Robert Guttmann On The Collapse of Credit Suisse, AT1 Bonds, And The Dilemma Central Banks Are Facing

Robert Guttmann is Professor of Economics at Hofstra University & former Associate Professor at the Centre d’Économie Paris-Nord (CEPN), Université Paris XIII.

By Aiden Singh, March 30, 2023

Aiden Singh: Last week three central banks - The Bank of England, The Federal Reserve, and The Swiss National Bank - all hiked their policy interest rates to keep up their fight against inflation, despite the financial turmoil we've seen over the last few weeks. Was this the right move?

Robert Guttmann: I’m not sure whether we can say it’s the right or wrong move because we are in uncharted waters. There are a lot of things that central bankers would like to know more about but can’t: the stubbornness of the inflation that they’re facing, how deep the fissures in the banking system caused by their hikes to date are, and where the breaking points that would cause greater panic are. So central bankers don’t know the right and the left of their structural dilemmas because they’re unprecedented in some ways.

Of course, we’ve had banking crises before and we know that tightening monetary policy always creates stress. In that sense, you're facing something you understand. But there are so many new elements to this banking crisis, such as the role of today’s technology. So one cannot say whether it was the right or wrong move.

These central bankers have to make strategic calculations. They currently have a credibility problem because they reacted to the inflation problem far too late. They are moving from a deflationary dynamic, which they got used to dealing with and did a lot to combat, to a sudden post-pandemic inflationary situation. And this inflation picture is very complicated with many structural elements that they can’t fully understand. They don’t fully know, for example, the full effects of the economic scarring of Covid and the supply disruptions it caused and where the multipliers are. They don’t fully know about how the energy crisis and inflationary transition to zero emission will work out. So there’s a structural inflation problem; it’s not the same as just overheating. It’s very much a supply driven inflation problem which is underwritten by the incredible injection of government money during the pandemic. So you’ve had a large number of shocks in a short period of time.

So what central bankers have done is to zig-zag. The Fed set up a facility - The Bank Term Funding Program - as a safety net for problems at regional banks. And they offer it against collateral valued at par so that the banks have a lot of liquidity. And the Fed enhanced dollar swap facilities. So they’ve put liquidity cushions in place globally and locally. And then they also tightened. So the central banks have zig-zagged, providing liquidity while also tightening to fight inflation.

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Aiden Singh: Do you have any thoughts on whether letting the policy interest rate hikes that have already been implemented take effect would be enough to rein in inflation? Or is continued hiking necessary?

Robert Guttmann: I think central banks will want to take a pause to let the hikes work through and try not to increase pressure on the banking system. They’ve already increased pressure on the banking system and it has caused significant damage: the collapse of SVB, the collapse of Signature, and the collapse of Credit Suisse. There is a lot of contagion potential. So they’ll want to take a pause, but they don’t want to do it right now because doing so might indicate panic. They want to avoid contagion and let things calm down, and I think they’re succeeding even though it’s a tricky process: one word by the Fed can be misinterpreted and the markets are incredibly reactive.

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Aiden Singh: We saw that UBS bought distressed Credit Suisse in an acquisition facilitated by the Swiss government. What are your thoughts on how this was handled?

Robert Guttmann: UBS and Credit Suisse were the two giants of the most financialized country in the world. And they were mortal enemies for centuries. The AT1 bond component of this situation presents a very important problem.

Out of the post-2008 crisis idea of not bailing out banks but instead resolving them, there was a European strategy and an American strategy. The American strategy was living wills, which haven’t even been discussed during this recent string of bank failures. The European model involved contingent convertible bonds (CoCo bonds) that would automatically turn into equity at preset price ratios during a crisis. In the Basel III agreement, CoCo bonds were to be the third capital buffer out of five. The conversion to equity is intended to occur at a very low price so that the bond-holders turned equity-holders have the potential for a large capital gain if this conversion works to stabilize the bank. These CoCo bonds are called alternative tier-1 or AT1 bonds. So under Basel III, banks have their main tier-1 capital and an additional buffer in the form of AT1s. These AT1s are meant to provide an additional buffer during a crisis so that you have some space for what is called resolution, which was meant to be the 21st century way for dealing with bank failures. And the collapse of Credit Suisse was a test case for these AT1 bonds.

Switzerland had only two days to deal with a collapsing Credit Suisse. And part of that had to do with credit default swaps (CDSs) - bets on the solvency of an institution. And movements in the market for CDSs - which is a very thin illiquid market - send signals to markets. So the collapse of Credit Suisse came incredibly fast because once the CDS market sends worrying signals, you get a run on deposits and the bank’s market capitalization falls rapidly, becoming so out of whack with its book value that the bank is basically dead.

What Switzerland did, instead of converting the AT1 bonds into equity - which would have been the first time this was done - was write-off the AT1 bonds and save the shareholders, giving them something rather than wiping them out to zero. So they deviated from the European resolution mechanism.

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Aiden Singh: It seems that whenever there is a banking crisis, certain too big to fail banks get even larger. What do you make of this?

Robert Guttmann: Banks are always getting bigger because they’re already too big to allow to fail, so when one is failing it has to be eaten up by a bigger bank. Basically a failing bank gets split up into a bad bank and a good bank. The good bank gets acquired and the bad bank gets socialized by the government.

The key is to not have taxpayer bailouts. None of the bank failures we’ve seen recently involved taxpayer money. Each of them was dealt with a in way that didn’t involve the taxpayer.

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Aiden Singh: The US government responded to the collapse of SVB and Signature Bank by guaranteeing all deposits at those institutions, even above the $250K FDIC limit for deposit insurance. Are we in an era where all bank deposits are de facto insured?

Robert Guttmann: Yes. But policymakers don’t want to state that explicitly because there’s a moral hazard problem that comes with doing so. They’re trying to manage the moral hazard and the contagion potential simultaneously.

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