Credit Suisse is on the way to collapse

Credit Suisse is on the way to collapse

Credit Suisse is on the way to collapse

Details on topic “Credit Suisse is on the way to collapse”

Prelim: Current events of national and international importance.

Mains: GS III: Indian Economy and problems relating to planning, mobilization, of resources, growth, development and employment.

Why in headlines:

  •  Since the start of 2022, the share prices of Credit Suisse, one of the oldest and historically one of the most influential banks in the world, have fallen close to 60%, it’s an all-time low.

 What is  Credit Suisse?

  •  It was founded by  Alfred Escher and Allgemeine Deutsche Credit-Anstalt in 1856; 166 years ago. Its headquarter of it is in Paradeplatz Zürich, Switzerland
  • It maintains offices in all major financial centres around the world and is one of the nine global “Bulge Bracket ” banks providing services in investment banking private banking asset management and shared services

–          Bulge bracket banks are the world’s largest multinational investment banks servicing mostly large corporations, institutional investors and governments.

How was it triggered?

  • The straightforward reasons for the downfall of Credit Suisse are
  • The losses were influenced by high-profile managerial malpractices and exit further undermining the confidence of investors.
  •  Like in 2020 The CEO Hdjane Thiam quit after it became evident that he was spying on Iqbal khan the head management executive.
  •  Credit Suisse directed many customers to invest as much as $10 billion in Greensill Capital. Greensill was a lender of sorts — it intermediated between suppliers and clients.
  • Like so, Credit Suisse was involved in many other controversies   in the past few years like
  •              Archegos Capital, 2021
  •              Drug money laundering scandal, 2022
  •              Suisse secrets leak, 2022
  •              Russian oligarch loans documents destruction after the invasion of Ukraine, 2022
  •            Social Media Rumours, 2022 and collected accumulation of all these resulted in losses for the institution.
  • It has made several risky bets and turned out to lose a lot of investor money.
  • As a result of it, Credit Suisse has hurt its profitability, eroded investor confidence, and made raising fresh capital costlier.

How is it impacting Credit Suisse?

  • The secular shrink in shares of Credit Suisse is one good way to understand how investors have gradually shrugged away from the iconic bank
  •  Additionally, the bonds of Credit Suisse became must cheaper due to this very few people who want to lend money to it.
  • Consequently, the yields rose quite sharply.
  • Higher yields basically indicate that the bank would have to pay higher returns for every dollar or euro it takes from the market.

Why this is so?

  • This has to turn into a problem, chiefly in the present scenario facing the developed economies, when growth prospects are tanking and central banks are raising the interest rates to contain inflation
  •  
  • The banks which have aggravated the profitability have to uplift the money at very rapidly increasing interest rates, but in a market that does not provide a very high return, it is predestined struggle.
  • The other equally worrisome issue is the rise in the spread of Credit Default Swaps.

What Is a Credit Default Swap (CDS)?

 

  • CDS is a financial derivative that permits an investor to swap or offset their credit risk with that of another investor.
  • To swap the risk of default, the lender buys a CDS from another investor who agrees to reimburse them if the borrower defaults.
  • Most CDS contracts are maintained via an ongoing premium payment similar to the regular premiums due on an insurance policy.

A lender who is worried about a borrower defaulting on a loan often uses a CDS to offset or swap that risk.

 Mechanism of CDS

  • A credit default swap is a derivative contract that transfers the credit exposure of fixed-income products. It may include bonds or forms of securitised debt—derivatives of loans sold to investors.
  •  For instance, consider a company selling a bond with a $100 face value and a 10-year maturity to an investor. The company might agree to pay back the $100 at the end of the 10-year period with regular interest payments throughout the bond’s life.
  • Because the debt issuer cannot guarantee that it will be able to repay the premium, the investor assumes the risk. The debt buyer can purchase a CDS to transfer the risk to another investor, who agrees to pay them in the event the debt issuer defaults on its obligation.
  • Debt securities often have longer terms to maturity, making it harder for investors to estimate the investment risk. For instance, a mortgage can have terms of 30 years. There is no way to tell whether the borrower will be able to continue making payments for that long.
  • That’s why these contracts are a popular way to manage risk. The CDS buyer pays the CDS seller until the contract’s maturity date. In return, the CDS seller agrees that it will pay the CDS buyer the security’s value and all interest payments that would have been paid between that time and the maturity date if there is a credit event.
  • Credit Events
  • The credit event stimulates causes the CDS buyer to settle the contract.
  • The credit event acknowledges the CDS purchases and is part of the contract.

The majority of single–name CDSs are traded with the following credit events as triggers

Reference entity default other than failure to pay:

  • An event where the issuing entity defaults for a reason that is not a failure to pay

Failure to pay:

  • The reference entity fails to make payments

Obligation acceleration:

  • When contract obligations are moved, such as when the issuer needs to pay debts earlier than anticipated

Repudiation:

  • A dispute in the contract validity

Moratorium:

  • A suspension of the contract until the issues that led to the suspension is resolved

Obligation restructuring:

  • When the underlying loans are restructured

Government intervention:

  •  Actions are taken by the government that affect the contract

CSD is used when

  • Like an insurance policy against a credit event on an underlying asset, credit default swaps are used in several ways.

Speculation

  • Due to swaps being traded, they naturally have fluctuating market values that a CDS trader can profit from. Investors buy and sell CDSs from each other, attempting to profit from the difference in prices.

Hedging

  • A credit default swap by itself is a form of hedging. A bank might purchase a CDS to hedge against the risk of the borrower defaulting. Insurance companies, pension funds, and other securities holders can purchase CDSs to hedge credit risk.

Arbitrage

  • Arbitrage generally involves purchasing a security in one market and selling it in another. CDSs can be used in arbitrage—an investor can purchase a bond in one market, and then buy a CDS on the same reference entity on the CDS market.

Advantages and Disadvantages of Credit Default Swaps

Advantages

  • Can reduce risk to lenders
  •  No underlying asset exposure
  •  Sellers can spread risk 

Disadvantages

  • Can give lenders and investors a false sense of security 
  • Traded over-the-counter 
  • Seller inherits the substantial risk

Legality of CDS 

  • Credit default swaps are not illegal, but they are regulated by the Securities and Exchange Commission and the Commodity Futures Trading Commission under the Dodd-Frank Act.

How India will be impacted?

  • Surely, a global financial crisis is always a concern but because Credit Suisse’s India operations are limited the threat to the Indian banking system is not grave.
  • Credit Suisse AG has an Indian entity.
  • It came to India in 1997 when the East Asian currency crisis was in full swing.
  • However, India remains unaffected by the currency crisis partly due to capital control. 
  • Like its parents, the bank in Indian entity focused on investment banking wealth management and share breakage services.
  • Also, Credit Suisse AG has an Indian operation under the branch model and is not a wholly owned subsidiary

 

sources 

https://bit.ly/3M8PraE(Investopedia)

https://bit.ly/3Em81dy(The Indian Express )

Plutus IAS current affairs 6th oct 2022

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