Initiated in the United States by the bankruptcy of Silicon Valley Bank (SVB) and the concerns of other American regional banks, the banking crisis 2.0 quickly crossed the Atlantic. Its biggest victim to date is Credit Suisse, a 166-year-old institution and one of the giants of the European Bank, which had never really recovered from the 2008-2009 financial crisis. With its rescue, the authorities hoped to restore confidence in the sector, whose woes weigh on financial markets. But it doesn’t look easy.
The reversal of risk
This is one of the most surprising aspects of the rescue (or repurchase) of Credit Suisse (CS) by UBS, its lifelong rival. While the holders of CS shares shared 3 billion Swiss francs (about 3 billion euros), the holders of AT-bonds1 of CS have lost everything, for approximately 16 billion euros.
The AT-1 obligations are special. Issued by banks to strengthen their funds, they automatically disappear when capitalisation ratios are under intense pressure. To offset this increased risk, they offer a higher interest rate than senior debt, which is more secure.
A priori, this debt is considered less risky than shares. In the event of a significant problem, the bank’s shareholders are first called upon before reaching the debt holders, whatever it may be. This logic has been reversed by the Swiss authorities, who risk being confronted with class action by the holders of this type of debt.
Reversing the risk hierarchy is troublesome for the banking sector, which often uses AT-1 bonds to strengthen its capital. As a result, this market, which weighs some 240 billion euros, was under intense pressure, with investors thinking that their assets were ultimately riskier than they thought since they were going after shareholders.
In an attempt to reassure, the ECB announced this would not be the case in the euro area. But the precedent created in Switzerland puts under pressure one of the financing channels of European banks. This contributes to nervousness across the sector.
Rising interest rates will weigh further
While treating AT-1 bonds is problematic, rising interest rates are the most considerable risk to the banking sector. Because banks are required to hold safe assets on their balance sheets, they contain much sovereign debt. However, in the face of very high inflation, the West’s central banks had no choice but to raise their key interest rates sharply, significantly impacting bond rates. This translates into substantial losses on the bank’s bond portfolio.
Since early 2021, European sovereign debt at 7-10 years has lost about 18% of its value. On maturities that exceed ten years, losses approach 30%.
The banks are therefore relying on huge losses on their bond portfolio but, a priori, without this harming the accounts, since they keep these assets on the balance sheet in a price-to-maturity logic, that is, on the assumption that they will keep these assets until maturity and continue to collect coupons until then.
But on the other hand, when, for one reason or another, the bank runs out of liquidity and has to divest itself of these assets, it immediately absorbs the loss, leading to poorly received capital increases on the stock exchange, which give a clear sign of weakness to investors.
That is why they are concerned about the continued rise in key interest rates and the gradual withdrawal of central banks from the debt market. When central banks disengage, they reduce demand for these assets and leave it to others to finance sovereign debt, pushing interest rates to higher levels. However, the higher the yields offered in the future, the greater the losses on the bond portfolio - widely bought while interest rates were otherwise lower - will be in the event of an immediate sale due to lack of liquidity.
Sustained high-interest rates are putting pressure on the sector, and the longer this goes on, the greater the chances that certain players will crack. This is why the industry is so fearful of crises of confidence and rushes on banks, why the authorities keep repeating that the system is well capitalised, much safer than during the financial crisis of 2008-2009 and why liquidity continues to be injected into the system.
Not just commercial banks
It should also be noted that while commercial banks are most affected by these risks since they have customers to reassure, others are also victims of significant losses on their bond portfolio. Among them are insurers and pension funds, but also central banks.
Since 2015, the Bundesbank has bought around €1 trillion of sovereign debt, mainly German, a safe asset. However, with the rise in interest rates in 2022, it suffered its first loss since 1979. And this is only the beginning: Over the next decade, the losses on its bond portfolio could approach 200 billion while the benefits realised over the last decade (and paid to the German State) are some 22 billion, similar to the sum of its provisions and capital.
The Bundesbank is therefore weakened. And it is far from being an isolated case. Central banks all over Europe are affected by the same phenomenon. So it is the pillar of the financial system that is under pressure.
Faced with this reality, the turbulence in the banking sector is far from over and the period of high rates we are entering - a real stress test for the sector - will not fail to reveal in the open the weaknesses that hide in assessments of enormous complexity. This opacity has led us to reduce the weight of banks in our selection in recent years.
So despite the price drop, we are happy to keep some bank shares.