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Sunday, March 19, 2023

Bank Capital Contagion Comment

The details of a shotgun marriage between UBS and Credit Suisse arranged by Swiss regulators have been leaking out. Credit Suisse has been plagued by problems, and one might hope that this act would finally clear them up. The concern I am seeing at the time of writing is the risk of contagion.

As an aside, we can tell this is a bit of a crisis by my posting frequency.

Credit Suisse had AT1 notes, which are a subordinated perpetual security that acts as bank capital. Under normal circumstances, perpetuals are senior to equity. However, AT1’s have clauses that allow regulators to write them down to zero — an option that the regulators seemingly exercised. I have seen a lot of people online surprised by this, since they were unaware of the contractual terms. We will find out Monday (possibly the hard way) how many portfolio managers were unaware of them.

The losses on these AT1 notes are insignificant by themselves relative to the size of European capital markets. The problem is contagion — will portfolio managers freak out about subordinated bank capital issues more generally? If so, this would generate bad headlines, as well as make it harder to inject regulatory capital. There is also the issue that anyone owning such securities while leveraged would face margin calls. Of these, the most dangerous effect is a chilling of subordinated capital instruments, since those are exactly what banks want to issue to clear up liquidity and capital worries.

I am not able to offer an informed comment on that question. My initial uninformed reaction is mixed. On the one hand, the losses are small. On the other, credit market pricing tends to overreact to credit losses. Even if credit portfolio managers are level-headed, it is possible that people in charge of asset mixes think that “bonds are safe, and you are not supposed to lose money” — and then demand a de-risking of the portfolio. A typical diversified fund will yawn at a 5% drawdown on its equity portfolio, but a credit loss of 2% on its smaller credit portfolio is a major event. If one is an academic desperate for a research topic, I guess this counts as a behavioural finance question to examine.

American Regional Banks

There are still ongoing liquidity concerns at American regional banks. This bears watching, but at the same time, injecting capital into non-global banks is not that hard to arrange if they are not complete dogs.

Concluding Remarks

Once again, my instinct is that we need large credit losses in the real economy in order for this to get real exciting. So far, we are just seeing some of the weaker members of the herd being culled.

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(c) Brian Romanchuk 2023

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