After the collapse of Silicon Valley Bank and the subsequent backstops implemented by the US Federal Reserve and US banking regulators, we were hopeful that markets would once again focus on the fundamentals of the global market and not be driven by short term sentiment.

However, this got thrown out of the window at the end of last week as issue ridden Credit Suisse created further negative sentiment within global banks, which led to sharp moves lower in its own share price and other financials. This added to the pressures that stock markets have been under over the past few weeks.

Credit Suisse is a far larger institution than SVB and issues with this bank could have led to problems with other creditors linked to the institution, and the European banking system as a whole.

Credit Suisse’s issues were idiosyncratic. Due to scandals, industry probes and criminal investigations, Credit Suisse has been in the headlines numerous times over the past few years and therefore has been a material underperformer in the banking sector. The recent issues with not submitting its annual report, restructuring problems and lack of deposit growth all added to the volatility. The spark that lit the most recent fire was the largest shareholder, Saudi National Bank, stating that it would not provide any more capital to the bank.

As with what occurred in markets due to the Silicon Valley Bank collapse, the weakness in Credit Suisse has also spread to other financials, with investors focused on contagion between banks and whether some form of crisis is on the horizon.

The problem with Credit Suisse was not a credit event or liquidity event, it was a profitability issue. On the evening of the 15th of March, they tapped into the Swiss National Bank to raise 45 billion Euros worth of capital, which they could utilise where required to shore up deposits. This liquidity buffer did not provide the stabilisation that the Swiss regulator was hoping for and over the following weekend a deal was struck between UBS and Credit Suisse, with the former acquiring the latter for 3 billion Swiss Francs, in what was described as an ’emergency rescue’.

The deal that was struck was not as simple as the headlines suggested. For UBS to accept the deal, the Swiss National Bank and Federal Department of Finance had to provide backstops of liquidity. This is in the form of AT1 bond holders, also known as convertible bank debt, being written down to zero, CHF 25bn of downside protection to cover costs and an extra 50% downside protection for non-core assets.

Having these assurances written into the deal makes the deal very one-sided in favour of UBS who will be able to cherry pick the assets that it desires, whilst also providing additional liquidity and capital to their own business in the short term. For Credit Suisse, the deal is a huge blow for creditors especially, as any holders of AT1 bonds will now receive zero from the deal. The price of these holdings before the deal was announced was 90p, these have now effectively been written down to zero, making them worthless.

Additional Tier 1 bonds are very important debt vehicles for banks. These types of bonds were first introduced post the Financial Crisis in 2008 with the help of global regulators, to help banks de- risk by providing greater capital and liquidity. What occurred on Sunday with the write down of all bonds to zero, endangered a very important asset class for not just banks but credit markets in general.

When AT1 debt is issued, it sits above equity holders within a bank’s capital structure. This means in any form of banking crisis within a specific bank, the equity holders will be wiped out first before AT1 bond holders. What happened in the case of Credit Suisse, is that due to a technicality in the bonds prospectus these AT1 bonds can be classed as non-viable and so the AT1 holders were wiped out ahead of the equity holders. The equity holders will receive payment from the sale as the deal struck was that equity holders in Credit Suisse would receive one UBS share for every 22.5 Credit Suisse shares held.

This caused a huge stir in markets yesterday, especially within banks as both the credit and equity price fell as the actions of the Swiss regulator has introduced doubt to the viability of a huge part of bank’s capital structure. Thankfully, other banking regulators around the world have come out to state that the move by the Swiss regulator of reducing the AT1 debt down to zero ahead of equity holders was specific to that case and will not be adopted in their specific regions. Both the ECB and the Bank of England made statements yesterday afternoon as follows:

‘Under the resolution framework that we continue to adopt after the Global Financial Crisis, equity shareholders should be the first to absorb losses, with AT1 bonds only required to be written down after all common equity capital has been exhausted’ Source: ECB 20th March 2023

‘AT1 instruments rank ahead of common equity and behind other creditors in the hierarchy. Holders of such instruments should expect to be exposed to losses in resolution or insolvency in the order of their positions in this hierarchy’ Source: Bank of England March 20th 2023

These statements from the Bank of England and the ECB are extremely important in restoring confidence back into financial markets and banks especially. It’s positive to see that what has occurred in the Credit Suisse case is specific to them and the Swiss regulator, and therefore should not feed across to other regions.

We believe the next few weeks will continue to be volatile. Markets will be focused on whether global central banks will continue to be solely focused on bringing inflation down in the short term or whether they need to assess the financial stability issues that could be increasing due to the large rate rises that have been implemented in such a short period of time.

We are in uncharted territory as the scale of hikes that have been implemented has never occurred in such a short timeframe before. From the swift action that has been implemented so far with liquidity backstops for deposits, the merger of Credit Suisse and the internal funding of other US banks, it does seem that everyone is clear in their view that keeping the banking system open and fluid is key for the global economy to continue to function properly, which should lead to less contagion than has been present in other banking crises

The team believe that where we are investing, in funds that are focused on quality, price and risk to return fundamentals, should provide the best opportunities to outperform over time and invest away from stocks, sectors and asset classes where these cracks lead to material underperformance.

What is pleasing to see in the discussions we have had with the fund managers we invest in over the past week, is that they are utilising the inherent weakness across markets and asset classes to top up holdings that they believe are being wrongly sold down due to the negative sentiment driving markets.