Credit Suisse Débâcle: The Bank Gets Sold

On Sunday, 19 March, 2023, Swiss rival UBS took over Credit Suisse for around $3 billion. Regulators, who were eager to curb further panic about the stability of the banking industry, pushed UBS into the deal. In the previous week, there was around $10 billion withdrawn from the bank every single day in fear of the bank going belly up. For fear of the bank becoming insolvent, regulators scrambled to make the deal. On Friday, 17 March, 2023, the Credit Suisse stocks were at an all time low of 1.86 CHF and missed its earnings per share by 23%.

Details of Deal

• The deal is happening at a 60% discount to Friday’s closing price of Credit Suisse
• Shareholders to get 1 UBS share for every 22.48 Credit Suisse shares
• As a condition of the acquisition, UBS is receiving liquidity assistance of 100 billion-franc or $106.7 billion from the Swiss central bank, while the government is providing a 9 billion-franc or $9.15 billion guarantee to cover potential losses associated with the assets being transferred from Credit Suisse
• The Swiss government agreed to let UBS cancel $17 billion of Credit Suisse bonds

Credit Suisse's Stocks Fell Below the Lowest Point of the Global Financial Crisis (GFC)

The trigger point was when its largest shareholder, Saudi National Bank wasn’t adding investment in Credit Suisse due to regulatory rules which led to loss of confidence and depositors withdrawing their money. Well the timing was also bad. The news came after SVB and Signature bank failure leading to more panic.

A few points we can point out leading up to the current situation at Credit Suisse are:

• Losses associated with the collapse of investment funds Archegos and Greensill Capital triggered the sell-off in Credit Suisse's shares in 2021
• Antonio Horta-Osorio resigned as chairman for breaching COVID-19 rules in January 2022, just eight months after he was hired to fix the bank
• Clients pulled 110 billion Swiss francs ($119 billion) of funds in the fourth quarter, while the bank suffered its biggest annual loss of 7.29 billion Swiss francs since the financial crisis
• An unsubstantiated rumor on an impending failure of the bank in the autumn sent customers fleeing in July 2022

Credit Suisse, like many other financial institutions suffered significant losses during the 2008 global financial crisis. The bank had to write down billions of dollars in assets and was forced to raise additional capital to shore up its balance sheet. After the crisis, Credit Suisse embarked on a strategy of focusing on its core businesses and reducing its exposure to risky assets. However, the bank continued to face challenges such as high legal costs, low interest rates and increased regulation.

Additionally, in recent years Credit Suisse has faced a series of scandals and legal issues, including the revelation that the bank had helped clients evade taxes. These issues have eroded investor confidence in the bank and made it more difficult for Credit Suisse to regain its footing.

But How Can a G-SIB (Globally Systemically Important Bank) Reach the Brink of Collapse?

After the 2008 financial crisis, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, a US federal law that was enacted in 2010. According to the Dodd-Frank Act, banks with more than $50 billion in assets need to submit stress tests(what if scenarios) testing their ability to survive economic and financial stress. But in 2018, the threshold for Dodd-Frank was increased to $250 billion. Hence, banks like SVB and Signature Bank were no longer subject to submitting the stress test and we know what happened to them already.

But on the other hand, Credit Suisse submitted the stress test report for 2022. There were a few concerning things in the Credit Suisse stress test report:

• Projected stressed capital ratios for the severe scenario fall below regulatory minimums, indicating Credit Suisse's insufficient capital to cover potential losses
• Low projected loan losses in the severely adverse scenario raise concerns about the accuracy of the stress test assumptions and scenario severity
• The drivers of the Common Equity Tier 1 (CET1) and Tier 1 Leverage Ratios show significant reductions, including pre-tax PPNR, pre-tax provisions, trading and counterparty losses and RWA Other Comprehensive Income. This indicates that Credit Suisse would struggle to maintain adequate capital levels in a severe stress scenario

In 2008, authorities neglected early signs of an impending Global Financial Crisis (GFC). The same is happening now. During the pandemic, with billions of dollars in COVID relief funds leading to higher loan losses for banks, increasing interest rates made borrowing less attractive and rising inflation already put pressure on the banks' balance sheet.The recent events involving Credit Suisse, Silicon Valley Bank, and Signature Bank have once again raised concerns about the stability of the global financial system.

How is It Different From SVB?

In the SVB collapse, the Fed or the US government allowed it to fail instead of using taxpayer money for a bailout. On the other hand, the Swiss government and the central banks are bearing almost $116 billion for the liquidity assistance and potential losses. Unlike SVB and Signature Bank which were more exposed to mortgage-backed securities, startup and crypto, Credit Suisse was well diversified in its investment, but not too careful. Its large investments in Archegos and Greensill Capital didn’t pay off.

Start of a Black Swan Event? Silicon Valley Bank, Signature Bank and now Credit Suisse

A black swan event is a rare and unexpected event that has a major impact on society and the economy. Black swan events are characterized by their extreme rarity, their severe impact and the fact that they are often difficult or impossible to predict using conventional methods.

In our previous newsletter on the failure of Silicon Valley Bank, we looked at reasons for the failure of the bank. The excessive exposure to mortgage-backed securities and concentrated deposits from startups, the increasing interest rate and the duration mismatch between asset and liability led to bank failure and ultimately resulted in FIDC closing the bank and its operation.

Another bank suffered the same fate. Signature Bank, crypto’s last major ally in the banking world, was seized by regulators earlier this week in the aftermath of Silicon Valley Bank’s failure. Signature played a key role in the US crypto ecosystem. If no bank steps in to reproduce its services, US crypto growth could slow significantly, some insiders say.

While the recent events surrounding Silicon Valley Bank, Signature Bank and Credit Suisse may seem alarming, it is important to remember that black swan events are by definition rare and unexpected. While the failures of these banks may have a significant impact on the financial sector, it is likely that the effects will be limited in nature.

While these events may be considered "black swan" events, their underlying causes have been known since 1930, as highlighted in one of our newsletters, "History of Quantum Shifts in Global Markets.”

The Cyclical Nature of the Financial Sector

From Lehman to Silicon Valley Bank: Why we can't escape booms and busts.

Chaos theory suggests that even though complex systems appear random, there are underlying patterns, connections and feedback loops. The current disruption in the financial sector may seem like chaos but there is an underlying pattern to it.

Below are the number of failed banks and total assets on the timeline between 2001 and 2022.

Image Source: FDIC

Major bank failures and their causes are summarized in the table below:

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The table gives us important insights into these bank failures. Subprime mortgages and excessive risk-taking are among the main reasons for most bank failures. These factors tend to repeat over time (because of the cyclical nature of these causes), leading to a pattern of booms and busts in the financial sector.

RBI: The Gold Standard

The Indian banking system faced many challenges but major among those - the IL&FS crisis in 2018 leading to liquidity crunch and defaults in NBFC sector and the COVID-19 pandemic. In response, the RBI implemented several reforms to strengthen the banking system and manage risks. Here are some important lessons we can learn from these reforms:

• Forced all private sector banks to raise capital: During Covid, RBI forced all private banks to raise capital to manage the crisis
• Covid NPA clean up: RBI forced all banks to undergo an asset quality cleanup with Covid. The systemic NPAs are now at a 10-year low
• Management of rising interest rates: In 2018, RBI released a circular advising all banks to create an Investment Fluctuation Reserve (IFR) to protect against an increase in yields in the future. All banks began to create this reserve, which helped them absorb rising yield losses
• Real-time monitoring of the Asset Liability Management (ALM) for banks and NBFCs: RBI implemented real-time monitoring of ALM for banks and Non-Banking Financial Companies (NBFCs) to mitigate risks
• Strong capital raising for banks: The RBI implemented strong capital raising measures for banks to ensure they have enough capital to withstand future crises

One can argue that the RBI is conservative in its approach (it keeps the bank ratios like CET 1, Tier 1 capital of Risk Weighted Assets (RWA) higher than recommended in BASEL III norms). But its approach has kept banks afloat and navigate through hard times and support Indian economy in time of need.

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