What happens when CoCos pop?

This article first appeared in Financial World, May 2023 Edition

Additional tier 1 bonds are popular with banks that need to raise capital but are risky for investors and may be controversial when a crisis occurs. Lyndon Nelson looks at whether they can still have a future

Contingent convertible bonds (CoCos) were seen as an important part of the response to the 2008 financial crisis. Policy makers wished to avoid the taxpayer-

funded bailouts of the crisis clean-up and to move to a world of bail-in, where the burden would shift to capital markets, which would be compensated for taking on this risk.

CoCos, as the name implies, convert into equity upon breaching a trigger – typically a specific core equity tier 1 ratio (CET 1). They are perpetual bonds, although markets had become used to them being redeemed at the first call option.

CoCos are designed to be loss-absorbing – either through the conversion to equity or by means of a principal write-down – and pay a coupon which, if the bank opts not to pay it, is non-cumulative. That is, it is lost forever and does not generate any further obligation.

Given these features, the Basel Committee on Banking Supervision allowed CoCos to count towards capital, which is why they became known as Additional Tier 1 (AT1). The Committee also set out that conversion should be triggered if a bank’s CET1 fell below 5.125%. There was also a discretionary trigger to be activated by regulators if, in their judgment, the bank had reached a point of non-viability. Finally, the amount of AT1 that could count towards capital was limited to a maximum of 1.5% of risk-weighted assets.

In the creditor hierarchy, AT1s rank junior to all other debt and are senior only to ordinary and preference shares. Because of this ranking, AT1s pay a higher coupon than traditional bonds and offer higher yields. When Credit Suisse refinanced its AT1 in 2022, it offered a coupon of 9.75%. To compare, the yield on 10-year treasuries in mid-June 2022 was 3.49%.

Why banks like AT1s

AT1s proved popular with banks that needed to raise capital, particularly European ones, which dominate the issuers. In the US, an instrument called preferred shares plays the same role as AT1s, with the same place in the capital structure. Outstanding issuance grew to around $275bn.

There were good reasons for banks to offer AT1s. They improve overall capitalisation, decreasing the fragility of a bank; narrow credit spreads – that is the difference

between what the bank pays to borrow and the risk-free rate; and lower the overall cost of funding. They do this without diluting equity, so long as there is no conversion. And, because coupon payments are tax deductible in many jurisdictions, while dividends are not, AT1s are cheaper to issue than new shares.

For regulators, AT1s provide additional loss absorbency in a capital-efficient way and do so at a time when a bank is under stress – the moment when other forms of capital raising would be difficult or even prohibitively expensive. In addition, a responsibly operated bank should wish to avoid triggering conversion and would manage itself accordingly.

Why investors get skittish

Investors in AT1s get comparatively higher coupons in exchange for higher risk. These risks vary in their opacity. One is the subordination to all other debt. Then there is the risk of write-down or conversion. Investors also have to consider changes in credit spread, which typically have a greater impact on subordinated bonds. Not least, there is also the uncertainty of potential regulatory intervention.

It is probably the intersection between policy makers wanting to maximise their room for manoeuvre if a bank is in a crisis, and the uncertainties that inevitably generates for investors, that has led the AT1 market to be somewhat febrile. The recent outcry over the write-down of the AT1s at Credit Suisse is making headlines now but there have been challenges before.

In 2016, for example, the then Chief Financial Officer at Deutsche Bank, Marcus Schenck, told analysts that he believed the bank would be able to pay the coupon on its AT1s. By raising the possibility of missed coupon payments, Schenck, predictably, spooked the market.

In 2017, the European Central Bank put Banco Popular Español into resolution, triggering the conversion of its AT1s, which led to unsuccessful litigation by bondholders.

In the UK, regulatory stress tests were generating outcomes that, if they ever came to pass in practice, would trigger AT1 conversion for some banks – serving as a reminder of the risks of AT1. More recently, during the height of the Covid pandemic, it was not unusual to see articles questioning whether the AT1 could survive.

The Credit Suisse controversy

This brings us to the present and the AT1 market is once again in the spotlight. On the face of it, the write-down of around $17bn in AT1s at Credit Suisse is exactly what should have happened. A major bank was effectively insolvent

and the write-down reduced the burden on the taxpayer by placing it on investors who knew they had bought risky instruments designed to be wiped out if the bank failed.

But the controversy is that shareholders were not completely wiped out. The normal credit hierarchy in an insolvency sees equity holders take the first loss. In this case, however, AT1 investors were treated more harshly than shareholders. The AT1 investors are now reaching for their lawyers.

Do they have a case? Credit Suisse’s AT1 documentation did allow for this outcome in certain circumstances. The Swiss regulator, Finma, said: “The AT1 instruments issued by Credit Suisse contractually provide that they will be completely written down in a ‘viability event’, in particular if extraordinary government support is granted.” Other jurisdictions, such

as the EU and UK, have been quick to reassure investors that they will abide by the creditor hierarchy, hoping that this isolates any investor concerns to just banks in the Swiss market.

Was Finma right?

Should the Swiss authorities have taken this decision? I don’t know, but I can understand it. A disorderly failure of such a large institution would have a severe impact on the financial system. There was a need for decisive action. Any action also needed to cause the least amount of secondary impact to stem any contagion risk. Given that the Swiss authorities had the option provided in the contractual terms to change the creditor hierarchy, they were duty-bound to consider it and evidently thought this was preferable. Many will argue that this was the wrong call, as they believe the contagion to the wider AT1 market is significant.

But, for the Swiss, I suspect, this came down to just a one-period game. Although UBS has a lot of AT1 in issuance, the merger with Credit Suisse gives it an asset base of around $1.5tn, according to S&P.To put that into context, the annual GDP of Switzerland is around $800bn. UBS is now not just the only globally systemically important bank in Switzerland, it is also clearly ‘too big to fail’. That means that many of the underlying AT1 risks are now, fundamentally, Swiss sovereign – and Swiss regulatory – risk. So, any future issuance of UBS AT1s will face a different risk calculation by investors, but it is uncertain what they might do.

The markets will be watching

Where this takes AT1 issuance will depend on the results of the legal cases and how the market prices in the experience of Credit Suisse. A situation in which AT1s become more expensive to issue than equity, which would equate to a full-out buyers’ strike, could prompt a debate about some of the design weaknesses of AT1s.For example, regulators might consider whether triggers should be set higher and thereby reduce the chances that a discretionary trigger is exercised. They could also look at whether triggers based on CET1 are sufficiently transparent to investors, given that CET1 levels are, typically, only disclosed quarterly.

Policy makers should consider whether they need to do more to explain their decision-making in times of crisis. This explanation is not just for the sake of the AT1 market but for the much larger market of Total Loss Absorbing Capital (TLAC). In Europe, the term used is the minimum requirement for own funds and eligible liabilities (MREL).

This is another set of liabilities designed to take losses in a crisis and banks have been issuing between $350bn to

$400bn annually since 2019. Because TLAC relies heavily on the decisions of policy makers in a crisis, today’s troubles for AT1 may be a source of similar contagion for TLAC. I am sure TLAC investors will be watching closely.