Friday, 29 September, 2023

Rescuing Credit Suisse Questions Bank’s Tier-1 Capital

Nironjan Roy

Rescuing Credit Suisse Questions Bank’s Tier-1 Capital
Nironjan Roy

There are some people in the world who are discussed more after their death. Similarly, there are some establishments in the world that are more discussed, analyzed and debated after their collapse. Credit Suisse is one such institution on which more discussion, analysis and debate are going on and will be continuing for a long time. Although Credit Suisse is one of the few largest banks in the world and the second largest bank in Europe, very limited people, particularly the selective people used to know about this bank. After the collapse of Credit Suisse, people across the world now know well about this bank. People from all strata i.e., from investors to analysts, bank executives to policymakers and even general people have been discussing the rise and fall of this bank. Many of them are questioning how the bank has been rescued and the consequences thereof.

Debate over Credit Suisse deal: Multidirectional discussion is going on over the strategy of rescuing Credit Suisse. Some investors and policymakers are supporting the approach the Swiss authority has designed and applied to rescue the bank because the measures according to their views have been able to prevent the contagion impact of the bank run. Some are, however, vehemently opposing the deal, because the measures will most likely cause a very negative impact in mobilizing capital for banks. According to the opponents’ views, the way Credit Suisse rescue deal was designed and applied has distorted the feature and properties of debt hierarchy. Usually, shareholders or common equity providers suffer first when a company goes bankrupt because their claim comes last if anything is left as residual after meeting all other eligible obligations, including bondholders’ claim. For all other available alternative options except litigation, bondholders, particularly AT1 providers, suffer first because this portion of capital is wiped out to offset the loss whereas shareholders’ interest remains intact. This is exactly what has happened in Credit Suisse because the rescue structure was designed in such a way that the bank’s USD 17.50 billion AT1 has been wiped out to offset the loss and this has infuriated the investors of convertible bond.

Bank’s capital structure: Capital of a company is commonly referred to as owners’ share of investment which can be specifically categorized as owners’ equity. Although most banks are publicly listed companies, its capital is quite different and has a broad periphery as some sorts of the borrowed fund and even ambiguous forms of investment also come under the purview of the bank’s overall capital. Therefore, various terminologies viz. capital, net worth and owners’ equity are used to define capital of limited companies. On the other hand, banks’ capital is defined in a different way and the term capital structure is generally used for referring to bank’s overall capital formation. There are two specific forms of capital in the banking business which include (I) Tier-1 capital and (II) Tier–2 capital. In addition, there is another form of capital which is commonly known as Additional Tier-1 (AT1) capital which is placed in between Tier-1 and Tier-2 capital. These are in fact, convertible bonds what are commonly termed AT1 bonds which have been designed to be a part of the bank’s core capital.

Tier-1, Tier-2 and AT1 Capital: Tier-1 capital is known as bank’s core capital which is in fact, common shareholders’ equity. So, Tier-1 capital mainly includes shareholders' equity and retained earnings which are explicitly stated in a bank’s financial statements. Tier-1 capital is the yardstick for measuring a bank's financial health and these funds come into play when a bank must absorb losses without ceasing business operations. On the other hand, Tier–2 capital is known as an incidental form of capital structure that in fact reflects a bank’s other sources of capital except common equity. Tier-2 capital includes revaluation reserves, subordinated term debt, general loan-loss reserves, and undisclosed reserves. Tier-2 capital is considered less reliable than Tier-1 capital because it is more difficult to accurately calculate and liquidate immediately whenever needed. Apart from these two typical forms of capital structure, there is another form of capital which is known as Additional Tier-1 (AT1) capital. The position of this capital is in between Tier-1 and Tier-2 capital. AT1 is defined as a financial instrument that is not common equity but there is an option to convert to common equity in future. This is in fact a convertible bond, so AT1 is categorized as contingent convertible or hybrid security, which has a perpetual term and can be converted into equity when a trigger event occurs. This hybrid financial instrument bears acronymic term “CoCo” which stands for Convertible Contingent.

Basel Committee’s role: It is learnt from the report published in the professional publication and as discussed among the market analysts, designing capital structure of the bank and introducing this hybrid form of capital is the result of Basel Committee’s role. In 1988, when Basel Committee recommended splitting a bank’s capital requirement into two specific categories which include Tier-1 and Tier-2 capital where the idea of hybrid financial instrument first came up. During the mid-1990s, most European banks were issuing capital notes in the US market where preferred shares have been a very popular means of raising additional capital for a long time. When this market condition has been continuing, Basel Committee came up with their Basel 2 reform that facilitated to formally bringing this cost-effective hybrid capital instrument, AT1. The scope and objective of designing AT1 was a kind of financial manoeuvring that allowed the transformation of debt in the hands of investors into capital in the eye of regulators. 

AT1 emerged after financial crisis: AT1 was devised in the aftermath of the financial crisis in 2008 to address the shortcomings of a previous form of instruments that failed to absorb the losses. The regulatory changes and measures undertaken as a consequence of the financial crisis in 2008, created the concept of a “point of non-viability” for a bank, where regulators would intervene before a bank completely lost the confidence of its shareholders and failed. Under these measures, a new line of AT1 bonds emerged to fit the new framework. Although US financial system was epicenter of the financial crisis in 2008, they did not allow AT1 as part of the bank’s core capital whereas the European market being the victim of that financial crisis, adopted this new layer of the bank’s capital structure for which they now seem to be falling into new trouble. Some may argue that since the USA has been allowing preferred shares for a long time, they are not required to allow an additional form of capital AT1 that has very close proximity to the preferred share. However, from an accounting perspective, preferred shares and convertible bonds may seem to bear close similarity but these are two distinct forms of investment as the former is related to the owners’ part of investment while the latter is part of borrowing investment.

Far reaching impact: It is learnt from the professional analysis that Credit Suisse had raised USD 17.5 billion AT1 which has been wiped out as a loss. Credit Suisse acquisition deal has caused severe losses to the AT1 investors which has created uncertainty over the future of AT1 investment market in Europe, where there is outstanding USD 280 billion AT1 bonds. The situation has become so grave over the process of treating AT1 in Credit Suisse deal that this special category of financial instruments will most likely lose its credibility in the market and thus banks may have to face severe difficulty in meeting the additional capital requirement in future. Therefore, all other regulators in Europe except Switzerland have hurriedly come forward and assured the AT1 investors that they would respect the usual hierarchy of creditors. Because, according to the litigation process, Tier-1 capital providers who are common shareholders will suffer loss first than Tier-2 and AT1 investors. Industry experts opined that if confidence in the hierarchy of creditors is destroyed, valuable sources for banks to raise their capital base might be compromised.

It is obvious that the collapse and subsequent rescue of one of the largest banks in the world would trigger question after question and would invite threadbare discussion, which will not end so quickly. It is also a perceivable fact that those who are the beneficiary of Credit Suisse rescue deal, have been praising whereas, those who are adversely impacted, have been criticizing the measures. Again, who are direct beneficiary, indirect beneficiary and losers of the deal are not made public yet, so we will have to wait for a long to know the eventual consequence of this much discussant rescue measures. However, one issue is very clear AT1 investors are the worst sufferers, so they are pointing their fingers at the Swiss authority and raising questions about whether rescuing Credit Suisse deal has benefitted the Tier-1 capital providers.


The writer is Banker, based in Toronto, Canada.

Email: [email protected]