Reviving AT1 Bond Market Using Pre-Mortem Strategy: A Potential Way To Recover From Credit Suisse’s Write-Off

The decision to bail-in the AT1 bonds issued by Credit Suisse has created a ripple effect in the $260 billion AT1 bond market

By Dr Gayathri Giri

The $17 billion contingent convertibles (Co Cos) controversy is not yet over. Despite Credit Suisse being rescued by UBS for 3 billion Swiss francs ($3.37 billion). As part of the acquisition, UBS has estimated a negative goodwill of $34.8 billion. The legal acquisition is expected to be completed in a week, and the combined entity will operate as a “consolidated bank group.”

The decision to bail-in the AT1 bonds issued by Credit Suisse has created a ripple effect in the $260 billion AT1 bond market. It has reduced confidence among investors to invest further. Although AT1 bonds offer high returns, they are considered the riskiest investment due to their vulnerability to losses, when a bank faces potential distress. Conversely, the write-off of AT1 bonds by Credit Suisse has compounded the banking jitters around the world. Providing a pre-mortem strategy report by banks (looking forward to issue the AT1 bonds), including predictions regarding possible failures (encompassing both systematic and unsystematic risks) and strategies to overcome them, along with information on maximum possible guaranteed returns, can help to retain investors and rebuild the market.

The 2008 financial crisis and the history of AT1 Bonds

The 2008 financial crisis began following the collapse of Lehman Brothers (the biggest bankruptcy in US history). Cheap credit and lax lending standards fueled a housing bubble. When the bubble burst, the banks were left with trillions of dollars in worthless subprime mortgage assets. Given the significance of this event, many aspects of bank supervision were subsequently strengthened, including rules on how much money they should set aside to absorb potential losses. In this context, banks can hold different levels of capital split into tiers. First, top tier 1 capital is the primary source of bank funding, which comes from equity and retained earnings. A further layer down is AT1 capital, which typically consists of hybrid instruments, such as AT1 bonds. These bonds are the riskiest type, perpetual in nature and carry a high coupon rate.

AT1 Bonds and Credit Suisse

As AT1 bonds serve as the second layer of banking capital, it can act as a capital cushion when bank capital ratio falls below a certain threshold. They are typically issued by banks to meet capital requirements under the Basel III regulations. Credit Suisse’s capital structure has a greater number of AT1 bonds than equities. As it reached “the point of non-viability”, which triggers to write down the AT1 bonds completely. When Credit Suisse declared a write-off of AT1 bond issuance, this triggered contagion fear effects across the credit market, causing the bid prices of the AT1 bonds of Deutsche Bank, HSBC, UBS, and BNP Paribas to fall sharply. Correspondingly, Goldman Sachs analysts have said that the eradication of Credit Suisse’s AT1 bonds could reduce demand for AT1 bonds in the long term.

Pre-mortem strategy and AT1 bond market

A pre-mortem strategy is designed to identify weaknesses in any project and improve the success of implementation. In order to revive the AT1 bond market, this strategy can help to identify risks at the outset, when banks are deciding to use AT1 bonds to finance their operations. Banks can use this strategy to identify the possibilities of potential write-offs (failures) in the future. The pre-mortem process should begin after deciding to include AT1 bonds in the capital structure or prior to the sale of AT1 bonds. During the process, board members independently write down every reason they can think of for potential failures, including both systematic (institutional failure or the options that shall pushes the bank falling below the capital ratio) and unsystematic risks (economic distress) associated with the bank that could lead to the write-off of AT1 bonds. The board should then review the list of risks associated with AT1 bonds, and look for ways to mitigate them as much as possible in order to provide guaranteed returns to investors.

To Conclude

AT1 bonds emerged as a response to the 2008 financial crisis, aiming to transfer risks away from banks. These bonds, characterized by their high risk profile, typically offer higher yields compared to other bond types. Cases like YES Bank and Credit Suisse AT1 bond write-offs are legally allowed under Basel III regulations. The impact of Credit Suisse’s AT1 write-off created a domino effect throughout the AT1 bond market, causing institutions such as European banks to struggle to sell their AT1 bonds. Providing the pre-mortem report as a part of banks’ annual reports or as an individual report, along with predictions and measures to address anticipated failures, would not only help improve investment in AT1 bonds but would also remove investors’ base rate neglect bias.

The writer is  a faculty at Great Lakes Institute of Management, Chennai.

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