The Crisis of Credit Suisse and the Impact in the Brazilian Market
Introduction
The beginning of this year has been marked by a turmoil in the international financial market. First, with the failure of Silicon Valley Bank in the US followed by the acceleration of the recurrent problems faced by Credit Suisse in Europe.
Earlier in March, a decision was taken to write-off the perpetual debt of CS that was accounted as regulatory capital of that institution. This controversial decision created a wave of protest and mistrust by international investors, exposed not only to the debt instruments of the Suisse bank, but who had purchased similar instruments from financial institutions all over the world.
The big question that everybody was asking was: could that also happen with transactions governed by regulations of other countries?
We will try to answer this question in relation to Brazil.
AT1 Regulation in Brazil
In relation to regulatory capital, Brazilian financial institutions must comply with guidelines established by the Central Bank and the National Monetary Council (CMN) regarding Basel III accord guidelines on risk-based capital adequacy. As such, and under Basel III definitions, regulatory capital is composed by two tiers: Tier I and Tier II. Tier I capital has a 6.0% minimum requirement to the Risk Weighted Assets (Ativos Ponderados pelo Risco or “RWA”) amount, divided into two portions: common equity tier I or capital principal and additional Tier I capital (the so-called AT1 capital) or capital complementar. Additional Tier I capital is basically composed of hybrid debt capital instruments authorized by the Central Bank and Tier II capital is composed of subordinated debt instruments authorized by the Central Bank, both with certain deductions.
One of the most important changes applicable to Additional Tier I or Tier II instruments under Basel III is that to be qualified as regulatory capital, the Basel III Regulations require an instrument to have a provision that requires such debt security to either be written off or converted into common equity upon a “trigger event”. Pursuant to art. 15, XV, and art. 20, X, of CMN Resolution No. 4,955, the instruments that are eligible there to shall be permanently written down in an amount at least equal to the total accounted as Tier 1 or 2 Capital of the issuing institution in the following situations:
- if the bank discloses that its Common Equity Tier I capital is at a level lower than 5.125% of the RWA of the bank (for Tier 1 Subordinated Notes) or lower than 4.5% of the RWA of the bank (for Tier 2 Subordinated Notes), unless disclosure is subjected to Central Bank review or to re publication;
- a commitment is executed for a public sector injection of capital to the issuing institution, pursuant to and in accordance with the terms of a specific written law, as established in Art. 28 of Brazilian Supplementary Law No. 101 dated May 4, 2000[1];
- decree, by the Central Bank of Brazil, of a temporary special administration regime[2] or intervention in the issuing institution; or
- the Central Bank, according to the criteria established in CMN Resolution No. 4,955 or other regulations issued by the CMN, determines in writing to write down the Subordinated Notes[3].
Having said all that, we believe it is theoretically possible under the Brazilian capital adequacy framework for a Credit Suisse-style situation to occur (i.e., where Additional Tier 1 Capital gets written down to zero but Common Equity Tier I capital holders may be left with some residual value).
Proposed Changes to Bank Liquidation
At the end of 2019, the Federal Government submitted to the National Congress the Bill No. 281/2019 that provides for the resolution regimes for institutions authorized to operate by the Central Bank of Brazil, by the Superintendency of Private Insurance (“SUSEP”) and by the Securities Commission (“CVM” and, together with the Central Bank and Susep, “Resolution Authorities”). This project is the result of several years of discussion by the Resolution Authorities with the market and is “inserted in the set of external commitments that Brazil assumed in the framework of the G-20” (as the explanatory statement presented to the National Congress says). The new law, if approved by the National Congress, will revoke Law No. 6,024 and bring some important changes to insolvency processes of financial institutions.
Also, the new law will establish mandatory planning, establishment of preventive measures and guarantee mechanisms to safeguard the soundness and viability of financial institutions.
One of the main stabilization measures proposed by the Bill is the use of resources to absorb losses and reconstitute the institution’s capital. Firstly, the declaration of the Stabilization Regime would result in the use of the shareholders’ resources to absorb the losses of the legal entity submitted to the regime, until the share capital is reduced to R $ 1.00 (one real). If this measure is not sufficient, the Resolution Authorities could determine that the trustee must promote the conversion of certain instruments into shares or quotas, in the following order: (i) credits against legal entities held by the controllers; (ii) debt instruments authorized to compose regulatory capital in the form established by the legislation; (iii) debt instruments that contain subordination clauses to unsecured creditors and a clause that provides for their extinction or the conversion of their value into capital in the event of a resolution regime being decreed; and (iv) other debt instruments with a subordination clause to unsecured creditors. The share capital resulting from the conversion of these instruments would be used to absorb the remaining loss in its entirety or until the share capital is reduced to R$1.00 (one real). Finally, if the legal entity subject to the Stabilization Regime does not meet the requirements and regulatory limits, after the full conversion of the instruments above, the Resolution Authorities could determine that the regime administrator must promote the conversion of the other credits against the person into shares or capital quotas, in the amount necessary for their reframing.
The expectation was that the Bill could be approved by the end of 2020, but, due to the pandemic, the timeframe for the approval of the Bill is now uncertain.
The important message here is that this mechanism would avoid the situation in which an AT1 security investor loses everything, and the shareholder is still able to recover some value from the company.
Conclusions
For the moment, the market for further AT1 issues seems to be closed.
However, given the urgency of the matter at the present moment, the Central Bank may start putting pressure in the Congress to have this PL approved and converted into law. This will certainly be extremely important to allow Brazilians issuers to be able to reassure international investors of the solidity of the local financial system and to successfully place those instruments in the international market.
Main Contacts
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[1] Supplemental Law No. 101, dated May 4, 2000, as amended, also known as the Fiscal Accountability Law, provides for the responsible management of public finances. Pursuant to Chapter VI of the Fiscal Accountability Law, public funds may only be allocated to the private sector to cover cash needs or other shortfalls if permitted by a specific law. Article 28 of the Fiscal Accountability Law further highlights that, unless authorized by a specific law, public funds cannot be allocated to bail out entities of the Brazilian financial system (i.e., financial institutions in general), including by means of financing transactions.
[2] In addition to the intervention procedures, the Central Bank may also establish the Temporary Special Administration Regime (Regime de Administração Especial Temporária or “RAET”) which is a less restrictive form of intervention by the Central Bank in private and non-federal public financial institutions. A RAET also allows troubled institutions to continue to operate their activities in the ordinary course. The main objective of the RAET is to assist the troubled institution under special administration to recover and avoid intervention and/or liquidation. Therefore, the RAET does not affect the day-to-day business operations, liabilities, or rights of the financial institution, which continues to operate in its ordinary course. The RAET also immediately results in the terminations of the institution’s administrators and members of the Audit Committee.
[3] CMN Resolution No. 4,955 sets forth the criteria as adopted by the Central Bank for determining in what circumstances securities accounted for as Additional Tier 1 Capital or Tier 2 Capital may be written off or converted into Common Equity Tier 1 Capital. Pursuant to CMN Resolution No. 4,955, the Central Bank can write off or convert such Additional Tier 1 Capital or Tier 2 Capital in case the Central Bank considers such measures necessary: (i) to make the continuity of the financial institution’s operations possible; and (ii) to mitigate relevant risks for the Brazilian financial and payment systems. The Central Bank can consider that the continuity of a financial institution’s operations are at risk when: (i) there is a material deterioration in (a) the value and liquidity of financial institution’s assets; (b) the financial institution’s solvency position; or (c) the financial institution’s credit risk, characterized by a significant decrease in its fundraising amounts; or (ii) there is a material increase in the default risk and, as a result, the safeguards and guarantee mechanisms used by Brazilian clearing chambers and services are activated, according to the rules applicable to the Brazilian payment system. A material risk for the Brazilian financial system can be verified by the Central Bank when the discontinuity of the affected financial institution can lead to: (i) an impairment in the operations of other financial institutions or relevant segments of the market that might create concerns regarding the stability of the financial or payment systems or (ii) a material loss to the availability (at adequate levels) of services that are considered essential to the financial system.
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