Neither Too Big To Fail, Nor Too Big To Save: It's Now Too Big To Hide

Monday morning when we come to the office, it could just be that Credit Suisse is ‘history’. There is a high chance that the bank merges with UBS, to make way for what could be the merger of the century. 

Switzerland’s second-largest bank, Credit Suisse is a systemically important financial institution globally with SFr 531 billion of total assets and SFr 1,294 billion of assets under management as of the end of 2022. The sheer size of the bank and the assets under management that it holds could mean large counter party exposures. 

Should, for some reason, the Swiss National Bank fail to convince (?) the UBS board to go ahead with the merger, the fall of the bank has the potential to trigger global financial stress unless a satisfactory resolution is found immediately. Incidentally, Credit Suisse Chairman happens to be Axel ‘Lehmann.

I am not inclined to forecast what is in store for tomorrow. As the Harvard economist John Kenneth Galbraith wrote, “There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know.” So let us just wait and watch for the events to unfold.

The Credit Suisse saga follows on the back of the Silicon Valley Bank (SVB) debacle, or rather the US regional banking stress, if one collectively looks at SVB, Signature Bank and the stress engulfing the First Regional Bank. 

We all know what led to US Regional Bank stress. The SVB debacle which was a clear case of asset liability management (ALM) mismatch, manifested into solvency issues for the bank. The cause behind the debacle was the decision to deploy much of the deposits received from customers into mortgage-backed securities classified as Held to maturity (HTM) instruments. 

When FED increased the rates and the interest rates started going up, it hurt the yields significantly and the HTM instruments suffered mark-to-market (MTM) losses. As the investments were in HTM securities, the MTM losses never showed up on the Balance Sheet. The ‘unrealised losses’ on such HTM instruments shot to USD 16 billion (from 0) by September 2022 as against the equity base of over USD 11 billion that quarter. The losses technically drove the bank to insolvency that quarter. Alongside this, depositors were also pulling out money. 

The chart below depicts the unrealized depreciation on HTM securities for top banks versus equity. These unrealised losses are not reflected in the stress tests or measures of capital adequacy. An increase in rates will drive these capital hits higher.  

To note, Bank of America Corp. is sitting on USD 109 billion of such losses which, if realised, would reduce its Common Equity Tier-1 (“CET1”). In the week gone by, ‘big’ U.S. banks have provided a USD 30 billion lifeline for smaller lender First Republic. 

United States banks altogether sought a record USD 153 billion in emergency liquidity from the Federal Reserve in recent days. So, uncertainty and volatility will continue to dominate US banking. The question that remains unanswered is why no one (including the regulators) saw it coming.

Let us now examine the single most important factor that led to the SVB downfall. The factor is not the rising interest rates, which caused the HTM portfolio of these regional banks to register huge MTM losses. Instead, it was the ‘management decision’ to go for asset-liability mismatch to earn a ‘few dollars’ more. 

The fact that accounting limitations did not report these losses aside, were the losses not visible to the Management of the Bank or for that matter the regulators? The lure of short-term profits got the better of prudence.

I am not counting on the global rating agencies which rated SVB as ‘A’ or the main operating unit Credit Suisse AG and other core subsidiaries A- / A-2 / A3 ( while maintaining CS Group rating at BBB/Baa2). The limitation of the global rating is known to those who are better than Indians, as these agencies continue to rate India as BBB- or Baa3 i.e., the lowest investment grade category. 

Back to Credit Suisse

While the US Regional bank stress is a function of the decision that lead to an asset-liability mismatch of sorts, the sell-off in Credit Suisse's shares can be traced back to 2021, triggered by losses associated with the collapse of investment fund Archegos and Greensill Capital i.e., investment banking decisions gone awry. 

What is worth noting is, through this stress the bank continued to rank amongst the world's largest wealth managers and crucially one of 30 global systemically important banks, whose failure would cause ripples through the entire financial system. This brings us to the question of what is a globally systemically important bank. 

The Financial Stability Board (FSB), in consultation with Basel Committee on Banking Supervision (BCBS) and national authorities, has identified a list of global systemically important banks (G-SIBs). The list for 2022 is based on end-2021 data and the revised assessment methodology published in July 2018, which is applied for the first time this year. The 30 G-SIBs included on the 2022 list are unchanged from the 2021 list.

The FSB member authorities apply the following requirements to G-SIBs:

Higher capital buffer

Total Loss-Absorbing Capacity (TLAC)

Resolvability

Higher supervisory expectations: 

One important variable that goes into the G-SIB classification is TLAC. In November 2014 the FSB published, in consultation with the BCBS a consultative document on an international standard for Total Loss-Absorbing Capacity (TLAC) to be applied to G-SIBs. 

The TLAC standard is designed to ensure that if a G-SIB fails it has sufficient loss-absorbing and recapitalisation capacity available in resolution to implement an orderly resolution that minimises impacts on financial stability, ensures the continuity of critical functions and avoids exposing public funds to loss. This contradicts the stress revolving around the possible failure of the bank. What went wrong needs introspection. 

The Basel Committee's assessment methodology for G-SIBs requires banks to report a set of indicators to national supervisory authorities. These indicators are then aggregated and used to calculate the scores of banks. Banks above a cut-off score are identified as G-SIBs and are allocated to buckets that will be used to determine their higher loss absorbency requirement. 

As mentioned above the assessment methodology was revised in July 2018 and is implemented for the first time in the 2022 G-SIB assessment. Possible case to review the same already? Or is it a case of reporting gone wrong? Was the bank management not aware of the stress? 

Many of the above factors, whether in the case of SVB or Credit Suisse, were visible to all, the management of the banks, the regulators, the rating agencies and the list goes on. When the going was good everyone chose to ignore the signals. As things unfolded in an unfavourable manner the ‘silent’ signals have now become ‘noise’. It is now ‘too big to hide!’ 

I would like to end my piece with simple logic, if we are in here to play the game for the long haul, we need to play it the right way. Borrowing from Simon Sinek’s Infinite Game, I can only say – “We can’t choose the game. We can’t choose the rules. We can only choose how we play”. 

While the regulators may try to govern and the analysts and rating agencies may attempt to understand, it is the management which is the most aware and the guardian for all stakeholders. If the Management overlooks and decides to play for short-term gains, rest assured, the end is around the bend.