VoxEU Column Financial Regulation and Banking

The Swiss authorities enforced a legitimate going concern conversion

Enrico Perotti
/

22 Mar 2023

Credit Suisse’s CoCo creditors will be wiped out while its shareholders retain some claim on the bank, as a result of a Swiss legislative decision that has been met with indignation. This column argues that this is precisely the risk that investors in high trigger contingent convertible bonds bought into. These bonds qualify as AT1 capital precisely because they should convert or be written down as a going concern when the bank is solvent but needs capital. To activate the trigger, the bank needs to report book equity below a very low number. There was no chance to publish adjusted accounting figures during the run on Credit Suisse, yet the bank was clearly undercapitalised. The decision to force a conversion of Credit Suisse’s CoCo debt ahead of the bank sale appears a fair adjustment to a flawed legal construction.

Enrico Perotti

Founder and Director of the Research Platform 'A Sustainable Future' at UVA Senior Advisor Financial Stability DNB Member of the ESRB Advisory Scientific Committee European Central Bank; Professor of International Finance University Of Amsterdam

At a time when Credit Suisse has been saved with a state-sponsored takeover by its competitor UBS, it is fitting to recall how UBS itself was bailed out 15 years ago by the Swiss authorities with a massive $60 billion package. After this rescue led to a furious popular response, the Swiss regulators led the way with the robust imposition of preventive measures to ensure bank investors absorb the risk they take.

In the Credit Suisse bailout, the decision of Swiss legislators to force the write off of a massive amount ($17 billion) of additional tier one (AT1) CoCo bonds has led to a furious market response, reinforced by the stand taken by European regulators. Its effect was to eliminate a massive debt overhang prior to the UBS purchase, avoiding yet another bailout.

Contingent convertible bonds were introduced in Basel III as a form of preventive increase in risk-bearing capital triggered when the equity book value falls below 5.125% of the CET1 ratio, or higher thresholds contractually agreed by the parties (7% for the Credit Suisse CoCos). They were meant as pre-planned recapitalisations to overcome the difficulty of raising new equity in times of debt overhang (Flannery 2014). Yet, the contractual trigger could be activated only once book equity is publicly reported to have fallen below a minimum threshold.¹ But clearly, a struggling bank will experience a full run well before it publishes accounts recognising insufficient book equity. The trigger is inadequate, just as in the case of pre-2008 subordinated debt.

Financial indignation has been directed at the notion that creditors may be wiped out while shareholders retain some (minimal) claim on the bank.² Yet this is precisely the risk investors in AT1 CoCo bonds bought into, and for which they receive higher coupon rates. CoCo bonds were treated as AT1 instruments as they are supposed to lose value when the bank is still a going concern entity. CoCo bond conversions were intended to be preventive, with the bonds automatically converted or written off so as to allow the bank to avoid distress (Kashyap et al. 2008, Flannery 2014).

Most CoCo bonds have been issued with an extraordinarily low book equity trigger (5.5% of risk-adjusted assets), so that they are triggered only in default. They are in practice indistinguishable from subordinated bonds. High trigger CoCo bonds, strongly encouraged by the Swiss regulators after 2008 (such as the 7.5% Credit Swiss CoCos), could theoretically be triggered, so they qualify under Basel III as additional tier one capital.³ They are treated as quasi-equity instruments, with the aim of reducing leverage in a going concern conversion, preventing distress. CoCo bond investors were rewarded with higher coupon rates to reflect their risk bearing. Credit Swiss issued its last CoCo bond for a 9.75% coupon in June 2022, when the difficulties of the bank were already discussed publicly.

Yet, to date, no contingent capital debt has ever been converted or wiped out in a going concern context. No coupon payment was ever denied. Every single case of CoCo bond conversion has occurred in default, so CoCo bonds for all trigger levels (thus including those posted as AT1 capital) were treated equally as de facto subordinated bonds. Supervisory practice resisted the principle of going concern activation, refusing in 2016 to suspend even a single CoCo coupon payment at Deutsche Bank precisely at a time when the bank could use more equity. Clearly, the effect was to undermine the preventive nature of the instrument and the credibility of early conversion (Glasserman and Perotti 2016), consolidating market beliefs that high-trigger CoCo bonds were unconvertible ahead of default and so had no equity content (Glasserman ea 2016).

Formally, to activate a CoCo conversion or write-off, the reported book equity of a bank has to fall below a very low number. This is a poor construction. It is clear that in the case of Credit Suisse, there was no chance to publish adjusted accounting figures while there was a run on the bank, yet the bank was clearly undercapitalised. Credit Suisse’s CoCo debt was designated to be written down in a preventive recapitalisation, so it was high time to activate its trigger.

In conclusion, the decision of the Swiss parliament to force a conversion of Credit Suisse CoCo debt ahead of the bank sale appears a fair adjustment to a flawed legal construction. It restores the original intent of a preventive increase in equity that avoids default and preserves continuity.⁴

It is legitimate on prudential grounds that shareholders may receive a little bit even though some of the creditors are wiped out. Preventive recapitalisation was the whole point of the reform!

If this principle could not stand, we must accept that high-trigger CoCo bonds are poorly constructed to serve their claimed purpose, and serve as a legal loophole for weakening equity content in bank capital norms. In this case, even high-trigger CoCo bonds should not count as AT1 capital.

References

Flannery, M (2014), “Contingent Capital Instruments for Large Financial Institutions: A Review of the Literature”, Annual Review of Financial Economics 6:225-240.

Flannery, M and E Perotti (2011), “CoCo design as a risk preventive tool”, VoxEU.org, 9 February.

Glasserman, P and E Perotti (2017), "The Unconvertible CoCo Bonds", in Achieving Financial Stability: Challenges to Prudential Regulation, World Scientific Publishing, pp. 317-329.

Glasserman, P, B Kay, R Neuberg and S Rajan (2019), “The Market-Implied Probability of Government Support for Distressed European Banks”, mimeo, Columbia University.

Hart, O and L Zingales (2011), “A New Capital Regulation for Large Financial Institutions”, American Law and Economics Review 13(2): 453-490

Kashyap, A, R Rajan and J Stein (2008), “Rethinking capital regulation”, in Proceedings-Economic Policy Symposium-Jackson Hole, Federal Reserve Bank of Kansas City, pp. 431-471.

Sundaresan, S and Z Wang (2015), “On the design of contingent capital with a market trigger”, Journal of Finance 70(2): 881-920.

Footnotes

The alternative view of a market value trigger (Flannery and Perotti 2011) was not pursued, not even as a signal to trigger specific supervisory actions (Hart and Zingales, 2009). While there were legitimate concerns of creating a market-driven trigger for runs (Sundaresan and Wang 2015) the choice of an accounting book equity value forced a reliance on publicly disclosed accounts.
This choice will generate a massive number of lawsuits. Two things are important to note. First, the possibility of a ‘principal write down’ of the CoCos were part of the prospectus, which also clarified that the write down event could materialise both in case of breaching the 7% CET1 threshold or in case of a ‘viability event’ determined by FINMA. Second, creditor hierarchy is a key principle of bankruptcy law as well as bank resolution. However, Credit Suisse was declared solvent by FINMA a few days before the sale and such declaration represents the ‘conditio sine qua non’ of the sale itself. Creditor hierarchy would have been strictly enforced in case of bank resolution, but outside of resolution contractual relationships govern the faith of the instruments and the contract allowed for going concern write down. The contention point is that such write down was contractually possible only thanks to a statute passed by the Swiss Parliament a few hours before the event.
Low-trigger contingent convertible bonds (typically converting at 5.5% book equity) were not considered sufficiently close to equity capital because they would clearly convert only upon default and had to be put in the Tier 2 box.
This measure was necessary because FINMA had to recognise Credit Suisse as a ‘solvent institution’ few days before to enable a sale, so that ascertaining the breach of the CET1 threshold had become unfeasible at that point.