being about to fail – emergency measure – but the existing shareholders are annoyed, as they didn’t get a vote – considering class action – I don’t know how far they will get given that FINMA (swiss regulator) was the one that took over control of the deal
      14. To sweeten the pot for UBS – part of this deal was that the Swiss Government provide a $100bn Swiss franc liquidity facility from the Swiss national bank, and a government loss guarantee of up to $9 billion Swiss francs ($163bn and $14.7bn in AUD)
   4. This is where the regulator, FINMA entered the market – they were the match maker and not only facilitated the deal, but did so in a manner that is very favourable to UBS – as part of the deal, they wrote off a lot of tier 1 capital that Credit Suisse held – $17bn dollars’ worth to be precise – good news for UBS but bad for these bond holders
4. This is what came as more of a shock to many bond holders – and is the most scandalous part of this deal – even though it shouldn’t be – as this is all part of the bail in legislation that regulators like FINMA or APRA can enforce on commercial or investment banks –

How does this work –

1. First – look at the capital that has replaced depositors’ funds as the reserve requirement – this is broken down into Tier 1 and Tier 2 capital – where the sum of these two make up the reserve requirements – net of any deductions on the banks balance sheets – what is important here is Tier 1 – as these are the very liquid instruments held on a banks balance sheet
   1. Tier 1 capital consists of the funding sources to which a bank can most freely allocate losses without triggering bankruptcy – essentially – assets that can be liquidated (sold), written down or converted to equity to cover losses quicky – hence it avoids a bankruptcy – includes:
      1. ordinary shares in the bank and retained earnings that the bank has on its balance sheet – makes up most of the Tier 1 capital held by Australian banks –
      2. But tier 1 capital also includes specific types of preference shares and convertible securities – such as capital notes but also bonds that can be written down – in the event the bank is about to collapse and they need to reduce their outstanding liabilities
         1. The way these capital notes or bonds operate is that the banks sells them as an investment – in return, the investor receives an annual income payment as a yield –
      3. This sort of provision may come as a surprise to many – but was first mentioned in a paper released from the RBA back in 2010 – was talking about the forthcoming regulatory developments that are now in place – for the better part of a decade
         1. Prior to the GFC – bond holders were immune as the fear was that this would spark further contagion fears – but since these provisions were introduced, some bond holders are the first ones to lose, ahead of equity holders
      4. This was to move more of the risk from equity holders into the debtors of a bank – i.e. the bond holders – seen as a way of strengthening the balance sheet and reducing the need for tax payer bail outs down the road – whilst also diversifying risks, essentially changing the game where shareholders carried the risks of default of a company
         1. This was done to ensure that even if a failed or failing bank is rescued through a public-sector capital injection, all of its capital instruments are capable of absorbing losses. This includes a requirement that the contractual terms of capital instruments allow them to be written off or converted into common equity if a bank is unable to support itself in the private market – which has been achieved by the capital notes which are convertible and form part of the bail in legislation – normally if a company defaults, debt holders in the company are the first to be paid, then if anything is left over, shareholder/equity holders may get a small piece
         2. These debt instruments can be written off if the bank goes into default – now called resolution proceedings were regulators take over control of banks – In Europe and For Credit Suisse, there were called AT1 Bonds – Back in Jan 2022 they were trading around their face value of $100 – with increasing interest rates, they slowly declined over the next 12 months, to be around $75 – normal repricing – but in a matter of days, the price went to $0
         3. A clause in the contract of these bonds states that regulators can enter into banks and take over control if the CAR for tier 1 assets drop below 7%, these AT1 bonds can be written down to $0 – it essentially disappears – this improves the balance sheet of the bank as a chunk of the future liability they own investors disappears – The clause in the bond purchase agreement allowed the Swiss authorities to goes against the normal order of priority for a company default –
         4. Typically – equity holders are the last to be paid out – But for this type of bond – Debt is used before equity in this case – but with these types of debt instruments, equity is above debt in the capital priority of the bank
            1. So it isn’t a bail out – but one of the first major bail ins that we have seen – for more on bail ins – Where to invest in preparation for the next financial collapse? Covering mainly where not to invest – Back in around October of 2019
            2. Not all debt instruments in banks work this way – many in Australia are capital notes that convert into equity – so they can write off the liability by issuing more equity – often at a discounted price as they would only do so at maturity of the capital note or if the bank is in trouble, at which point their share price is probably in the toilet – these are considered hybrid securities – every contract is different

• But it’s not like these debt instruments have been hidden – it is in the PDS documents – but many people didn’t know what they were buying, as who reads a 100-page document?

1. Why would anyone buy these debt instruments? Because of the yields – they pay a risk premium so can generate an income of 7% to 10% p.a. – and many people may think this is at small to no risk – as they are tied to a banks collapse

3. But now the merged bank will be huge – one monopoly Swiss bank twice the size of the Swiss economy – as a comparison, CBA would need to be 30 times larger in its market cap to be the equivalent, as Australia’s current largest bank to be the equivalent
4. Given that each individual bank, UBS and Credit Suisse was deemed to big to fail – where does this leave the new monopoly bank for the Swiss? Greater systemic importance – and greater systemic importance – Anti-trust measures were waved, which were in place for a reason – so will this cause problems for the Swiss population?
   1. Initially – flow on effects from this event comes in the form of those who hold equivalent bonds in other banks – could their invested money be on the chopping block? Many think there is a chance – as this news sparked a major selloff of other banks similar bonds occurred – the AT1 bond ETF index dropped on the news losing about 15%

But this brings us to the crux of the episode – looking at regulations and moral hazard

1. In economics, a moral hazard is a situation where an economic actor has an incentiveto increase their exposure to risk because they do not bear the full costs of that risk
   1. At the individual level – this could be someone in relation to car insurance – if you have comprehensive cover on your car, you might be more likely to drive differently than if you didn’t have insurance – or leave you car parked on the street –
   2. But at the corporate level, or in particular, banks – when a company knows that it doesn’t bear the full weight of their risks, they can take on higher risk knowing that its covered, either through the fact that they have insurancethat they have will pay the associated costs or in this case, the governments and central banks that will provide a back stop to banks –
      1. This is an insane moral hazard and major risk to the financial system – between regulators and central banks, investment and commercial banks bear almost no risk – whilst benefiting fully from their profits – it has effectively privatised profits, whilst socialising losses – this is all part of the too big to fail legislation
   3. A moral hazard may occur where the actions of the risk-taking party change to the detriment of the cost-bearing party after a financial transactionhas taken place – this was most prevalent during the GFC – I don’t believe that it is as dire now with these forms of bail in debt instruments – as the losses are incurred by the investors – again not the bank, as regulators allows for the bank to write off the debt instruments – but investors in these instruments should know the risk
2. But it brings up the fact that those who run major banks know they will be saved if they take too much risk and fail – either by investors or governments/central banks – how does this affect their investment making decisions – or their risk management practices? It would be naive to say that it has no impact on how they allocate their capital
3. This in turn can increase the risk – think about the makeup of a bank – it is individuals – these individuals are likely self-interested – i.e. what bonus can they get this year, plus promotions, which are tied to performance – if their bonus is tied to their performance, along with their career progression, and their performance is tied to the risk they take on, as it is a gamble on them providing returns, it is natural that more risk will be taken, given that not only are they not losing their own money, but they money of others that they may lose is either guaranteed by governments, or if the bank fails, it would be bailed in, then out
4. What we have just seen is the first major bail in, through the collapse of credit Suisse – structure of writing off tier 1 capital and then UBS getting the deal of a lifetime
5. What we have ended up with is rather than thousands of banks that try to compete for your money, providing different interest returns and lending rates – based around risk, we have a homogenised banking system – one that is effectively state run – where there is no real competition – perception of competition where they try to undercut one another by a few basis points – but they still operate cartel pricing – this has increased the risk to the system as it is top heavy, and you can have zombie banks, like Credit Suisse that can never truly die, but just get bought out or bailed in if they make poor management decisions
   1. Privatising the gains, whilst socialising the losses – letting large banks fail would be bad – people and business losing deposits – but through regulations, this form of legislation is unfortunately required

Summary –

1. Swiss regulators got a shotgun wedding to happen – with Credit Suisse and UBS
2. Favoured stockholders over the bond holders – raised many eyebrows
3. Test of a regulatory framework for the first time through these bail in bonds being triggered
4. This may continue to be tested – first time these bail ins have been triggered – confidence may be the first thing to go, if nobody wants to buy these investments, regardless of the risk premiums, then there is no capital to bail in, hence bail outs may be required
5. But doesn’t solve the problem with the financial system – the more that banks see there is a bail out, restructure or eventually bail in backstop to their poor decisions, the more risks they can take on
   1. In private business – you are not afford these same measures – you make a mistake, you bear the full costs of this – if in banks that are considered systemically important, you bear minimal risk but all of the rewards – gambling with someone else’s money
   2. In the case of UBS – this bank is now too big to fail in the view of FINMA – as it is the monopoly in Switzerland
   3. Means that further bail ins could happen – but UBS will be extended whatever lifeline they need in the future to survive