Taking Stock of the European Banking Sector

Credit Suisse has become the latest casualty of a crisis in confidence in the banking sector, resulting in the bank being forced to merge with UBS. The bank’s demise has spooked the markets, but the event was more likely idiosyncratic in nature with no lasting implications for the larger European banking sector.

Credit Suisse has been the weakest link in the European banking system for over two years now, which led the bank to face a crisis in confidence on the back of market volatility in March. A deal with UBS was struck on the back of the intervention of the Swiss Financial Market Supervisory Authority (FINMA) and the Swiss National Bank. This was an important positive step as it prevented systemic contagion driven by counter party risk.

Credit Suisse’s fallout was the result of idiosyncratic risk and overall has limited long-term impact on the European financial sector. Even so, any such event can shake up confidence which necessitated a major circuit break. Under the circumstances, the UBS/Credit Suisse deal was the best option available for the regulators.

The Case of AT1 Bonds

For the deal to be palatable to UBS, a number of guarantees were given, which included the write-off of US$17 billion worth of additional tier 1 bonds (AT1) issued by Credit Suisse. While AT1 bonds were fully written off, FINMA did not fully penalize equity investors, upsetting the conventional waterfall mechanism of privileging bond holders over equity investors.

This situation has created some tension in the funding markets, but both the European Central Bank (ECB) and UK regulators have issued statements to support the AT1 market and help ease fears. Andrea Enria, Chair of the Supervisory Board of the ECB, gave a speech to the European Parliament on March 21, emphasizing the point that the “hierarchy of claims is clearly defined in our resolution framework, and common equity tier 1 (CET1) capital would always be first to absorb losses and would be fully written down before AT1 instruments could be written down.”

But inevitably scars have been made and a step up in AT1 costs could evolve as investors re-price the risks associated with this asset class. Nonetheless, as we look back at the sources of volatility over the past two weeks in the financial sector, those associated with Credit Suisse have now been contained. In addition, the strong balance sheets of euro area banks have been a source of resilience and would be a crucial driver of how they navigate the current events (Figure 1).

Europe’s Regulatory Environment Robust

The Silicon Valley Bank fallout is also not directly relevant to Europe, where interest rate risk is not an issue for banks. Besides, as of last reported financials, even if all available for sale and held-to-maturity unrealized securities losses of European banks went through their capital, the average hit would be less than 5%.

This is primarily due to the different regulatory environment in Europe where supervisors have enforced Basel rules on interest rate risk in the banking book (IRRBB) and have been proactive in monitoring this risk. Mr. Enria underscored this point in his speech to the European Parliament when he stated, “there is no direct read-across of the US events to euro area significant banks.”

Mr. Enria pointed to the fact that all banks are subject to liquidity coverage (LCR) and net stable funding ratio requirements. The LCR ratio is on average well above 160% for euro area banks and has declined only modestly since the start of monetary policy normalization (Figure 1).

A key point made was that “more than half of the existing buffers of highly liquid assets are made up of cash and central bank reserves, which sensibly mitigates the risk of mark-to-market losses when liquidity needs arise.” Overall, corporate deposits and household deposits are also holding up well in the euro area (Figure 2).

In Conclusion

Following the Global Financial Crisis, European banks have been under the watch of a hawkish regulatory environment. They now have high LCR ratios, double the capital ratios and are in good shape to weather the current market volatility. Undoubtedly, after the series of idiosyncratic events that we have observed over this month, regulators should take the opportunity to review their assessment of liquidity and consider some adjustments in assumptions of deposit flows.

Understandably, markets have been in panic mode over the past few weeks. However, as market sentiment moves beyond this tumultuous period, and other factors remain stabilized in the external environment, European banks, we believe, are well positioned to regain their momentum on the back of strong balance sheets that are supporting increasing capital returns to shareholders.