Is Another Panic in European Banks Likely?

The bankruptcy of Silicon Valley Bank, the end of the several-year agony of Credit Suisse with the takeover by UBS and concerns about the stability of not only the American but also the European banking system, is a summary of the events of the last 2 weeks. In addition, we saw significant discounts in the financial markets in response to the increase in risk aversion. Is the emotional reaction of investors based on fundamentals and concerns about the condition of the banking sector justified?

SVB – the genesis of the problem in a nutshell

On Friday, March 10, Silicon Valley Bank, the 16th largest bank in the US, filed for bankruptcy. It is the biggest failure of a US bank since the collapse of Lehman Brothers in 2008. As a result, the management of the bank was fired and shareholders lost their money. What was the reason for the decline of SVB? The bank’s customers were mainly start-up entrepreneurs. Two years ago, in an environment of low interest rates and a liquidated financial sector, investment funds invested in American technology start-ups. They, in turn, deposited their surplus cash with banks such as SVB. Banks, on the other hand, invested their cash surpluses mainly in bonds. The whole process worked flawlessly until the Fed was forced to start a rate hike cycle in response to rising inflation. This subsequently led to two negative phenomena in the context of the described procedure.

• First, rising interest rates caused the prices of bonds held in the portfolios of banks, including SVB, to fall. This resulted in the difference between the book value and the market value of the bonds, which is professionally referred to as the so-called unrealized loss. This is a “paper” loss that is harmless unless the bank is forced to sell its bond portfolio before maturity.
• Second, rising interest rates have increased the cost of capital, with the result that start-ups have struggled to raise new funds from investors. To cover the cost of day-to-day operations, they started companies collect deposits from banks including SVB.

As a result, SVB was forced to sell a US$21 billion bond portfolio to maintain liquidity and recorded a US$1.8 billion loss, leading to its insolvency.

So what happened to Credit Suisse?

After last week’s turbulence following the collapse of SVB Bank, financial markets expected normalization. Not only did the situation not stabilize, but the already tense situation in the financial sector escalated. News hit the markets over the weekend that Credit Suisse’s years-long agony is finally coming to an end, with UBS acquiring it for $3 billion.

As part of the deal, existing CS shareholders will receive 1 UBS share in exchange for 22.48 Credit Suisse shares. That’s a big loss for shareholders, but worse for holders of AT1 bonds, a type of bond issued as a result of regulations following the global financial crisis in 2008. These bonds were created so that in the event of a bank failure, creditors would bear the costs first, not the taxman taxpayers.

The CoCo problem

It’s not this “Credit Suisse stock sale” that has caused panic in the financial sector. This is due to the repayment of AT1 bonds, the so-called CoCo’s (contingent convertible bonds) issued by Credit Suisse to the value of USD 17 billion, thereby bypassing the usual ranking of creditors. The reason was the stabilization of the bank’s financial position. In practice, this means that bondholders will be left with nothing. As noted 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 “violation of the hierarchy of claims”. As a result, the market price of AT1 bonds saw a drastic decline. The financial sector realized that if another bank failed, history could repeat itself and AT1 bondholders would once again be left with nothing. Which European banks are potentially most exposed?

Source: Bloomberg

UBS Group is more dependent for its capital on the type of subprime bonds that were repaid during its acquisition of Credit Suisse Group AG than any other major lender in Europe. The other Tier 1, or AT1, bonds are equivalent to about 28% of the Swiss lender’s high-quality regulatory capital, according to Bloomberg calculations. That’s only slightly more than Barclays Plc, while the average exposure among Europe’s 16 biggest banks is around 16%. The key issue is again the preservation of liquidity. This “bond time bomb” is relatively harmless unless another bank fails.

Shares of Credit Suisse (green line) and UBS (blue line)

Who’s next?

According to Reuters, at least two major European banks are analyzing risk scenarios in the banking sector and are expecting a more substantial statement from the Federal Reserve and the ECB on possible support. Both banks have been conducting their own internal consultations on how quickly the European Central Bank should take measures to ensure the stability of the banking sector, in particular its capital and liquidity position. Directors of the banks concerned said the banks and the sector are well capitalized and liquidity is high. Liquidity is again the key word.

Can banks count on government help?

US Treasury Secretary Janet Yellen has announced that the government is ready to provide additional deposit guarantees if the banking crisis continues to develop. She further clarified that: “The action we took was not aimed at helping specific banks or classes of banks. Our intervention was necessary to protect the entire US banking system. Similar actions might be warranted if banks were affected by the outflow of deposits that pose a risk spreading [krize].” In short, the US Treasury and the Fed will do everything to prevent a repeat of the 2008 situation.

Relax, it’s just panic

The panic in the financial markets that we witnessed seems to have been out of proportion to the scale of the problem. 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 piling up for many years, and its takeover by UBS was not a matter of sudden failure of the entity.

In the case of Credit Suisse, the panic in Europe was triggered by the AT1 bond default, which bypassed the creditor hierarchy, and the realization that creditors may be left with nothing at all. The two cases were unrelated, the genesis of the problem was different, and liquidity was the key word in both cases.

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