UBS and Credit Suisse: The Next Shoe to Drop in the Financial Crisis of 2023?

With the number of emergency / news-related articles on this site lately – two in a row! – it’s starting to feel a lot like 2008.

Before delving in, though, I want to start with the elephant in the room: I was partially wrong ~5 months ago when I wrote about Credit Suisse, UBS, and Deutsche Bank, and whether they would become Lehman Brothers 2.0.

Technically, my assessment in that article was correct:

“The short answer is that it’s very unlikely that any of these firms will go bankrupt.

But a spin-off, divestiture, restructuring, or another major event is likely.”

However, the tone of the article was too optimistic, and I should have recommended looking for “Plan B” options more forcefully.

I made the same mistake the regulators did: ignoring shifts in the Credit Suisse deposit and cash base because its regulatory capital ratios looked “fine.”

So, what happened?

Why did UBS just acquire CS for less than $1.00 per share when it was trading above $8.00 a year ago?

Is the financial system going bust?

And what should you do if you have an internship or full-time offer at CS or UBS?

UBS and Credit Suisse: What Happened?

In case you somehow missed the news, UBS on Sunday (March 19^th) announced plans to acquire Credit Suisse for ~$3.2 billion at a P / BV multiple of 0.1x – exceptionally low for a commercial bank.

It’s so low that UBS is, effectively, paying a negative amount for CS because $17 billion of the bank’s bonds are also being written down.

The deal is backstopped by the Swiss government, which committed ~$10 billion to absorb potential losses (UBS will absorb the first ~$5 billion). If the losses are even higher, UBS and the Swiss government will split them above this $15 billion level.

UBS did not want to acquire Credit Suisse, but the Swiss government made the deal happen via the “offer you can’t refuse” methodology.

One strange aspect of the deal is that about $17 billion of Credit Suisse bonds will be written down, making them junior to the common shareholders.

These are known as “Additional Tier 1 (AT1) Bonds” or “contingent convertible” (CoCo) bonds, and they allow a bank to boost its capital ratios without diluting shareholders via an equity issuance.

Investors panicked and bid down the prices of other AT1 bonds in Europe, which prompted EU regulators to step in and state that this “would not happen to other banks.”

The AT1 bondholders are now banding together to file a lawsuit.

But it seems that the Swiss government designed the AT1 bonds to work this way, at least if you read the fine print for their “bail-in regime” (click the image to view a larger version with legible text):

In another twist, this entire deal took place without shareholder approval from either side – because everyone would have rejected it.

I explained the reasons for Silicon Valley Bank’s failure in last week’s article: incompetent risk management, massive losses on HTM securities, and a run on the bank that created the need to sell securities at a loss and get cash to cover the withdrawals.

By contrast, Credit Suisse barely had any HTM securities.

And while it did have a decent amount of unrealized losses, they were tiny next to its Net Loans balance of nearly $300 billion:

As I pointed out in the previous article, its capital ratios were fine, and its Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) were both above 100% (for more, see our full tutorial on Bank Regulatory Capital):

It even passed the Federal Reserve’s “stress tests” in the U.S. with flying colors!

The short answer is that none that mattered because depositors didn’t care and began withdrawing all their cash anyway.

Ratios like the LCR are designed for “moderate stress” scenarios, such as a bank losing 20% of its deposits over 30 days.

CS was facing $10 billion in customer deposit withdrawals per day against a cash balance of only ~$130 billion, so it was not going to last long:

Only a few strategies can prevent or mitigate a bank run, and most of these need to be set up far in advance:

• Limit the Allowed Withdrawal Rate – Besides being legally dubious, this one might also make the eventual problem worse by drawing attention to it.
• Insure the Deposits – But this is expensive and is available only up to a certain per-account limit in most countries, such as CHF 100,000 in Switzerland and $250,000 in the U.S.
• Get an Emergency Loan from the Central Bank – The central bank is supposed to be “the lender of last resort,” so this strategy can work – but only up to a certain withdrawal percentage.
• Do Not Use Customer Deposits for Funding – Some financial institutions operate like this, but it’s much more expensive, so they need to make riskier loans and investments to profit (think: mortgage REITs and business development companies).

OK, But What Was the Catalyst for the Run on Credit Suisse?

The “run” on CS started last year if you look at the Balance Sheet above, but it accelerated with the Silicon Valley Bank failure the week before.

Investors and large depositors looked at the market and said, “OK, banks are in trouble. What’s the weakest link now that Silvergate, Signature, and SVB are down?”

And the answer was “U.S. regional banks with high percentages of uninsured deposits and scandal-plagued European banks like Credit Suisse.”

As with SVB, Credit Suisse did not “fail” in a few days.

It had been making horrible moves for years/decades, its risk management was non-existent, and it accrued one of the longest Wikipedia sections I’ve ever seen for “controversies.”

Everyone knew it was in trouble; the main question was whether it would be sold whole or in pieces.

What Happens Next with UBS and Credit Suisse?

First, Credit Suisse is obviously no longer a bulge bracket bank, so I’ll have to update that article.

But that would have happened anyway because of the firm’s plans to spin off its IB group into Michael Klein’s advisory firm, M. Klein & Co.

Before this deal, I had expected that “CS First Boston” would become another elite boutique and a strong competitor to the likes of Evercore, Lazard, and Moelis.

But this spin-off might not even happen now; UBS has said that it plans to continue moving away from investment banking in favor of wealth management (it’s currently ~54% of revenue).

They may keep some CS investment bankers in the U.S. and Asia, especially in sectors like tech and TMT investment banking, but Europe is much more uncertain.

The biggest beneficiaries here are, as usual, the large U.S. banks (GS, MS, JPM, BofA, and Citi).

With the retreat of both CS and UBS, these firms’ market shares in Europe and Asia will continue to grow.

Also, many of the elite boutiques will benefit because they’ll be perceived as “lower risk” after this crisis due to their lack of large Balance Sheets.

What If You Have an Internship or Job Offer at Credit Suisse?

Unfortunately, as of Wednesday (March 22^nd), neither CS nor UBS has said anything about what will happen to incoming interns or those with full-time offers.

In 2008, some banks rescinded internships and full-time jobs, so it’s safest to assume that will happen again.

Even if internships somehow proceed this summer, the chances of getting a full-time offer at these firms are very low (and even if you got one, would you want to accept it?).

Unfortunately, because of the accelerated timing for internship recruiting, you’re probably not going to find another IB internship that starts in a few months.

So, if you’ve accepted an offer at CS, all you can do at this point is network around and look at fields outside of IB (Big 4, corporate banking, valuation, corporate finance, etc.), and see if anything is available at the last minute.

In terms of full-time jobs these firms, the target company’s employees are usually at greater risk than the acquirer’s, and middle and back-office functions are at higher risk than front-office jobs.

But this is an odd scenario because UBS has explicitly stated that it wants to reduce its investment banking footprint.

My guess is that most wealth management jobs will be preserved, IB/markets job cuts will vary by division and region, and there will be painful cuts in various MO and BO roles.

If you’re at UBS or you’ll begin working there soon, you’re probably OK for now, but I wouldn’t recommend staying for long.

They’ll always maintain some presence in investment banking, but you don’t want to spend years and years at a firm that has already shifted away from that market.

The Macro Impact of UBS and Credit Suisse (and SVB)

I expect more bank failures, hurried/forced acquisitions, and “emergency backstops” before this crisis is over.

In a standard bank failure, a larger, healthier bank acquires the troubled bank’s assets and liabilities, and the lenders and common shareholders lose all/most of their money while the depositors preserve theirs.

But with these recent deals involving SVB, CS, and others, the regulators and government officials seem to be making up rules on the spot:

• SVB and Signature Bank got “exceptions” that allowed the government to treat them as systemically important banks (they aren’t).
• UBS and CS got a backstop from the Swiss government and special treatment that allowed the CS AT1 bonds to be wiped out (“legal,” but it will be challenged in court).
• Midsize banks are now lobbying for “exceptions” that allow the government to guarantee all deposits in the U.S.

I would argue that these exceptions and special rules are making these problems worse by drawing so much attention to banks’ problems and implying that any bank without special treatment is at risk.

In the long term, these policies will lead to more centralization and a flight to the larger, “too big to fail” banks (~30 banks worldwide are considered “systemically important”).

This is negative for the financial system because the rescue costs will be even higher in the future if when one of these “systemically important” banks does something stupid.

Effectively, these large banks are becoming quasi-governmental entities, which is the opposite of how a healthy economy should function.

Central banks could also use these events to push even more dystopian ideas, such as central bank digital currencies (CBDCs) and social credit scores.

It will be a repeat of what happened during COVID: the Chinese Communist Party introduces dystopian ideas and promotes them with propaganda, and NPCs in Western countries believe everything and try to copy them.

What Should Banks and Regulators Do?

I’ve seen many proposals about how to “prevent” SVB and CS-style bank failures:

1. Remove the deposit insurance limit or increase it from $250K to $10 million in the U.S.
2. Impose stricter regulations and requirements, even on smaller banks below $250 billion in assets.
3. Don’t create new regulations; just force regulators to do their jobs and take action to wind down or sell a bank when it is approaching insolvency.
4. Create a “free” national bank that offers checking/saving accounts for everyone.
5. Bitcoin! Crypto solves everything.

Insuring all deposits or deposits up to $10 million is a bad idea because it will encourage bank executives to be even more reckless.

Why not gamble everything on subprime mortgages or CDOs if the government will save your customers? You might even get a higher bonus!

Enhancing existing regulations or enforcing them correctly might help to some extent, so suggestions #2 and #3 could be starting points.

But the cold, hard truth is that nothing can “prevent” bank failures unless the government simply takes control of all banks.

Even if banks had to maintain 100% reserve ratios – enough cash to cover all potential deposit withdrawals – they could still fail if everyone withdrew 100% of their deposits simultaneously.

The “answer” is to accept that banks will fail and make sure that their wind-downs and takeovers by healthier banks are as orderly as possible.

This means that in some cases, companies and individuals will not be able to access all their cash immediately – but percentages matter.

If a company with $100 million in the bank fails because it can access only $50 million next week, this company should not exist in the first place.

On the other hand, if it can access only $1 – 2 million of its cash for a week, the bank takeover process needs to be revamped.

Regulators should not cave into threatening tweets from VCs who claim the world is going to end because their portfolio companies cannot “make payroll.”

And there should be no backstops because banks should not be allowed to grow to their current sizes in the first place.

The idea that some banks can be “too big to fail” is ridiculous, which is why there’s a strong case for breaking up these firms into smaller entities.

A healthy economy should have dozens/hundreds of mid-sized and smaller firms competing, and the failure of a single firm should never create systemic risk.

Of course, implementing these policies would represent a complete reversal of the consolidation in the U.S. banking system since ~1930, so don’t hold your breath:

But maybe there is some cause for optimism.

Once ChatGPT-7 is released and your social credit score is linked to your checking account, your deposits might finally be safe – as long as you haven’t offended anyone on Twitter.