Credit Suisse’s near-167 years of history came to a screeching end on Sunday as the lender sought refuge in the arms of cross-town rival UBS.
The $3.2 billion deal, brokered by a Swiss government under considerable pressure from abroad to contain the problem, marks the latest peak in a new financial crisis that claimed its first European victim.
Yet astonishingly, regulators at Swiss financial market watchdog Finma—almost up to the very end—gave the lender a clean bill of health under its highly demanding “Too Big To Fail” regulatory regime.
Finma president Marlene Amstad told reporters on Sunday evening Credit Suisse met the minimum threshold for both balance sheet strength and cash at hand right up until last week.
Tightened regulations introduced following the 2008 global financial crisis never foresaw what she called a “vicious circle” that triggered a stampede of customers withdrawing their funds for the second time in a matter of months.
“Unfortunately the loss in confidence was too great," Amstad said during a press briefing. “The ‘too big to fail’ provisions are strongly geared at solvency problems."
In other words, it sought to address the wrong issue.
Credit Suisse’s collapse marks the third major financial institution to fail in as many weeks following the spectacular implosion of Silicon Valley Bank and Signature Bank, respectively the second and third largest lenders to collapse in U.S. history.
So how could this all happen?
How can a bank perceived to be healthy suddenly fail?
In short, all it takes is a loss of confidence to spark a run on the bank.
Even a healthy lender with far more revenue-generating assets than liabilities listed on its balance sheet might temporarily find itself in a cash crunch for various reasons.
That’s because banks usually have a mismatch between the profitable long-term loans they hold that are often difficult to sell—such as your average mortgage—and its short-term funding needs.
The problems start when they are forced to divest these assets at distressed prices lower than their carrying value. Under accounting rules, they must be marked down and the resulting losses can turn a temporary liquidity shortfall into a full-blown solvency crisis.
It was depositor flight that ultimately killed off SVB and then Credit Suisse.
Why was Credit Suisse hit?
The bank, which held nearly $575 billion in assets on its balance sheet, had no known exposure to its smaller, failed U.S. peers. Simply put it had been in the doghouse following scandal after scandal.
By the time it failed, it was already on its third pair of chairman and chief executive since February 2020—that pace of turnover in senior management erodes client trust.
A sudden and massive outflow of customer funds nearly sank the bank in October already, but the team around new CEO Ulrich Körner was able to restore some measure of confidence.
After its most loyal investor revealed he had abandoned ship at the start of this month, questions over its future returned.
Amid the jitters surrounding SVB Financial and the broader U.S. banking system, Credit Suisse’s large shareholder Saudi National Bank inadvertently poured fuel on the fire when it emphatically refused any further help last Wednesday, sending the shares tumbling to a new record low.
“The recent events originating in the U.S. hit us at the worst possible time. One time last year [in October] we were able to overcome the deep uncertainty,” said Chairman Axel Lehman on Sunday, “but not a second time.”
Is this a bailout?
Not exactly. Credit Suisse hasn’t been seized and put under receivership, nor has it been nationalized. Instead, UBS is bearing much of the risk going forward by acquiring the ailing lender.
Moreover, CS shareholders are taking a significant hit with the value of their stock overnight dropping by almost two-thirds.
Finally, CS bondholders are being “bailed in” as well, since the value of their Additional Tier 1 (AT1) paper worth roughly $17 billion is being wiped out entirely in the process.
It is, however, broadly speaking a bailout in the sense that an impending bank failure forced the Swiss government to intervene, and taxpayers are partially on the hook.
Up to 200 billion francs in liquidity guarantees have been extended by the Swiss government and central bank, 75% of which can be called upon without any form of collateral at all.
The bigger problem stems from the sale of a portfolio of long-dated derivatives holdings like swaps.
The first 5 billion francs in losses would be borne by UBS, but the Swiss taxpayer would be on the hook for a further 9 billion if more ensue.
Luckily, UBS chairman Colm Kelleher indicated these were not toxic assets sitting on the balance sheet at artificially inflated prices. Rather he claimed they simply did not fit with his bank’s investment bank-lite business model and would gradually be sold in a managed process.
Is Credit Suisse another Lehman Brothers?
Certainly there is a ton of debt sloshing around in the financial system following an unprecedented period of zero interest rates that encouraged excessive risk-taking. This time however there is an important difference.
At the heart of the 2008 crisis were opaque, hard-to-price assets like collateralized debt obligations.
This involved mortgage providers like Countrywide Financial originating loans with little to no regard for the creditworthiness of its client.
These would then be bundled into complex securities for sale by Wall Street complete with the same ultra-safe AAA debt rating that agencies like Moody’s slapped on U.S. Treasury bonds.
Since these highly tailored securities had no real market price to use as a reference, banks used internal models to value them, akin to students marking their own homework. When U.S. housing prices declined nationwide, they quickly became worthless.
What were the risks if Credit Suisse filed for bankruptcy?
Lehman represented the disorderly bankruptcy where policymakers simply let free markets work and a lender fail without taking contingencies—presumably fearing a bailout would only encourage excessive risk-taking and lead to moral hazard in the future.
Since no one knew who had what kind of exposure to Lehman, banks stopped trusting each other and froze all interbank lending. This briefly brought the system of extending credit to the real economy to a complete standstill.
Were Credit Suisse allowed to fail without any intervention, it is quite possible the global financial system would have suffered another cardiac arrest.
"A collapse of CS would have had grave implications for the economy both in Switzerland and abroad," the country's finance minister, Karin Keller-Sutter, told reporters.
How is this different from Lehman?
Many of the assets held by banks like Credit Suisse and SVB are standard products like Treasuries that can be easily sold—albeit at a potential loss.
The source of today’s turmoil is not credit and counterparty risk so much as depositor flight heightened thanks to the advent of modern technology. Facebook, Reddit and Twitter barely existed at the outset of the global financial crisis and payment systems are also faster and more efficient.
Now rumors and speculation mean a run on a bank run can happen in real-time.
Under pressure to prevent another Lehman moment at all costs, Swiss authorities brokered a deal much more akin to the Fed stepping in to coordinate the March 2008 acquisition of Wall Street investment bank Bear Stearns by J.P. Morgan
Since the Swiss government is exercising emergency powers, closing is expected before the end of June to end uncertainty for employees, depositors and counterparties as soon as possible.
Investor consent of any kind is not required as the authorities made it explicitly clear the very health of the global financial system was at stake.
The cost of insuring UBS debt against default soared on Monday, following the bank’s takeover of rival Credit Suisse. UBS 5y CDS jumps. pic.twitter.com/Sy5ZJv9acj
— Holger Zschaepitz (@Schuldensuehner) March 20, 2023
What does the deal mean for UBS investors?
The leadership team of Chairman Colm Kelleher and CEO Ralph Hamers, which will remain in place, plan to cherry-pick the two best crown jewels that Credit Suisse has to offer.
Following completion, UBS will have over $5 trillion in global assets under management and double the size of its highly profitable domestic universal banking business.
At the same time, it will downsize CS’s investment banking operations.
Their combined activities will equate to no more than a quarter of the new entity’s risk-weighted assets, UBS will align what remains of Credit Suisse’s IB business with its own conservative risk culture, and it will unwind market positions in CS’s trading book that don’t fit with its strategy.
What effect is this having on financial markets?
Shares in European banks are down across the board due to indiscriminate selling and spreads on credit default swaps—a gauge of insolvency risk—are rising, for example with UBS.
The bigger impact however could come from declining demand for risky contingent convertible (CoCo) debt that was created to avoid taxpayer bailouts.
These so-called “bail-in” instruments, like Credit Suisse’s AT1 bonds, are designed to act as a cushion in a crisis, by transforming debt into loss-absorbing equity.
The decision to allow CS shareholders to preserve a symbolic amount of their investment while letting AT1 bondholders take the full fall is controversial.
Typically the first to see their investment go to zero are owners of a company’s common equity.
How are central banks reacting?
Their number one priority is to quarantine sick banks before they infect healthy ones: the dreaded contagion effect.
The easiest way to prevent this is for central banks to act as the lender of last resort, providing liquidity to all solvent commercial banks that temporarily have a shortfall in funding.
There is perhaps no surer sign of stress in the global banking system than a coordinated effort between the world’s largest central banks to extend dollar swap lines—most recently this emergency measure was taken at the outset of the COVID pandemic.
Virtually every major international lender has large liabilities denominated in dollars since the greenback serves as the global reserve currency.
Cheap dollar funding is often one of the first things to disappear in a credit crunch, so the Federal Reserve, the European Central Bank and four other major peers agreed to provide dollars on a daily rather than weekly basis.
Whether this is enough to stave off a further escalation of a now global banking crisis is something only time will tell.
