The Credit Suisse CoCo wipeout: Facts, misperceptions, and lessons for financial regulation

The response to the global financial crisis (GFC) of 2007–2008 has famously been described as problem too-big-to-fail.1 In middle a worsening crisis, regulators had recognize that bank bailouts were only way stabilize markets. One two priorities regulatory reforms post-crisis was address too-big-to-fail by introducing resolution procedure for systemically important institutions.2 Among (with notable exception USA), contingent convertible bonds (CoCos) seen major innovation and quickly became popular “bail-in” instrument facilitate instant recapitalization distressed bank. quick deleveraging could be achieved with CoCo conversions would serve dual roles recapitalizing “a going-concern bank” reducing costs “gone concern” During press conference on March 19, 2023 Swiss Financial Market Supervisory Authority (FINMA) announced that, part emergency package in loss trust run Credit Suisse, Suisse Additional Tier 1 (AT1) capital written off.3 decision FINMA took many surprise provoked flood negative market commentary, commonly stated view conversion violated priority order claims between debt equity. Indeed, final rescue deal, shareholders retain around $3 billion equity value, while bond principal write-down amounted wipeout $17 investors. Implicitly corroborating this European Central Bank (ECB), England, other made public statements Monday following deal they do not intend follow approach respect usual resolution.4 How can these divergent views reconciled? Why did AT1 bondholders face losses before wiped out? What are lessons effectiveness post-GFC reforms? This article provides clarification questions. designed absorb at conversion, thereby helping capitalize Their primary purpose is reduce need injection government times when nobody else willing provide additional external capital. Such support costly taxpayers exacerbates moral hazard. have main contract features: absorption mechanism trigger activates (illustrated Graph 1).5 CoCos either converting into common or through (partial full). mechanical (i.e., defined terms ratio) discretionary (subject supervisory judgment). defines point which activated. CoCo-issuing drops below pre-specified fraction its risk-weighted assets. bank's measured based book value value. discretionary, non-viability (PONV), activated supervisor's assessment possible insolvency. PONV triggers give authority convert, if decide issuer reached state. Because difficult determine ex ante, introduce uncertainty about timing circumstances leading activation regulator. typically more than one trigger. case multiple triggers, any breached. Under Basel III rules, all required trigger, present issued exactly what allowed write down instruments 2023. second feature CoCos. Once activated, converted pre-defined rate subject write-down. case, delevers and/or boosts ratio. For CoCos, price stock time price, like issuance. It also combination prespecified floor, where latter floor hence protects existing holders from unlimited dilution. various options setting lead different exposures dilution risk holders, thus create varying incentives avoid holders. haircut full partial. However, most potentially encourage taking managers acting interest shareholders. treatment under supplementary requirements national shape design choices features issuing banks (that 2). framework, must satisfy qualify first requirement, applies both T2 instruments, satisfied requirement rule, specifies minimum level CET1/RWA 5.125%. addition, perpetual. Importantly, necessarily outcomes optimal contracting rationale improve banks’ resilience shocks strengthening their buffers providing investors an investment opportunity distinct By raise limiting current issuance likelihood becoming insolvent requiring bailout. particular, allow seamlessly recapitalize during stress. allows transfer some investors, ensuring failures borne rather taxpayers. addition cost distress, possibility bankers limit probability distress. attractive long-term who understand able take crisis. offer higher yields traditional due nature, low ranking (on par even lower investors), high systematic component risk. institutional mandates often block fixed income positions yield may contain premium sophisticated flexible segregation. 2013 Primer published International Settlements, colleagues Stefan Avdjiev, Anastasia Kartasheva, Bilyana Bogdanova show yield-to-maturity newly average 2.8% subordinated debt, 4.7% senior unsecured same bank.6 popularity partly driven search environment, touted advisors sometimes misrepresented product relatively safe boosting yield. perceived similar total absorbing capacity (TLAC) since troubled banks. There are, however, key differences two. delever amid writing capital, both. maintain cushion going concern TLAC, usually (GSIBs) enable single entry resolution. goal TLAC ensure holding companies systematically sufficient so operating affiliates continue without putting liabilities contrast, place still concern. A 2020 Journal Economics we wrote Avdjiev comprehensive analysis issuance.7 Out 731 Coco issues raising over $500 2009 2015, largest share (39%), U.S. absent list. At event, estimated $254 billion.8 About 56% include Though years our sample mandatory prevalent, become time, eventually dominating market. Finally, slightly half (55%) up 2015 classified tend emerging economies. Our shows propensity issue larger better capitalized Presumably healthy banks, remote risk, reasonable cost. Another reason beneficiaries bondholders, whereas expose themselves JFE CDS spreads issuers decline upon announcement issue, indicating generate risk-reduction benefits debt. While reduction spread 2.7 basis points, drop prominent (5.0 bps), including those (3.3 bps). Conversion associated 6.2 bps spreads. Only contributed CDS. issuances no statistically significant impact issuers’ prices, except levels, involve responses significantly positive average. contrast suggests potential hazard shareholders’ excess will convert superior fragility. outstanding why received stake merger UBS. Had shares merged company. collapse Silicon Valley (SVB) 10, sent shockwaves system drew investors’ attention weaknesses impelled seek CHF 50bn liquidity National (SNB) 16, dramatic move failed quash speculation, slow deposit withdrawals, extent 2 days later SNB begun proceedings organize takeover authorities decided best avert another GFC strong institution, playbook Federal Reserve US Treasury 2008 Bear Stearns JPMorgan colloquially known “Jamie deal” reference CEO JPMorgan.9 revealing deals, contexts limits legal different. nearly push law. invoke section 13(3) Act claim “under unusual exigent circumstances” broker-dealer. Beyond (and Treasury) means suasion get management agree merge proposed $2 per share. They sidestep shareholder agreements JPMorgan, outside Chapter 11 bankruptcy. structured bankruptcy purchase-and-assumption whereby agreed assume liabilities. share, too risky might receive blessing To overcome hurdle back innovative collateralized special vehicle—Maiden Lane LLC. vehicle financed junior tranche $1 $29 Reserve, it purchase $30 worth assets Stearns, de-risking balance sheet. make concessions $10.10 Although successfully implemented May 2008, temporarily brought calm markets, few months attempt Lehman Brothers Barclays failed, unleashing GFC. much position engineer bypass approval, bringing swift uncertainty, put money complex de-risk All precisely such event. And just announcing “the extraordinary [of Suisse] complete nominal amount CHF16bn, increase core capital.”11 de-levering Recall criticisms rescue, interventions fall bailout creditors rescues created dangerous lending precedent.12 Viewed light, help sheet but counter expectations institutions always bailed out predictable, caused consternation markets mini Investors surprised though remained standing, incidence history. people, noted, seemed egregious violation absolute priority. Jérôme Legras, managing partner head research Axiom Alternative Investments, told Times: “The likely shocked blatant inversion hierarchy sweeten expense holders.” precedent 2017 Banco Popular taken Santander, essentially out, there least appearance priority, is, being claim, respected. off guard Switzerland. Fearing contagion $250 market, Dominique Laboureix, chair EU's Single Resolution Board (SRB) reacted, saying CNBC “In here, context, hierarchy, wanted tell very clearly misunderstood: choice hierarchy.”13 On FINMA's SRB together EBA ECB statement: “… ones losses, after use down. consistently applied past cases guide actions banking supervision interventions.”14 These reactions business leaders understandably led further confusion. matter talk lawsuits emerged. law firm Quinn Emanuel Urquhart & Sullivan Pallas Partners lawsuit order, portraying dressed merger,” commenting “you know something gone wrong come politely [they] respected ordinary priorities”. Major David Tepper, founder president Appaloosa Management, hedge fund, weighed “if left stand, how you security Switzerland, wider Europe, governments change laws fact… contracts honoured.”15 But FINMA, fact, post violate contractual obligations bonds? As highlighted above, recent terms. example, SGD 750,000,000 Singapore 29, 2019, contains terms: “CET1 Write-down Trigger: 7.00%, Group AG consolidated CET1 Write-down: If Contingency Event, prior Statutory Loss Absorption Date (if any), Viability Event occurs, notes mandatorily permanently down…. See “Terms Conditions Notes—Condition 7 “Write-down”” Information Memorandum definitions Event.” information memorandum states “A “Contingency Event” occur (i) group's tier (“CET1”) divided weighted (“RWA”) quarterly date (or, certain specified FINMA) 7%, (ii) publication ratio write-off, applicable, shall because actions, events had, imminently have, effect restoring above 7% deems adequate.” provision clarifies PONV: ‘Viability Event’ notifies CSG determined write-off relevant instrument, holders' member group pursuant operation law, capable written-off customary measures CSG's adequacy inadequate unfeasible, essential prevent insolvent, bankrupt unable pay material debts due, ceasing carry business, receives irrevocable commitment sector (beyond transactions arrangements course) has, improving which, determination bankrupt, business. occurrence referred ‘Point Non-Viability’ ’PONV’.” documentation that: circumstances, power open restructuring (see “—CSG regime regulations” below), and, Notes already write-down, cancel Notes, each whole part. Holders should aware equity, set laws, means, among things, does feature. Furthermore, cancellation, cancelled cancellation capital.” Granted, provisions easy follow. nevertheless exercised deemed PONV. “going triggering intended be—namely, viability reaching toward filed against April 21, 2023, claiming disproportionate act good faith.16 Following SVB, pressures built falling rising (Graph 3). reflected failure $50 borrowing facility reverse expectations. entertained default bonds, priced spreads, interestingly, figure anticipate until mid-March, eve 4). say proportion anticipated completely out. example 2019 shows, offered rates plain vanilla compensation coupon attracted yield-searching sales pitch. Reports January 2021 portfolio manager exemplifies sentiment complacence offers 3.62% … high-yield 2.88%, definitely see lose almost two-thirds breach triggers.”17 Many risks exposed to, given pitched highly remunerative fixed-income securities stable institutions. unaware fact written-down effectively expressed Farro Capital: “Most Asian private securities, people excited enhanced these.”18 reaction temporary panic takeover, realization nature recovered 5). Except 2017, learn Would work intended? shore distress markets? We speculate look expected Even event gives us observation, drawn obvious lesson creating lot appear confused difference gone-concern distinction, did, difference. function stay viable layer complexity gave rise existence automatic triggered regulator activate unnecessary uncertainty. increases misrepresentation challenges determining precisely. No clear criteria defined, giving considerable discretion post, felt reassure deviate evidence ambiguity embedded leads pricing complexity. Both combination, difficulty predicting accurately triggered. off-the-shelf models used securities. Investor dismay seemingly contradictory interpretations ECB, initial undermined source shame outcome elimination fulfilled purpose: allowing seamless recapitalization, facilitated completion UBS, limited exposure Suisse. creates precedent: discipline reminding bears brunt credit diligence advised investing products. reform simplification designs desirable confusion proposal overlooked early stages introduction great revisiting writers Frederic Samama 2012 Economic Policy.19 three virtues: simplicity, pricing, recapitalization. design, specifically, instead option essence (collateralized) new strike opposed conventional investor holds option. unambiguously right CoCo. substitute resolution, line effect, form insurance adverse changes enables predictable 2012, Samama, showed lowers buffer them needed pre-determined (a issuer), well-established theory, straightforward using model. result, substantially reduced. advantage simple solution implementing countercyclical favorable recession, relaxes constraint. added flexibility appropriate recapitalize, removing pressure relax requirement. Moreover, optimally converts price-to-face low, needed. eliminates involvement risks), currently III. aftermath sued government-orchestrated “expropriated” UBS.20 regulators. Despite enormous effort regimes GSIBs GFC, lack transparency procedures increased resolving GSIB assumption UBS backed safer. According Times,21 critical meeting Wednesday, 15, “authorized backstop, delivered message: “You announce Sunday evening Asia opens. optional,” person briefed conversation recalls.” “Resolution disaster introduced threat world,” executive declared. “Our interests aligned wealth-management brand. So said, terms, help.” Later, Karin Keller-Sutter, finance minister seven members Council, declared interview Neue Zurcher Zeitung “would international crisis… globally active cannot simply wound according ‘too big fail’ plan. Legally possible. practice, economic damage considerable. crash dragged abyss.”22 disputes assessment. inevitable implication reassess SIFI living wills comes shove choose shown dragging abyss. efficient addressing reduced saving taxpayer. Of tools, play role. Going forward, regulation focus enhancing role failure. review variety level. Discretionary (PONV) widespread makes 2020, reduces CoCos.23 alternative equity.24 standard, transparent, robust manipulation issuer. Improving refining Switzerland worldwide coming years.