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Riot police officers take position in front of the headquarters of Credit Suisse bank ahead of a demonstration following the announcement that Swiss banking giant UBS had agreed to take over Credit Suisse in a government-brokered deal in Zurich on March 20.FABRICE COFFRINI/AFP/Getty Images

Swiss regulators have upended credit markets by favouring shareholders in troubled Credit Suisse Group AG UGLDF over the bank’s lenders, in a move that raises concerns about a key backstop put in place to avert another global financial crisis.

On Sunday, UBS Group AG acquired Credit Suisse CSGKF in a marriage hastily arranged by Switzerland’s government. The Swiss National Bank, the country’s central bank, said the union would “secure financial security.” The deal will see Credit Suisse shareholders receive US$3.25-billion in UBS stock.

Critically, investors holding US$17-billion of Credit Suisse additional tier 1 (AT1) bank debt were wiped out in the rescue, overturning long-established traditions of debt holders taking priority over equity investors. The move has experts questioning why regulators encouraged banks to issue AT1 debt – also known as “bail-in bonds” – to avoid repeating the government bailouts required in the 2008 global financial crisis.

Regulators around the world, including in Canada, worked with banks to roll out bail-in bonds as part of a program to build capital reserves from private sector investors, rather than government coffers. Banks responded by issuing US$260-billion of the debt, including more than $6-billion of bail-in bonds from Canada’s biggest banks.

If a bank gets into trouble, bail-in-bonds are meant to convert into common stock, reinforcing the bank’s balance sheet at a time when it otherwise cannot raise equity, said Laurence Booth, a finance professor at the University of Toronto’s Rotman School of Management. In return for accepting the risk of conversion, bail-in bonds pay higher interest rates than traditional corporate debt, a feature that makes the securities popular with hedge funds.

At Credit Suisse, common shareholders are getting paid “while the bail-in bonds are reduced to zero,” said Mr. Booth, who holds Rotman’s CIT Chair in Structured Finance. “This is certainly not what was expected when these bonds were designed, and will make them more difficult to sell in the future unless the contractual features are redesigned.”

Some of the world’s largest fund managers, including PIMCO and Lazard Asset Management, face significant losses on their Credit Suisse AT1 bond holdings. Law firms are threatening to sue the Swiss banks and government.

The outlook for Credit Suisse’s lenders is unclear, with government agencies still working to sort out details of the weekend rescue. “European regulators issued a statement today saying they would give AT1 bond holders seniority over shareholders, throwing shade at the Swiss regulators,” said Elisabeth Rudman, global head of financial institutions at DBRS Morningstar. She said Credit Suisse filings do make it clear Swiss regulators have the ability to write off the AT1 before equity in certain circumstances.”

On Monday, the Office of the Superintendent of Financial Institutions attempted to clear any confusion around Canadian bail-in bonds by clearly stating their owners outrank common shareholders. In a press release, the federal regulator said if a Canadian bank fails, AT1 “bondholders are entitled to a more favourable economic outcome than existing common shareholders, who would be the first to suffer losses.”

OSFI said bail-in bonds ”are and will remain an important component of the capital structure of Canadian deposit-taking banks.”

After Credit Suisse’s rescue and the recent failure of California-based Silicon Valley Bank, Finance Minister Chrystia Freeland said her government has been working closely with domestic regulators and bank executives to ensure Canadian capital markets remain robust.

“We have strong institutions, and we have a financial system that has proven its strength time and again,” Ms. Freeland said in a speech on Monday. “Our financial institutions have the capital they need to weather periods of turbulence,” she said. “A hallmark of our Canadian banks is prudent risk management – and this is also a core principle for those of us who regulate the financial system.”

European regulators introduced the bail-in bond concept in 2013, at a bank in Cyprus, in the aftermath of the global financial crisis. Regulators in Europe, Canada and the U.S. put a framework in place in 2018 that encouraged these bond issues for both banks and institutional investors.

Royal Bank of Canada was the first Canadian lender to issue bail-in-bonds, with a $2-billion offering of five-year debt in 2018. The five other major domestic banks followed with their own issues.

Capital markets experts predicted AT1 debt would become commonplace at Canadian banks and insurance companies, because of a favourable tax treatment for investors. In a 2020 report, law firm Osler, Hoskin & Harcourt LLP said investors pay withholding tax on dividend payments from common and preferred shares, while there is no withholding tax on AT1 bond interest payments.

“Market participants expect that over the coming years, Canadian banks will replace their outstanding preferred shares with AT1″ bonds, said Osler partners Timothy Hughes and Rosalind Hunter. Because bail-in bonds have an international following, the lawyers said Canadian banks will benefit from “shifting the existing domestic, retail investor base for preferred shares to a global institutional investor base.”

With a report from Bill Curry

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