by Bjarne Rogdaberg, Caroline Bruyant Bonde, Sebastian Sundberg and Klaus Henrik Wiese-Hansen
We receive a lot of questions these days on what is happening in the banking sector, and whether the recent events affecting investors that had invested in AT1 instruments issued by Credit Suisse could also happen to investors of AT1 instruments issued by banks in the Nordics. There is a lot of confusion in terms of what AT1 instruments are, and why the shareholders of Credit Suisse were not the first to absorb losses in accordance with the normal principles of priority in case of insolvency.
First of all, it should be noted that the rules that apply in insolvency situations relating to banks and other credit institutions differ a lot from other businesses. This is not only because of the significance such institutions have for our financial markets and society in general, but because a bank's balance sheet looks quite different from the balance sheet of a normal business. A bank's balance sheet includes a huge debt side that would quickly turn off any investor interest, if it was not for the fact that it is a bank. So, when banks face financial difficulties there is a fairly new and unproven EU legislation in force called the Banking Recovery and Resolution Directive (BRRD), which is intended to set a uniform standard for managing banks in financial distress within the EU/EEA. The purpose of BRRD is basically to ensure that what happened during the financial crisis of 2008 will never happen again.
We need to keep in mind that in addition to the BRRD, since 2008, there has been a wave of banking regulations that has been implemented in order to increase the robustness of the European banking sector, requiring European banks to be well capitalized with adequate liquidity. The BRRD is not intended to ever be fully applied in relation to a systematically important bank, think of it more as the regulatory equivalent of a nuclear deterrent to banks and financial markets participants – essentially signaling that "if you mess things up, the regulators of the EU/EEA will basically have all the powers you could ever think of to intervene if a bank is failing". This includes not only to write down AT1 instruments, but to do whatever the regulators want with such failing bank, the instruments issued by that bank, and all contracts ever agreed upon by that bank. The message is clear: "Do not mess this up (again)."
Unfortunately, Credit Suisse did mess up and the Swiss regulator took decisive measures to avoid a deeper crisis. Many of us have reacted to the fact that the Swiss regulator wiped out $ ~ 17 bn worth of AT1 instruments without first writing down any ordinary shares. This has had (and may continue to have for some time) a negative effect on the AT1 market overall as the value of such instruments have dropped significantly due to the perceived increased risk, as a result of the Swiss regulator's actions.
Switzerland is not part of the EU/EEA, and the Swiss regulator therefore operates under a different regulation than the BRRD. However, there are similarities between the structure of the rules in Switzerland and the EU/EEA and AT1 instruments are risky investments if a bank ends up in financial difficulties, whether it is an EU/EEA bank or not. So why is that?
We mentioned that the balance sheet of a bank consists of a large debt side. If the value of the assets of a bank drops, this means that the ratio between the bank's assets and its debts shrinks. This is not good for any business and may swiftly become critical for a bank – as we have seen recently with Silicon Valley Bank. Accordingly, one action in order to swiftly strengthen the balance sheet of a struggling bank would be to eliminate a part of that huge debt side of the balance sheet and the tool for doing so is to use AT1 instruments. These are debt instruments that may be converted into ordinary shares or written down, in whole or in part.
As such, the AT1 instruments are the pawns of the chess board, their function is sacrificial by nature, to take the hit and any investor should consider this before investing in them. However, having that said, according to Article 34(1) and Article 48 (1) of BRRD, shareholders should always bear losses before holders of AT1 instruments. The principle is implemented in Swedish law in Chapter 6, Sections 11 – 13 of the Resolution Act, in Danish law in Sections 12 and 17-18 of the Restructuring and Liquidation of Certain Financial Business Act, and in Norwegian law in Section 20-14 (1) of the Finance Institutions Act.
Hence, if Credit Suisse would have been a Swedish, Danish, or Norwegian bank, the respective financial supervisory authorities would first of all have to expire the share capital, before writing down the AT1 instruments, and the shareholders of the bank would had taken the first blow in such case. The principle of the BRRD was also emphasized by the European Central Bank in its statement of 20 March 2023.1
The decision by the Swiss regulators to wipe out the AT1 bonds will surely have a legal aftermath. On 21 March 2023, Reuters reported that certain Credit Suisse AT1 bondholders, including a number of institutional and hedge fund investors, are exploring litigation options in the Swiss courts as well as in London and New York.2