MC Explains | Credit Suisse and the darkening spectre of instability

A sign above the entrance to a Credit Suisse Group AG bank branch in Geneva, Switzerland, on Monday, July 25, 2022. Photographer: Jose Cendon/Bloomberg

The UK government’s fiscal incontinence through unfunded tax cuts that dragged the Bank of England (BoE) back to quantitative easing (QE) took on a nasty turn last week.

As UK gilt yields continued to fly, investors joined the dots to conclude that two of the biggest European investment banks were on the brink of collapse. Just like wildfire, the possibility of contagion and financial instability spread to other markets, particularly the US.

But how did Credit Suisse and Deutsche Bank go from being poster boys to (potential) fallen angels? We explain:

Also Read | Credit Suisse shares fall around 10% in early trading

What happened in the UK last week?

Ever since the UK government announced unfunded tax cuts on September 23, bond yields have been flying. The 10-year UK bonds now trade at around 4.10 percent, more than 3 percentage points higher than year-ago levels. The 30-year gilt has also climbed to 3.7 percent.

A surge in bond yields results in losses on the books of investors, that include UK pension funds and investment banks. As rates rose, they triggered collateral calls for pension funds, forcing them to scramble for cash.

Also Read | Credit Suisse in market spotlight despite moves to calm concerns

The BoE’s announcement that it would buy gilts was attributed to preventing pension funds from getting pummelled with margin calls. Soon, markets began to wonder whether investment banks would face a similar fate.

Also Read | Credit Suisse shares hit record low as CEO fails to calm markets

Why did the names of Credit Suisse and Deutsche Bank come up?
Both Credit Suisse and Deutsche Bank shares have been under pressure since the beginning of the year. Their shares are trading at valuations not seen since the 2008 financial crisis. In early trade, shares have fallen more than 10 percent today. In light of the troubles with gilt yields, investors feared that these investment banks would face big losses on their books, especially with leveraged finance.

ALSO READ: Credit Suisse is at ‘critical moment’ as bank prepares for latest overhaul, CEO says

Credit Suisse’s investment bank vertical has reported depressed earnings in the past quarters. Deutsche Bank faced immense pain in 2016 when the firm had reported a big hit on its revenues, and its chief had announced a restructuring plan wherein dividends were suspended. Investors feared the bank was headed for yet another spot of trouble. The bank’s current equity valuations are termed as distressed.

What else was the market spooked by?

The fear was reflected not just in share prices, but in the credit default swaps, the cost of insuring against the credit risk of Credit Suisse’s bonds.

Swaps surged to 14-year highs, cementing fears that the investment bank was unravelling. This resembled the movement in swaps of Lehman Brothers just before the bank collapsed. Ironically, Credit Suisse CEO Ulrich Koerner’s comments in an internal memo only sparked more suspicion.
Koerner said the bank was at a “critical moment,” but stressed that its capital and liquidity positions were strong. The investment bank will announce a new strategic plan to turnaround the business on October 27.

Bloomberg reported that the plan would outline sweeping changes to its investment banking business. Koerner’s comments assuring that the stock price does not reflect the firm’s financials were compared with similar assurances by Lehman bosses before its collapse.

Is Credit Suisse really in deep trouble

The bank’s main earnings are from its banking and wealth, investment banking, and asset management verticals. Its net revenues were flat between 2019 and 2021, but operating expenses were higher. The bank also downsized its workforce and took recourse to more contractual employment. It saw a change in its top management, and a restructuring of its investment banking division, to reduce risks.

In short, Credit Suisse has been in a major transition in 2022, and that has kept investors wary. Further, the bank’s July quarter earnings showed that wealth management fees were down 74 percent year-on-year, and that its investment banking division had taken a mark-to-market hit of $245 million.

ALSO READ: Credit Suisse CEO Ulrich Koerner seeks to calm markets as default swaps climb

Investors are awaiting the bank’s overhaul plans, and the Financial Times has reported that the bank plans to package its troubled investment bank book into a bad bank and sell it.

What is in store for Credit Suisse and the markets?

According to analysts, Credit Suisse’s recent earnings do not inspire confidence. Also, the bank’s assumptions and outlook for business for the third quarter hasn’t panned out. For instance, Credit Suisse had said that its mark-to-market losses would reduce once the fixed income credit spreads narrow. But spreads have only widened since then.

The firm has also suffered steep losses due to a securities fraud by Archegos Capital, which raised questions about its risk assessment capabilities. The bank suffered a blow to its reputation as well due to a string of scandals associated with its investment banking.

It is no surprise that the Credit Suisse stock continued to fall today to record lows and its swaps continue to climb. The bank’s assurances seem to have backfired.

Comparison with Lehman Brothers may seem overdramatic, but the bank’s troubles surely go deeper than they appear. Given the bank's "too big to fail" tag, markets are in for a tumultuous period.