Contingent convertible (CoCo) bonds are the ultimate ‘quantum’ capital instrument, behaving as either debt or equity depending on circumstances.
Until those circumstances are defined, CoCos hold a unique position on bank balance sheets as both debt and equity – able to occupy two states simultaneously – rather like the cat in the box in the famous thought experiment by physicist Erwin Schrödinger in 19351.
Curiously, when financial regulators probed the fissures in ailing Swiss banking giant Credit Suisse in March 2023, it was revealed that CoCos can also be neither debt nor equity.
In a recent article, European academics Edoardo Martino and Tom Vos analysed the extraordinary move by the Swiss National Bank (SNB) and the country’s Financial Market Supervisory Authority (FINMA) that would wipe out Credit Suisse’s CoCos2.
The pair noted that FINMA and SNB “declared Credit Suisse perfectly solvent to calm down the markets a few days ahead of the sale”.
“It would have made little sense to adjust accounting numbers and declare the bank almost insolvent a few days after to convert the CoCos, leading to the paradoxical situation of a ‘Schrödinger’s bank’, at once perfectly solvent and yet almost insolvent,” Martino and Vos wrote.
The wave-particle resolution
Schrödinger and his contemporary quantum physics pioneer, Werner Heisenberg, might have understood the CoCo conundrum.
Heisenberg kicked off a new era of quantum – or particle – physics in 1925 with his complex ‘matrix mechanics’ formulation of sub-atomic processes, The centenary of this breakthrough is being celebrated this year through the United Nations-led ‘International Year of Quantum Science and Technology’, a global initiative that seeks to raise awareness about its importance.
The year after Heisenberg published his groundbreaking study, Schrödinger realised his intuitively simpler ‘wave function’ equation to describe the quantum world.
The scientific community quickly concluded that Schrödinger and Heisenberg approaches were – surprise, surprise – mathematically equivalent, leading to strange conclusions that ‘stuff’ at the quantum level operated as both wave and particle.
The two pioneering physicists laid down the foundations of quantum mechanics by answering a question – typically framed around the nature of light – that had been bugging scientists and for centuries.
Back in 1801, British polymath Reverend Thomas Young’s seminal ‘double-slit’ experiment illustrated that light travels in waves (see diagram below).
Figure 1: The double slit experiment
Almost a century later, German physicist Max Planck clearly showed that light (or energy) is composed of discrete packets, or quanta – giving birth to the first quantum revolution3.
About three decades before those quantum insights – which would go on to shape the twentieth century – the Scottish physicist James Clerk Maxwell published a series of equations which demonstrated that electric and magnetic fields travel through space as waves moving at the speed of light.
Albert Einstein’s 1905 paper on the photoelectric effect – which would go on to win the Nobel Prize in Physics in 1921 – confirmed those findings, and again illustrated that light is a particle.
If Heisenberg and Schrödinger would go on to eventually resolve the wave-particle paradox – albeit in the process producing new paradoxes – financial markets are still waiting for a CoCo solution.
Tiers for fears: an AT1 recap
Introduced as a ‘bail-in’ bank recapitalisation mechanism in the wake of the 2008-09 global financial crisis, CoCo bonds found regulatory favour as Additional Tier 1 (AT1) instruments.
The appeal of CoCos lies in the fact that they offer a yield like a bond but are structured to convert into equity in the event of a bank capital crisis. On paper, CoCos look good as financial ‘crumple zones’4, which is a subject Fiorino has discussed before.
However, since the CoCo-led collapse of Credit Suisse, banks, investors and regulators have begun to reassess assumptions about the efficacy of AT1 securities.
Investors and regulators have begun to reassess assumptions about the efficacy of AT1 securities.
For example, in December 2024 the Australian Prudential Regulation Authority (APRA) confirmed a phase-out for AT1 capital requirements for banks as part of a regulatory framework set to take effect on 1 January, 2027.
And in June this year, Switzerland introduced tough new AT1 rules that seek to impose significant capital requirements on UBS (following its shotgun union with Credit Suisse).
The on-brand ‘Swiss Finish’ approach to financial regulation shows the Swiss authorities are keen to limit any future taxpayer risk should the now-enlarged UBS – and its massive investment bank division – encounter further turbulence in the future.
On the face of it, however, the existing bank capital structure appears sound (as below):
Figure 2: Bank capital structure
The takeaway from the Credit Suisse CoCo write-off is that, in practice, AT1 securities did not act as ‘going concern’ instruments; but more like ‘gone concern’ Tier 2 capital – which is primarily useful during periods of extreme bank distress (or prior to full resolution).
Translating that lesson into a sector-wide re-rating of bank capital is unlikely to be easy with about €230bn of AT1 and more than €500bn of Tier 2 notes still on issue. Regardless, no new regulations on this matter are on the horizon.
Furthermore, the Credit Suisse example demonstrated that AT1 worked as capital buffer, even if a little later than regulators had expected and more violently than investors had factored in.
Post-script: new evidence has come to light
In a twist worthy of the wave-particle quantum debates of the early twentieth century, however, the Swiss Federal Administrative Court (FAC) found FINMA did not have the legal authority to trash the Credit Suisse CoCos during the 2023 bank crisis.
The partial decision handed down in October this year might have shocked participants who argued at the time that the AT1 write-down provision was ‘in the prospectus, stupid’.
There is more to come: both FINMA and UBS will appeal the FAC finding in a process set to take at least a year.
Meanwhile, the CoCo question still hangs over the market: is it debt or equity, or both, or neither?
For now, the cat is back in the box.
Erwin Schrödinger (1887 – 1961), inventor of wave mechanics on how interpretations of his work influenced quantum theory.
For more blogs deciphering complexity in global financials.
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1 Schrödinger’s cat is a thought experiment about quantum physics suggested by Erwin Schrödinger in 1935 where a cat in a sealed box is considered to be both alive and dead at the same time until the box is opened.
2 Credit Suisse CoCos: Why the Write-Down Makes Sense | Oxford Law Blogs.
3 The first quantum revolution was the 20th-century scientific revolution based on the discovery of quantum mechanics, leading to technologies like the transistor, laser, and semiconductors. This first phase involved developing a new conceptual framework to understand the behaviour of matter and energy at the atomic and subatomic levels.
4 In a motor vehicle, a crumple zone, at the front and rear, is designed to crumple easily in a crash and absorb the main force of an impact.
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