In a column published in the Financial Times on Thursday, Tidjane Thiam argued the distressed sale to cross-town rival UBS upended international finance’s traditional hierarchy, in which stock owners such as the Saudi National Bank are always the first to lose their shirts when a company fails.

Instead the all-share deal forces investors that bought $17 billion in so-called Additional Tier 1 bonds to take a bath, argued the Ivorian, who served as CEO from 2015 until February 2020. This precedent could prove costly for lenders on the continent by further pushing up their funding costs.

“There is a basic principle that common equity takes the hit first,” he wrote, amid reports that affected bondholders are considering taking legal action.

“It seems that the treatment of AT1s, even if correct under the current Swiss rules, will raise the cost of capital for Swiss banks and European banks. This will have some of their U.S. peers rubbing their hands,” Thiam added. 

The market is already pricing in higher capital costs for European banks

The deal values Credit Suisse’s equity at 3 billion Swiss francs ($3.3 billion). While the terms impose heavy losses on shareholders—with the battered stock losing a further two-thirds overnight— investors like the Saudi National Bank that pumped in 1.5 billion francs late last year did not lose everything.

By upending the traditional heirarchy of a bank resolution, bondholders will likely demand a higher return on their investment before subscribing to the next AT1 issue, according to Thiam.

“This new layer of uncertainty will have an adverse impact on the competitiveness of the European banking sector. Net net, U.S. and Asian rivals could come out of all this relatively stronger.

In fact investors are already pricing this added risk in, with shares in German lender Deutsche Bank selling off hard on Friday. Other European banks like UBS, Société Générale and UniCredit were also hit, albeit to a lesser degree.

DB, Barclays, SG sub cds spreads blowing out. Now wider than on March 15th. Hearing it’s party due to counterparty hedging and weakness in bonds but the move is really violent. pic.twitter.com/YKDjD93nAj

— boaz weinstein (@boazweinstein) March 23, 2023

The cost for credit default swaps, a financial instrument that effectively protects investors against a company’s insolvency, has also soared. This can be seen in particular for “subordinated” debt that paid back only after senior-ranked creditors are made whole, a reflection of the jitters around AT1 bonds.

Understanding the potential impact from the controversial move, banking regulators at Frankfurt’s Single Resolution Board and European Central Bank distanced themselves from the Swiss solution, making clear that in the euro zone common shareholders would always be the first to get wiped out before any AT1 bondholders would take a hit.

“This approach has been consistently applied in past cases and will continue to guide the actions of the SRB and ECB banking supervision in crisis interventions,” they said in a joint statement on Monday.

Why do banks even issue ‘Additional Tier 1’ securities?

AT1 bonds were created as an answer to the question of how to make lenders more resilient without cutting off the supply of credit to the real economy.

In the aftermath of the 2008 global financial crisis, European regulators wanted banks to build more powerful shock absorbers into their balance sheet to guard against the need for unpopular taxpayer bailouts. 

But issuing fresh common equity in the form of new shares—the highest quality form of capital around—is also the costliest. Achieving more robust levels of solvency by mandating ratios of Common Equity Tier 1 (CET1) that was disproportionately higher to their overall asset base than elsewhere would have two effects.

Firstly it would limit European banks’ profitability, putting them at a structural disadvantage to foreign peers permitted to operate with more leveraged balance sheets. Secondly, it would lower their appetite to extend loans in particular to small and medium size businesses that tend to be the lifeblood of an economy. 

Enter contingently convertible (CoCo) debt. 

Under the new “Basel III” regulatory regime—which the U.S. importantly has yet to adopt—a new asset class was created: AT1 bonds that would either be written off or automatically convert to loss-absorbing common equity should a bank’s solvency buffers be fully depleted.

In exchange for the risk investors could be “bailed-in” at any time and lose everything, these securities would offer bondholders a higher return over more senior ranked debt paid out first in the event of bankruptcy.

On Wednesday, Citigroup CEO Jane Fraser lauded Monday’s statement from European regulators guaranteeing common equity owners would lose everything before AT1 bondholders took a hit, saying it provided greater certainty for banks and their investors.

“I think all of us were quite relieved when that clarification came out, as it obviously took people by surprise,” she said.