As markets consider the impact of UBS' rescue of Credit Suisse, investors are asking whether a lack of market confidence could cause contagion in the European banking sector. In our view, the answer is no. One week ago, we stated that European banks' strong deposit bases and ample liquidity mitigate risks for the sector (see "European Banks See Limited Contagion Risk From SVB," published March 14, 2023, on RatingsDirect).

S&P Global Ratings maintains its view that, overall, European banks benefit in the rising interest rate environment (see "European Banks: Resilient And Divergent As The Economic Reset Kicks In," published Jan. 23, 2023). This remains our base case. As we said last week, rated European banks do not exhibit a combination of large unrealized losses on securities portfolios and highly confidence-sensitive funding models (see also "Credit FAQ: Will Unrealized Losses On Financial Assets Affect Ratings On European Banks?," published Jan. 19, 2023). Despite its other challenges, Credit Suisse did not have large unrealized losses on its securities portfolio.

Nevertheless, we remain mindful that the seismic shift in monetary policy will be a game changer for parts of the financial sector (see "When Rates Rise: Risks To Global Banks Could Emerge From The Shadows," published Feb. 16, 2023). We expect the market turmoil will take time to recede as investors come to realize that the macroeconomic environment brings nuanced but far from dire consequences for European banks, and that the banking sector remains solid.

Credit Suisse is an outlier among major European banks.  We see the business and risk management deficiencies that led to Credit Suisse's takeover by UBS as quite unique in nature and scope relative to the European banking sector. Credit Suisse had pursued an evolutionary approach to change its business model, but management missteps and cyclical hurdles for its investment bank amplified the depth and urgency of its restructuring, and significant deposit outflows aggravated the situation. Although other internationally active European banks also had to restructure their operations in recent years, most of those have been completed. Even smaller European banks have been forced to adjust their business and operating models to the new banking landscape, whether due to changes in regulatory requirements or evolving competitive dynamics following a wave of digitalization.

This is not to say that rising policy rates would sufficiently boost European banks' profitability for the long term. Banks' cost of equity has also risen, and many commercial banks could struggle to sustainably generate double-digit returns that satisfy their stakeholders. We therefore foresee banks facing the constant challenge of generating strong returns without taking on substantially higher risk.

Monetary authorities are trying to avoid a credit crunch.   The Swiss authorities' decisive action in facilitating a quick takeover by UBS and providing a massive liquidity backstop to banks is testament to their desire to definitively shore up market confidence. We would expect similar actions by any European central bank faced with the same situation. The parallel coordinated actions by the U.S. Federal Reserve Bank, BOE, European Central Bank (ECB), Swiss National Bank, Bank of Canada and Bank of Japan to increase the frequency of dollar swap operations similarly seek to avoid potential stress in funding markets that could lead to a shrinkage of credit supply. And these follow the Fed's announcement of a bank lending facility to ensure banks can meet depositors' needs.

The dual objectives of delivering monetary policy tightening and ensuring financial stability lead to a tricky balance for European monetary authorities, not least when, as our economists expect, the authorities seem likely to pursue their planned policy rate rises to tame inflation. We expect the ECB will carefully manage this process and deal pragmatically with financial stability issues should they arise.

At a more micro level, Credit Suisse's bank counterparts had materially reduced their exposure to the group over the past weeks and months, but Credit Suisse remained a major counterpart in financial markets. Although UBS will absorb Credit Suisse, it has stated its intention to significantly pare back Credit Suisse's markets and investment banking business. Once the deal is completed, likely in the coming weeks, the practical consequences of this decision for Credit Suisse's institutional clients will become clearer.

The funding market for bank capital may remain choppy for a while.  We do not see the Swiss regulator's decision to write-off Credit Suisse Group's additional Tier 1 (AT1) instruments, on its own, as likely to lead to a rise in European banks' funding costs. Nevertheless, it will put pressure on the cost of regulatory capital and is likely to lead to restricted access to new AT1 issuance for a period. AT1 instruments are a capital rather than funding instrument for European banks, accounting for less than 15% of regulatory Tier 1 capital on average, and are perpetual in nature. Banks are not obliged to call these instruments and can, in theory, keep them on their balance sheets for as long as needed. However, we expect the size and impact of the hit to Credit Suisse's AT1 investors to lead to reduced appetite for new AT1 investments and higher new issuance costs. While AT1 instruments in other European markets don't have the same viability-based write-down triggers (outside resolution or insolvency) as in Switzerland, this development is a stark reminder to AT1 investors of their extreme vulnerability if a bank gets into trouble, and of their dependence on decisions taken by public authorities.

One surprise to some market participants is that Credit Suisse's AT1 instruments will be written down to zero even though common shareholders will retain some value. This is a different outcome than usually expected, given typical creditor hierarchies, even though it is clearly a possible scenario under the documentation for these particular AT1 instruments. EU and U.K. authorities have been quick to remind investors that they see common equity instruments as the first to absorb losses, and only after their full use would AT1 instruments be written down in the EU. Yet, we expect it will take time for AT1 investors to come to terms with all the potential ramifications for AT1 hybrids in a riskier operating environment. Although banks are used to AT1 markets closing for several months, we expect the cost of regulatory capital could rise.

As for the broader evolution of funding costs for European banks, we remain mindful that technological disruption and multi-bank platforms now allow clients to shift their deposits rapidly, and this can heighten competition (see "The Future Of Banking: One-Click Deposits (Risks Included)," published April 8, 2021). In this context, we see banks' strong and diverse deposit franchises, alongside deposit insurance, as enduring factors that can help mitigate deposit outflow risk.

Related Research

• Global Credit Conditions: A More Difficult Way Out, March 20, 2023
• European Banks See Limited Contagion Risk From SVB, March 14, 2023
• When Rates Rise: Risks To Global Banks Could Emerge From The Shadows, Feb. 16, 2023
• European Banks: Resilient And Divergent As The Economic Reset Kicks In, Jan. 23, 2023
• Credit FAQ: Will Unrealized Losses On Financial Assets Affect Ratings On European Banks?, Jan. 19, 2023
• The Future Of Banking: One-Click Deposits (Risks Included), April 8, 2021