Additional Tier 1 capital pressured after Credit Suisse takeover

Last week’s market volatility that started with U.S. regional banks continued over last weekend and expanded into Europe. Creditors, investors and depositors of battered Swiss bank Credit Suisse lost confidence in the bank’s ability to operate.?

What happened to Credit Suisse?

In an effort to restore stability and confidence in the European banking sector, Swiss regulators structured an acquisition of Credit Suisse by rival bank UBS. As part of the Credit Suisse takeover, its Additional Tier 1 (AT1) capital instruments were written down to a value of zero.?This treatment was a design feature of these capital instruments intended to help support the bank in case it ran into very severe financial difficulties or insolvency.

Why the AT1 instruments write down is significant

AT1 instruments are a type of subordinated unsecured investment. Credit Suisse’s AT1 instruments are now worthless as a result of its acquisition by UBS. However, unlike holders of AT1 instruments, equity holders in the company are in a position to recover some of the value of their investments. This resulted in investors globally questioning the capital structure and hierarchy of AT1 instruments within their own jurisdictions. Market participants have repriced AT1 instruments with the most significant move taking place in European markets. However, AT1 capital in North America has also experienced credit spread widening.

Do Canadian AT1 instruments provide better terms for investors?

Naturally, the write down of Credit Suisse AT1 capital has many investors asking about AT1 instruments issued by Canadian financial institutions, particularly Canadian banks. AT1 capital instruments issued by Canadian banks consist of preferred shares and hybrid securities which include Limited Recourse Capital Notes (LRCNs).?

In the unlikely event a Canadian bank is deemed to be non-viable or is given government support, these AT1 securities wouldn’t be written down to zero as was the case with Credit Suisse. Instead, these AT1 instruments would be converted into common equity, diluting the original common shareholders and providing AT1 investors with an ability to still obtain value for the original investment.?

To provide clarity and guidance to Canadian investors, OSFI released a statement reiterating this treatment of AT1 instruments. “Such a conversion ensures that Additional Tier 1 and Tier 2 holders are entitled to a more favorable economic outcome than existing common shareholders who would be the first to suffer losses. These capital requirements are administered by OSFI as well as the conversion of the Additional Tier 1 and Tier 2 capital instruments.”

CIBC Asset Management’s investments in AT1 instruments

Our CIBC Asset Management mandates continue to invest in AT1 instruments (where appropriate)—and we remain comfortable with the companies we own because of our due diligence and credit research processes.

Our credit team is an integral part of our firm’s ability to successfully navigate market cycles including downturns such as the Global Financial Crisis and the Covid-19 pandemic. The team continues to be a strength in our investment management process. CIBC Asset Management’s managed fixed income portfolios had zero exposure to Credit Suisse.

The fixed income team continues to actively monitor the level of risk in all portfolios in today’s environment. We leverage our strong credit research capabilities to avoid unintended risk in all of our investment portfolios.

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