Seeking comfort for AT1 holders amidst a banking crisis

After a few pivotal weeks in the markets, our Co-Heads of European Financial Institutions Debt Capital Markets, Asad Husain and Victor Blanchard, asked Christy Jenkins, Head of Capital Solutions, Debt Capital Markets, to review the current developments in the banking sector and discuss potential implications for the bond markets going forwards for both issuers and investors.

We've all seen the events that have unfolded over the last two weeks. What's your read across for the wider banking sector? And do you see risk of further contagion from here?

So, looking at both Credit Suisse (CS) and also the U.S. regional banking situation, particularly Silicon Valley Bank (SVP), fundamentally, the read across to European banks and other large cross-border banks is limited. The events can be narrowed down, I believe, to fairly idiosyncratic issues within the banks. The Credit Suisse situation was ultimately one of viability given the significant client franchise erosion. This culminated in significant client and deposit outflows. Silicon Valley Bank's issues can very simply be narrowed down to a combination of very weak regulation of small US regional banks, and a unique and risky business model. And most of these factors simply don't apply either at all or to the same extent for, say, European banks. That said, contagion risk is also a function of confidence and, obviously investor sentiment has clearly been dented by the events of the past few weeks.

In terms of Additional Tier 1 (AT1) holders, clearly given the Credit Suisse situation, it's an important one to address although there are so many discussion points here and not really enough time. But I think it's fair to say that there are provisions in the Swiss banking law and in AT1 prospectuses that limit the read across to other AT1s in different regions.

Perhaps the biggest actual read across to other jurisdictions is the reminder of the vast range of powers that regulators have in order to enable them to act quickly during a crisis. They need to fend off instability, and they need to avoid taxpayer fund usage. And bondholders are dependent on those decisions. So, this is a risk factor that perhaps needs a little bit more careful consideration going forward. This was evidenced by Switzerland, when the emergency ordinance that was passed, which provided the regulator with one of the necessary powers to write down AT1s. I don't currently see any need immediately for the E.U., U.K. or other global banking regulators to make any fundamental changes in resolution laws to clarify AT1 risk. But perhaps issuers may wish to add some additional risk factors in their AT1 prospectuses, or to maybe reinforce some of the regulatory requirements and add additional slides to investor decks.

And in terms of Issuers providing investors with greater comfort, what else could they do in providing comfort around their own liquidity positions?

Yes, I imagine many issuers have been fielding quite a lot of calls from investors already seeking comfort and clarification about their respective balance sheet positions. I think some of the metrics that investors are probably doing due diligence on right now and where they will be keen to get more disclosure on include, for example on the asset side, as much information around the investment portfolio as possible. In particular, the split between the fair value of OCI and amortised cost assets and how those are accounted. One of the key metrics that investors are looking at, rightly or wrongly, is the potential impact on Common Equity Tier 1 (CET 1) from the marked to market of the securities in the amortized cost book, however unlikely it is that that portfolio ever gets sold. It is something that investors are looking at given the Silicon Valley Bank situation. Also, anything generally on interest rate risk management. European banks, for example, employ significant hedging activity, which wasn't the case for example with SVB. And any information around to help investors appreciate how banks manage asset liability management risk is helpful. And then on the deposit side, quite simply as much granularity as institutions are comfortable sharing around the deposit mix given the significant share of uninsured depositors at SVB and also CS.

We've seen various regulators release statements on credit hierarchy. Do you think they've done enough to provide reassurance for the AT1 asset class?

I think up to a point, yes, I think the statements were helpful in reiterating the position of AT1s as higher than equity in the context of a resolution framework and I think that is useful to have and it's important to reiterate that. But there are still some wider concerns for AT1 holders that needs a little bit more thought.

First, what is bond holder risk outside of resolution? For example, when providing liquidity support to a solvent institution or through emergency M&A. Perhaps more work needs to be done in by relevant parties to actually understand the risk for bondholders rather than during resolution where the tools are more clearly defined, and the no creditor worse off safeguard is better reflected.

Secondly, how important is the loss mechanism, i.e. equity conversion versus write down features? Should there be a differentiation in valuation? Will investors prefer one over the other over time? It's reasonable to argue right now, for example, that being converted into equity should ensure that the creditor hierarchy is maintained, while a permanent loss through write down does expose bondholders to alternative less favourable outcomes.

And then my final point is also understanding the implications of liquidity assistance. I think we've taken for granted that liquidity assistance is always there and it has been at the sector level during times of crisis. But I don't think there is enough clarity around how liquidity-based government support for individual banks impacts viability-based triggers for AT1s. Generally, these triggers are linked to solvency support, so understanding how providing liquidity to a solvent bank can trigger burden sharing of capital instruments and how that mechanism works I think will be maybe something to you to address going forward as well.