Explanation of New Type of Bond: CoCo Bonds (AT1) | Credit Suisse's CoCo Bonds (AT1) Written Down to Zero, ECB States Violation of Loss Absorption Hierarchy

Yesterday, Switzerland's largest bank UBS acquired all shares of Credit Suisse at a super low price of 3 billion Swiss francs, decisively cutting off the risk of bank bankruptcy overflow. However, what surprised the market was that the Swiss Financial Market Supervisory Authority FINMA "directly wrote down 160 billion Swiss francs of Credit Suisse's CoCo bonds AT1 to zero to ensure that private investors help bear the cost." With this seemingly casual statement, what exactly does it represent? It even prompted the European Central Bank to speak up!

What is CoCo Bonds?

The 16 billion Swiss Franc bond, commonly known as "CoCo Bonds" or Contingent Convertible Bonds, emerged as a new type of bond after the European debt crisis. It is designed by banks to meet regulatory capital requirements quickly in times of emergency without relying on government bailouts.

CoCo Bonds can convert between "bonds" and "stocks." When a bank's capital level is too low, these CoCo Bonds can be converted into equity, i.e., the bank's stocks, to increase the bank's capital adequacy ratio. Due to its convertible nature, these bonds are designed with the characteristic of "higher returns than regular bonds in good market conditions and significant risks in adverse market conditions."

In the corporate capital structure, CoCo Bonds have the following priority as shown in the diagram below, ranking below regular bonds but above common stocks.

Two Types of CoCo Bonds: AT1 v.s. T2

CoCo Bonds are divided into two types: Additional Tier 1 (AT1) capital and Tier 2 (T2) capital. AT1 CoCo Bonds have no maturity date and are a type of perpetual bond, while T2 CoCo Bonds typically have a term of more than five years. The triggering scenarios and impact on the bank's capital adequacy ratio differ between the two, with the priority of claims being T2 > AT1 > CET1, which is common stock.

FINMA has fully written off the Swiss Credit CoCo Bonds, meaning that the conversion process of AT1 was skipped, and the bonds were written off to zero. However, the original common stocks were transferred to UBS at a price of 30 billion Swiss Francs, indicating that the priority of bond claims was lower than that of equities, completely overturning traditional financial thinking.

ECB Disagrees with the Action, AT1 Importance

The European Central Bank (ECB) and the Single Resolution Board (SRB) subsequently issued a statement stating that Europe has established a resolution framework post-financial crisis, emphasizing that shareholders and creditors of troubled banks should bear losses in a specific order.

Common stock is the first tool to absorb losses, and only after its full utilization should AT1 be written down.

The ECB stated that this guideline has been followed in past cases and will continue to guide the SRB and ECB in crisis intervention actions. The ECB also emphasized that AT1 is currently and will continue to be an important component of the European bank capital structure.

Silicon Valley Bank UK Branch Written Off to Zero

The Bank of England issued a statement stating that the UK banking sector has a clear legal framework, and shareholders and creditors will bear losses in resolution or insolvency scenarios. The Silicon Valley Bank UK branch also adopted this approach:

All AT1 and T2 of SVB UK were fully written off, and the entire equity of the company was transferred at a nominal amount of 1 pound.

The priority order is: T2 > AT1 > CET1