Senior officials from Switzerland's top bank, UBS, and Swiss authorities raced against time over the weekend to broker a takeover of beleaguered peer Credit Suisse in an effort to calm nerves and arrest contagion fears.

The swiftly engineered state-backed deal worth 3 billion Swiss francs (€3 billion, $3.23 billion) did instill investor optimism initially, but that soon evaporated. Banking stocks and bonds slumped in Asia and in Europe with the sector's Stoxx Europe 600 Banks index falling more than 5% in morning trading. The index has recovered somewhat from its morning lows.

Credit Suisse shares fell over 60% below the takeover price and UBS shares were also in the red, as were the shares in Germany's Deutsche Bank and BNP Paribas in France. The Japanese yen, which is seen as offering relative safety to investors in stressful times, jumped on Monday, as investors refrained from indulging in riskier assets.

The carnage on the financial markets is being mainly blamed on one particular aspect of the Credit Suisse merger deal. Under the agreement, holders of the lender's additional tier-1 (AT1) bonds worth $17 billion (€16 billion) are set to be wiped out.

The surprise move, which penalizes the bondholders while preserving the shareholders, has unnerved investors in other banks' AT1 debt. They fear that other authorities could also upend the long-established investor hierarchy just like the Swiss government did.

"This is controversial given that the common equity — which is typically considered junior to AT1 in the capital structure — was not entirely wiped out," Andrew Kenningham, chief Europe economist at Capital Economics, said in a note to clients. "There could be legal challenges to the agreement, prolonging the process and creating further uncertainty."

What are additional tier-1 (AT1) bonds?

AT1 bonds are a relatively risky class of debt issued by banks. Just like other bonds, they pay regular interest, but they carry a higher coupon to account for the greater risk.

They were created following the 2008 global financial crisis as a hybrid debt designed to help shore up a bank's finances in times of crisis by imposing losses on creditors and preventing taxpayers from having to shoulder the bill.

Also known as contingent convertible bonds, or CoCos, they can be converted into equity or written down when a bank's capital levels fall below a specified threshold.

AT1 write-downs have taken place in the past, including during the takeover of troubled Spanish lender Banco Popular in 2017 where the bank's AT1 bonds were wiped out as part of the rescue effort.

Talking about the wipeout of the Credit Suisse AT1s, Jeffrey Gundlach, chief executive and chief investment officer at DoubleLine Capital, tweeted that the bondholders should have managed their risk better.

Why is the AT1 wipeout hurting the banking sector?

The move by the Swiss authorities has shocked other AT1 bondholders who seemed worried that they could potentially face a similar fate at a time the banking sector is reeling from bank collapses in the United States and fearing contagion risks. 

This means that the banks who had already been paying a premium to raise funding by selling the AT1 bonds might not find any takers for the hybrid debt, reducing their options to raise capital. AT1 bonds have been a crucial source of funding for banks.

Prices of AT1s in Asia slid on Monday, with debt securities of some banks in the region falling by record amounts, according to data compiled by news agency Bloomberg.

HSBC's 8% US dollar AT1 bond issued on March 7 was trading at 90 cents to the dollar, down about 5 cents, registering its biggest daily drop since it began trading.

"What the market is saying today, is that between now and maturity there's a risk on this debt which hadn't been priced correctly in light of what's happening in banks in the US and around the world," Sean Darby, global equities strategist at Jefferies in Hong Kong, was quoted by Reuters news agency as saying.

What about recession worries?

Recession risks have heightened, including in the US where the economy had been holding strong despite aggressive interest rate hikes over the past year. Analysts fear that the collapse of the Silicon Valley Bank and New York-based Signature Bank and the fallouts from the Credit Suisse deal could trigger a broader credit crunch. While banks could see raising capital become more difficult and costly, businesses can expect to shell out more for loans as lenders grow cautious.

In such a scenario, a lot would depend on how the central banks respond to the current crisis.

Major central banks such as the US Federal Reserve and the European Central Bank have been raising interest rates at a frantic pace to tame the prices of goods and services. The current crisis could prompt them to take a breather amid expectations that the banking crisis could slow economic growth.

Bets are growing that the Fed, which has its monetary policy meeting this week, will not raise key interest rates or do so by a meager 25 basis points, especially given that the credit situation is already tightening in the market.

How are authorities reacting?

The ECB said the European banking sector is "resilient" with "robust levels of capital and liquidity."

In a bid to calm the nerves of AT1 bondholders, the central bank in a joint statement with the European Banking Authority and the EU's Single Resolution Board stressed that in the eurozone, shareholders would be the first ones to absorb losses before AT1 bonds are written down, as has been the practice in the past.

"Additional Tier 1 is and will remain an important component of the capital structure of European banks," they said.

The Fed offered daily currency swaps to ensure banks in Canada, the UK, Japan, Switzerland and the eurozone have enough liquidity of the world's dominant reserve currency widely used to conduct international trade. So far, the central banks haven't witnessed a dash for dollars, indicating that the crisis may not be causing undue stress to the financial system, Bloomberg reported.

Edited by: Uwe Hessler