Swift action: UBS takes over Credit Suisse
The market reacted positively to the agreement reached with UBS, with sentiment not deteriorating further. This is a relief and an indication that market participants are prepared to « wait and see » at the Fed meeting on 22 March.
Contagion involving other banks remains fairly limited for the time being, while we monitor the evolution of CDSs. Equity markets have been hit harder, with Europe’s bank index down 15% since the beginning of March, wiping out all the gains made since the start of the year.
Central banks, including the US Federal Reserve, the ECB, the Bank of England, the Bank of Japan and the Swiss National Bank (SNB), are also providing liquidity to the markets by strengthening dollar swap lines as part of a coordinated response. This appears to be a very pre-emptive action, as the SNB has provided $101 million in a daily seven-day reverse repo, while the ECB has provided only $5 million to a single bidder and the BOE and BOJ have not received any bids.
The terms of the agreement
After a weekend of negotiations between FINMA, the Swiss National Bank, the Swiss government, UBS and Credit Suisse, UBS is acquiring Credit Suisse (CS) in an equity transaction worth CHF 3 billion, as the bank is no longer considered viable as a stand-alone entity. The transaction involves a discount of 59% to the close on Friday 07 March and triggers a full write-down of the nominal value of all Credit Suisse AT1 shares by approximately CHF 16 billion, and therefore an increase in core capital.
In addition, the Swiss National Bank (SNB) will support UBS with a further CHF 100 billion of ELA liquidity, while the Swiss government will provide UBS with a CHF 9 billion guarantee on CS losses in a second tranche, with UBS risking the first CHF 5 billion of losses (if losses are higher, they will be split between UBS and Switzerland).
Other details:
UBS has confirmed that it will reduce investment banking to less than 25% of group risk-weighted assets (RWA) and expects annual cost reductions of more than USD 8 billion by 2027. UBS will continue to pay dividends but will temporarily suspend share buybacks and expects the merger to be accretive to earnings per share by 2027.
The transaction will make UBS the largest bank in Switzerland, with more than USD 5 trillion under management, including the asset management and wealth management divisions. The takeover will create the second-largest wealth manager in the world and the third-largest asset manager in Europe.
As the takeover will create a larger bank, it will be subject to higher capital ratios. FINMA will grant appropriate transitional periods for building up these reserves. This should lead the combined UBS-CS entity to a probable increase in its G-SIB category – from category 1 (1.0% of risk-weighted assets) to at least category 2 (1.5%). The agreement is expected to be finalised in the second quarter of 2024.
In the short term, while the situation of the US regional banks remains unresolved, this agreement seems to have reassured investors. However, this solution has shaken the AT1 market, with investors reassessing the risks associated with these instruments. The market is worth $275 billion. In the future, this could increase the cost of capital for banks. However, this problem is thought to be relatively limited, as these instruments can only represent 18.75% of a bank’s total regulatory capital and managers always have the option of using pure (core) capital, which could be the end of the game if AT1 costs are too high. In addition, the AT1 bonds already issued are perpetual instruments, with no redemption obligation, so there is no refinancing risk. Finally, to date, insurance companies’ exposure to AT1 bonds seems negligible.
No one can predict the markets, so diversify. John C. Bogle
Impact on an economic scenario and market views
The action taken by the authorities to maintain public confidence in the banking system and the speed with which the crisis is resolved are key elements of a scenario. While we continue to believe that the main scenario (slow growth in the United States and the eurozone) remains the most likely, we must recognise that the risk of a much more unfavourable scenario has increased. In any case, the events of the last few days are likely to lead to a further tightening of financial conditions and, if they continue, to a cut in terminal rates.
Given recent financial events in the United States, this could lead to a further 5-10% fall in commercial and industrial lending ($140-280 billion fall in bank credit, or 0.5-1% of GDP). The impact on the economy will of course depend on the scale and duration of the shock. In the eurozone, a tightening of credit conditions was also underway, and residential investment is expected to contract by 5% (-0.3% of GDP). This impact could be greater if credit conditions tighten further.