Banks failing: Lessons learnt from the Credit Suisse collapse

November 23, 2023 •

5 min reading

Banks failing: Lessons learnt from the Credit Suisse collapse - Part 2

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This is the second article in the series by Dr Giuliano Bianchi that sets out to explain why, how and to what effect have Switzerland's two biggest financial institutions (UBS and Credit Suisse) been bailed out in the last 15 years.

Two bailouts in just 15 years

In the wake of the 2008 bailout by the Swiss National Bank (SNB) and the Swiss taxpayer of the country’s largest systemic bank, Union des Banques Suisses (UBS), the authorities in Bern went straight to work to hammer out new financial legislation.

“Never again” was the mantra and the goal was to bring Swiss laws in line with other frameworks (namely the U.S. and the EU) and to follow international financial recommendations (i.e., the Basel accords). The Swiss regulator sought to shore up the stability of the system and bring it in line with international capital market standards, in hopes of bolstering the attractiveness of the Swiss financial marketplace.

Fast-forward to 2023, and it's déjà vu all over again. Unfortunately, just 15 years after the 2008 Great Recession, Switzerland finds itself in the same exact spot: a systemically-important bank was extending an open palm to the SNB, which was not even the authority designed to handle bailouts. If you think it is within the national bank’s remit, think again. The SNB has a very conservative mandate, echoing the old Taylor rule: fight inflation.

Now, during a period when Switzerland is facing inflation and the SNB should be mulling an interest rate hike, offering a line of credit of CHF 100 billion is not exactly in line with such a policy. And if you think the Credit Suisse bailout was not as dramatic as the one in 2008, think again. True, the magnitude is not as big as 2008, but in the interim the Swiss legislature had been working to grant more firepower to FINMA, the Swiss markets watchdog.

Yet, FINMA was unable to stave off a collapse of the confederation’s second-largest bank, despite warning signs of instability—and a series of ugly scandals—in recent years. Despite having at its disposal brand-new legislation, which was designed precisely to avoid such an outcome, Credit Suisse failed. This is quite frightening as the capital markets rely entirely on trust. But if you think the bad news ends there… think again.


The bank takeover and its consequences

How did FINMA orchestrate UBS’ absorption of Credit Suisse? FINMA decided to write off Tier 1 capital, tout simplement. This financial instrument was created by the international regulatory community after the 2008 financial meltdown to guarantee banks would have access to capital in case of distress.

The idea is quite simple: Tier 1 works as a bond, but if and when the bank needs capital, they get converted into shares. This conversion carries extra risk that is compensated by a risk premium. The market expected Tier 1 bonds (dubbed “CoCos” for ‘contingent convertible bonds’) to be—in one way or another—converted into stock or compensated in some other way. Nein! FINMA decided to write the bonds off instead, with two lasting repercussions.

First, the decision might sound the death knell for CoCos (or Tier 1) as an asset class. Who’s going to trust them now? Conventional wisdom says that investing in shares of stock is riskier than holding bonds. But FINMA just unilaterally decided to wipe out $100 billion in bondholder wealth. So a tenet of investing wisdom has been turned on its head.

Second, the Swiss authority has put national interests ahead of international credibility. Finance has another truism: “Banks are international in life, but national in death”. FINMA has sent a scary message to investors, which may cut the legs out of a market that has proven to be efficient in preventing bank failures. The decision, to its credit, seems to have halted (or at least slowed) the spread of bank failures that ignited in the United States with the collapse of Silicon Valley Bank. In a recent speech, President Biden’s response was unequivocal: “Investors in the banks will not be protected. They knowingly took a risk, and when the risk didn’t pay off, investors lose their money. That’s how capitalism works.”


The investment devil is in the contractual details

In a press release published on the March 23, 2023, FINMA explained the legal basis supporting the decision. The regulator’s arguments can be summarized as follows: the contract clearly states that in case of a viability event, the CoCos would be written down. The suspensive condition materialized, and so AT1 rights were cancelled. Pacta sunt servanda: “agreements must be kept”, i.e., read the fine print of the contract before investing. Can we argue with that? Maybe, maybe not.

Swiss law acknowledges the concepts of i) “clause abusive” [oppressive clause] and ii) “clause insolite” [unusual provision]. Basically, the first refers to a clause in a contract that is buried in the fine print that the consumer cannot be expected to be aware of. This applies more to consumer goods, but doesn’t necessarily apply when investment firms have teams of lawyers to suss out every last detail of an investment contract.

Moving on, the second term refers to a clause in the contract that is so out of the ordinary that it changes, substantively, the investment proposition. This, argued in a court of law, may hold up. But there is a larger problem. It might be a moot point given that the highest law in the (mountainous) land, i.e., the Swiss Federal Council, ordained the merger by invoking articles 184 and 185 of the country’s constitution. This allowed regulators to sidestep legal issues, such as the law on mergers and acquisitions.

Under normal circumstances, would the anti-monopoly authorities have approved a merger of the country’s two biggest banks? Doubtful. A constitutional amendment, dated March 19, 2023, states: “At the time of the credit approval, FINMA may order, in accordance with Article 5, the borrower and the financial group to write down additional Tier 1 capital.” Voilà, that settles that!


Economic vs financial impact

First of all, Switzerland is not yet done regulating its financial sector. The country’s two biggest financial institutions have been bailed out in the last 15 years. The amendments to the legislation, which were undertaken in 2008 to avoid another intervention, may have delayed the bank’s demise and softened the blow of its dissolution, but ultimately failed to prevent Credit Suisse’s downfall. And yet, the writing was on the wall for years, including a series of scandals and subpar performances.

So FINMA has an army of fantastic lawyers to explain their way out of trouble. But what are economists saying about the deal? Is it good for the Swiss economy? Economists could provide a better understanding of the financial engineering, how markets operate and the dynamic behind it, which would help to predict and anticipate events in the future. Maybe there are too many lawyers and not enough economists in Bern. While law and economics is a well-established discipline in the U.S. and other countries, Switzerland seems to be clinging to an antiquated legal interpretation of events. This is even more worrisome considering Swiss laws are not based on lex mercatoria (i.e., commercial law).

Moreover, more statistics and numbers are needed. It is surprising that in an era of AI, BigData and machine learning, the authority’s website offers so few numbers or data for the public and academics to pour over. A much more detailed quantitative analysis is essential in today’s digital world.

To its credit, FINMA is right on one point. The market has to understand that contracts are crucial. No matter how complex they are, how messy the financial engineering, in the end the contract is the backbone of every transaction. And every contract must comply with contract law. Nearly every contract contains a “non-execution clause”. Dura lex, sed lex. The law is hard, but it’s the law!

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Written by

Associate Professor of Economics at EHL Hospitality Business School

Andrew Brenner
Written by
Andrew Brenner

EHL translator & editor