After the UBS-CS merger Federal Administrative Court ruling leaves other banks trembling

A ruling from St. Gallen has sparked a global debate: the write-down of Credit Suisse AT1 bonds was unlawful - with consequences that shake the foundations of the modern banking rescue system.

A single ruling - and the financial world is upside down.

The ruling by the Federal Administrative Court in St. Gallen in mid-October sounds dry in legal terms, but it is highly explosive: the write-off of CHF 16.5 billion from Credit Suisse's AT1 bonds was unlawful. A sentence with an impact in the billions - and possibly the beginning of the end for an entire bond class.

The reaction of the markets was not long in coming: the written-off CS securities experienced a veritable price rally. And other AT1 bonds - such as those of UBS with ISIN CH1485827070 - also rose noticeably, as the "Handelszeitung " writes.

No wonder: the ruling suddenly made the risky bonds attractive again. This is because the chance that they would simply be written off in the event of a crisis seems to have diminished.

But the euphoria has a shadow.

Do AT1 bonds still work at all?

Behind the scenes, concern is growing: has the ruling by the Swiss judiciary permanently damaged the mechanics of AT1 bonds? These securities, once intended as a safety net for failing banks, could lose their function in the future - even if a bank actually still has a good chance of survival.

Lawyers and supervisors are sounding the alarm: if the ruling stands, many of the AT1 bonds issued will no longer count as regulatory capital.

This could be expensive for banks such as UBS, which currently holds 16 billion dollars in AT1 instruments. In an emergency, they would have to be replaced by hard equity - a costly restructuring with consequences running into billions.

The spare wheel is wobbling

AT1 bonds - or "Additional Tier 1" bonds - are a product of the 2008 financial crisis and are intended to help stabilize a bank before it goes bankrupt. The idea: a flexible buffer, a "spare wheel" that takes effect before the tow truck has to come.

In Switzerland, banks are allowed to cover part of their capital requirements - specifically 4.3 percent of risk-weighted assets - with AT1 securities. The rest must be covered with real equity.

But now it turns out that the spare wheel may not work when it is really needed.

Small print with a big impact

The problem lies in the detail - more precisely in the terms of issue. Finma accepted contractual wording from Credit Suisse that was narrower than the legal requirements. The court therefore ruled that the bonds should not have been written off because CS had received state liquidity assistance but no capital injections.

A fatal signal - because similar wording can also be found in the AT1 bonds of UBS, ZKB and Luzerner Kantonalbank. It is unclear whether all of these securities could really be used for stabilization in an emergency. Although FINMA and the banks refer to the ruling, which is not yet legally binding, the uncertainty remains.

A risky game with liquidity and trust

Capital and liquidity are not the same thing - but they are closely linked. If a bank finds itself in a liquidity crisis, this can quickly threaten its solvency. Assets then have to be sold at rock-bottom prices, which puts pressure on equity - a vicious circle.

Economics professor Yvan Lengwiler sums it up for the Handelszeitung: "Until now, AT1 was considered a flexible instrument - in the event of market losses, a banking storm or technical problems. The ruling now raises the threshold. Only if the solvency requirements are not met may write-downs be made."

Reforms urgently needed - or reversal of all AT1s?

The consequences are dramatic: if the ruling stands, banks may have to buy back their existing AT1 bonds and replace them with new ones with legally secure conditions. Alternatively, Finma would have to remove the bonds from core capital - a regulatory disaster.

ETH economist Hans Gersbach is calling for far-reaching reforms: Not only would the issuing conditions have to be adjusted, but the Capital Adequacy Ordinance itself would also need clarification - particularly on the question of what exactly falls under "state aid". Lengwiler also advocates more room for maneuver for Finma - even at constitutional level.

A look at Australia shows where the journey could take us: AT1 bonds are to be abolished altogether there. Gersbach sees the ruling as confirmation of his skepticism - and predicts a similar fundamental debate in Switzerland.

This article is for information purposes only and does not constitute financial advice. The analyses and assessments contained herein are based on thorough research, but are no substitute for an individual assessment by experts. The development of the financial markets is influenced by numerous, sometimes unpredictable factors. Investments in shares, cryptocurrencies and other financial products are associated with risks, including a possible loss of capital.