The past two weeks have been a wild ride for banks, with the fall of Silicon Valley Bank (SVB) and Signature Bank in the US, the bailout of First Republic by the private sector in the US, and the buyout of Credit Suisse by rival Swiss bank UBS on Sunday.
However, Credit Suisse is in a different league to the other banks. One of only 30 lenders considered ‘globally systemic banks’, the reasons behind its collapse and the mechanics of the takeover orchestrated by the Swiss authorities is likely to have resounding repercussions on the banking sector.
Following years of controversies – including corporate espionage and corruption with its involvement in the so-called ‘tuna bonds’ scandal in Mozambique, and massive losses following the collapse of financial services firm Greensill and hedge fund Archegos – the situation came to a head last week when its biggest investor, the Saudi National Bank, said it could not provide any more financial support due to regulatory restrictions.
Other investors pulled their funding and the share price plummeted. An emergency $54bn lifeline from the Swiss National Bank failed to restore investor confidence in the bank, culminating in the UBS buyout over the weekend.
Undoubtedly, the ramifications will become clearer as the situation unravels and the market reacts, but already the potential fallout for UK banks and auditors should be on the collective radar.
Revaluation of the risk-reward trade-off of Additional Tier 1 bonds (AT1).
AT1 bonds, aka ‘contingent convertibles’, or ‘CoCos’ were created post-2008 financial crisis as a way for failing banks to absorb losses, making a taxpayer-funded bailout less likely. AT1s are high-yielding bonds as they are risky; if the lender gets into trouble, the AT1 can be converted into equity or written down completely.
The Swiss regulator, FINMA, confirmed that all $17bn of Credit Suisse AT1s would be written down to nil as part of the deal. This is controversial – not the write-down of AT1s as such, but the fact that the bank’s shareholders will receive some compensation when bondholders will not. Ordinarily, bondholders rank higher than shareholders in an insolvency – but arguably, this is not a traditional bankruptcy situation.
The big question is what this seeming break from convention will do to the $275bn market for AT1s. Will investors have a reduced appetite for AT1s or demand higher yields given the perceived shift in risk and rewards? Surging yield prices on AT1s the day after the takeover suggests this may be the case. Does this then mean reduced access to markets for banks in the future, and where will they look to backfill the vacuum?
Statements from the European Central Bank and the Bank of England (BoE) have sought to distance themselves from FINMA’s decision, probably in the hope that it will allay the markets. The BoE has said that the UK “has a clear statutory order” detailing which shareholders and creditors were expected to take on losses. AT1 bonds ‘rank ahead’ of equity investments, it stressed, adding that this same process had been followed in the unwinding of SVB UK. Whether this will be enough to reassure the markets remains to be seen.
Strong capital ratios and other measures of financial soundness are not a guarantee of viability.
To the very end, Credit Suisse was solvent and had relatively high levels of regulatory capital. At the end of 2022, Credit Suisse had a Common Equity Tier 1 (CET1) ratio of 14.1% and an average liquidity coverage ratio (LCR) of 144%, both of which are comparable with other large UK banks including HSBC and Barclays.
SVB was in a similar situation – at the end of 2022, its CET1 ratio was 15.26%, although it did not publish its LCR as it was below the US regulatory threshold and was not subject to minimum LCR (this would not have been the case if SVB were a UK bank).
Investors and the market itself turn a great deal of focus on to these ratios to determine the financial health of institutions, but it has become increasingly clear they are not the be all and end all.
Greater appreciation of developing risks in going concern assessments.
The collapse of three banks in the past two weeks will place how auditors challenge the going concern assumption for banks under the microscope.
Undoubtedly, auditors face a dilemma in calling out viability issues. Banking is built upon the trust and confidence of depositors. Where going concern issues are raised, they might act as a catalyst for failure and become self-fulfilling.
It is increasingly clear that assessments need to adapt to take into consideration issues that are not always apparent in headline prudential metrics. Social media and online banking make it more likely for situations to escalate quickly as depositors get cold feet and follow the herd. In terms of the severe but plausible stress scenarios that inform funding and liquidity risks, this is certainly an area that warrants greater attention.
Importance of internal controls in supporting the confidence of investors and the market.
On 14 March 2023, management at Credit Suisse reported that it had identified “material weaknesses” in its internal controls over financial reporting. Poor control environments can impact upon an auditor's ability to adequately test key financial reporting areas and this can often be exacerbated by the complexities inherent in many banking business models.
Although the auditor of Credit Suisse concluded that the material weaknesses noted by management did not ultimately affect the clean opinion on the consolidated financial statements, it is very likely to have further damaged investor confidence.
There are parallels to be drawn at SVB, where poor controls were also evident; it has subsequently emerged that management were using inappropriate models for assessing the bank’s own risks amid rising interest rates. As a result, SVB was under regulatory supervisory review for much of 2022.
We expect an increased focus by auditors and regulators on weaknesses in the control environment of banks and regulators potentially taking a more proactive approach in pushing banks to rectify issues.
Both SVB and Credit Suisse have idiosyncrasies that were exacerbated by panicked markets and they are not necessarily reflective of broader issues in the banking markets.
Nevertheless, these are not isolated incidents – nothing operates in a silo in the banking world – and we need to be conscious of the butterfly effect, especially as investors and markets spooked by recent events will be scrutinising financial institutions for any suggestions of the next domino to fall.
- Polly Tsang is Financial Services Regulatory Manager at ICAEW
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