Bail-outs are out. Two years on from its crisis-triggering collapse, the final legacy of Lehman Brothers may yet end up being a decisive shift in how regulators and governments approach the resolution of failing banks, particularly the most systemically important institutions from bail-outs to bail-ins.
Drawing on corporate restructurings, a bail-in involves recapitalising a bank on the brink of failure by looking first to its own capital base. It apportions losses according to seniority in the structure typically, wiping out equity and converting subordinated debt to equity. If necessary, it may also move on to haircut other capital providers, such as senior debt holders.
In the post-crisis environment a clear political will for creditors to take the full consequences of bank failure, which bail-outs generally spared them, has emerged. A further element is the desire to neutralise too big to fail, which many believe incentivises banks to take excessive risk since their downside is much limited by this status, by removing implicit state guarantees.
Increasingly, these impulses are now coalescing around bail-ins. Recently the Basel Committee on Banking Supervision (BCBS) used the term in a public statement for the first time, when it referred to "a well integrated approach to systemically important financial institutions which could include combinations of capital surcharges, contingent capital and bail-in debt". The Financial Stability Board (FSB) and the G20 have also appeared to endorse the concept lately.
Individual regulators have also added their voices. "If bail-in can work, too big to fail can become a relic of the past," noted Thomas Huertas, director, banking services, at the UKs Financial Services Authority (FSA) and vice chairman of the Committee of European Banking Supervisors, in a recent speech.
Some also see the new Dodd-Frank Act as enshrining features of bail-in in US law. Denmark is adopting a burden-sharing approach that also looks to creditors, while some lawyers interpret Germanys proposed new credit institutions act similarly.
The FSB is due to make recommendations to the G20 at its November summit in Seoul. Basel now receiving submissions on proposals for regulatory capital instruments to increase loss absorption at the point of non-viability, which many see as a first step in implementing bail-ins should update its position the following month.
Market responses are notably divergent. Banks such as Credit Suisse, where two senior managers wrote a prominent article in The Economist this January that helped popularise the concept, and Standard Chartered have been prominent in making the case. "I think the argument for the going concern recapitalisation approach has won a lot of hearts, especially in Europe," says Wilson Ervin, senior advisor to the chief executive officer of Credit Suisse and one of The Economist articles co-authors. "It is getting into more of the conversation and while not everyone agrees with the approach it has been gaining broader support." Industry bodies such as AFME, the British Bankers Association (BBA) and the Institute of International Finance (ILF) "have come out with a positive early view on bail-in," he notes.
A key industry body the Association for Financial Markets in Europe (AFME) has adopted a notably enthusiastic stance too. It also has published an influential report on bail-ins.
"We agree fundamentally with the Basel Committee on shifting losses away from taxpayers and on to investors. The world has clearly changed and markets will have to adjust to the removal of implicit state guarantees on bank debt," comments Gilbey Strub, managing director at AFME.
Nonetheless, many banks and investors remain sceptical. A host of uncertainties over the proposals inform this stance. These include:
Definition of systemically important institutions
Definition of triggers
Limits to regulatory discretion
Scope of liabilities subject to bail-in
Grandfathering of non bail-in securities
Timetable for introduction
In addition, critics identify several potential weaknesses. These include regulatory inconsistency and scope for arbitrage between jurisdictions; gaming, such as the use of derivatives to construct transactions exempt from bail-in; and contagion specifically, the risk that the triggering of a bail-in might weaken rather than strengthen confidence in the overall banking sector.Investor appetite for bail-innable debt is also very unclear, especially in view of many institutions strongly negative stance (see box).
Some of the uncertainty should lift when Basel and the FSB unveil more detailed plans. But regulators strategy may include a deliberate lack of clarity, particularly over the trigger for requiring a bank to bail in.
"It is smart of Basel to not define non-viability," says Gerald Podobnik, co-head of capital solutions at Deutsche Bank in London. "The trigger for bail-in capital would be linked to a banks general non-viability, and the determination that this point is reached would be at the discretion of the lead regulator. That is something that people would understand. If you make the trigger specific losing 50% of capital, for example its much more difficult to judge if bail-in capital would work then as there is uncertainty if a specific metric is breached when a bank becomes non-viable."
Proponents stress that the trigger should be as late and remote as possible. This would give comfort to investors, and draw on regulators existing powers to seize failing banks.
Not all market participants are happy, however. "Investors do not want to see blanket discretion in relation to when the state can cause them to suffer losses," says Prasad Gollakota, head of capital solutions and liability management at UBS in London. "They are pushing for something objective, as this gives them clarity as to their risks. This needs to be balanced with the fact that regulators want some degree of discretion and that objective triggers may not always trigger when required. There needs to be a middle ground where regulators retain some discretion, but only after due process and independent verification."
Banking on bad news
Until recently market participants alert to the development expected bail-in language to apply to all banks if enacted and to all of their capital and possibly even their senior debt. "That realisation was a lightning bolt through the capital markets," recalls Mauricio Noé, managing director and head of senior and covered bonds at Deutsche Bank in London.
"While the proposal is attractive in terms of improving financial stability, if extended to senior bondholders, there is a concern that it causes a fundamental rethink of what it means to be a senior creditor of a financial institution and at what point a liability is no longer a liability," says Nik Dhanani, head of capital solutions within HSBCs global banking and markets group. "The relative ranking of senior bondholders vis à vis other senior creditors such as derivative counterparties and trade creditors would also need to be carefully considered."
Yet not all issuers have noticed. "Many commercial banks are not as aware of this workstream as they should be. It is surprising that it is not on market-facing participants radar screens," judges one FIG banker. He notes too "a sense of disbelief that this will come in."
The potential inclusion of senior debt arouses concern that buyers would demand a very high premium for a staple product that is key to the funding of most banks, or migrate to secured debt. At a time when weaker lenders and even stronger ones in weak economies are struggling to attract capital markets financing, transforming their senior debt into a form of quasi-equity could worsen their challenges.
Moreover, implications for liquidity may be unsupportive. "Liquidity was the critical issue for banks in September 2008, so one of the key considerations around bail-in capital has to be how it will impact liquidity at the most challenging point in the cycle," notes Vinod Vasan, European head of FIG DCM at Deutsche Bank.
Bail-in proponents draw parallels with corporate debt to support the case for including senior debt. "In the industrial world everyone accepts this," says Ervin at Credit Suisse. In Chapter 11, debt holders receive equity all the time in pre-packaged bankruptcies and view that outcome as much better than liquidation. Lehmans liquidation "triggered enormous losses, perhaps five times bigger than a bail-in going concern-style process, where you could have given senior debt holders something worth 85 to 90 cents," he notes, citing Credit Suisse estimates.
One suggestion is that haircuts could be limited to a known maximum (25%, say). "With something like this, investors are more likely to be pragmatic about pricing," says UBSs Gollakota.
A further concern is that banks might end up with more classes of capital, not fewer. The possibility of bail-in debt being contractual rather than a statutory requirement adds to this. "If it is a separate class, you would then have hybrid tier one, core tier one, loss absorbing tier two/gone-concern contingent capital, bail-in senior, ordinary senior and covered, and you might also have going concern contingent capital for systemically relevant banks. That could create a more complex capital structure at a time when Basel III is already changing the liability and capital landscape," notes Deutsches Podobnik.
To some, this could have value nonetheless. "A more realistic tranching of the vast senior market would be beneficial, rather than telling everyone youre at risk," comments Adrian Docherty, head of financial institutions solutions advisory at BNP Paribas in London. BNPP calculates that bail-in might apply to only 30% of a typical large banks balance sheet, due to likely exemptions for many senior creditors.
Some players argue that banks nearer-term funding needs make this the wrong time for altering the risk profile of senior debt. "Financial institutions in Europe have a lot of refinancing to do in the next two to three years," says James Garvey, head of capital markets and advisory at Lloyds TSB Corporate Markets in London. "They have more than enough to deal with without having to reinvent the product as well. The real benefits from a systemic risk perspective will come from getting the capital regime right."
Equally, though, he and Lloyds colleague Tristan Whittingham, director, FI DCM, note that a current absence of higher yielding products creates a supportive backdrop for more innovative forms of capital that is economic for issuers and meets regulators concerns. "The market is quite receptive to new instruments since yields are so low, though we would hope the next generation of structures is more consistent and uniform. The required phase-out of old structures from 2013 could reinforce this trend."
The new net stable funding ratio (NSFR) adds to the challenge. Meeting NSFR requires banks to term out their senior debt, while adding as much as Eu1tr-Eu2tr to their borrowing needs, according to estimates. "Its like a perfect storm. Regulators are saying you have to have more long-term senior debt just when its cost is going up and its availability down. I dont think the policy process is well co-ordinated and am not sure if anyone is looking at it holistically," says one FIG banker.
"Insurance solvency requirements are on to their fifth draft since 2003, and there is likely to be a sixth. The G20 is requiring that we fix a systemically more important sector in a much shorter time," laments another.
Even though Septembers Basel committee announcement clarified that bail-in is directed at "systemically important" institutions, concerns remain. Some see this as a way of levelling the playing field between national champions and lesser lenders.
Others argue to the contrary. "It makes us more competitive, helping our cost of capital relative to others, and pushing towards fewer, larger banks" says one FIG banker at a too big to fail institution.
If investors demand a premium to buy the strongest banks bail-innable debt, widening their spreads, they will hardly spare weaker institutions with less certain resolution outlooks. Struggling lenders already without borrowing alternatives to the European Central Bank (ECB) might then be plunged into crisis if ECB facilities were withdrawn or limited as their potential funding sources would be priced outside their net interest margins.
"The argument has to be whether you are serving the consumer by preventing banks from funding at an economic level," notes a FIG banker. "Its a delicate argument to make as since the crisis the perception has been that the transmission mechanism from state-aided funding to lending into the economy is failing."
Indeed, bankers point to their institutions social roles. "Banks are very unique beasts, performing maturity transformation which is an essentially risky proposition. When we socialise that, it is going to cost," comments a FIG specialist.
This may leave a continuing role for the state. "Certain banks might be able to issue $10bn of debt in this format, but this might not be material relative to the size of the balance sheet $1.5tr for example. Can a bank issue $60bn? Extremely unlikely. If the market doesnt absorb the instruments banks need, the state will have to be the investor of last resort," UBSs Gollakota warns.
Just as the revised Basel capital requirements are being phased in over an extended period to 2019, full adoption of bail-in could also be protracted, judges Simon Adamson, CEO and senior analyst, European Financial Services, at CreditSights. This would reflect the challenge of imposing a single system on multiple national insolvency regimes particularly in Europe, where state bail-outs are also not yet fully ruled out in some countries.
Banks likely lower future profitability is also a factor here. This will slow their progress towards the new Basel targets through internal capital generation. Higher funding costs as a result of bail-in risk will only exacerbate this, while increasing the challenge of raising capital.
Yet senior debt is so central to many European banks overall funding strategy that any shift to a higher proportion of deposits will be slow. "That cant be rectified overnight. Growing deposits is a very slow process," Adamson notes.
Canadian mini maximises support
Bankers fret over the potential for regulators to apply bail-in requirements inconsistently. "Similar to the process with respect to Basel III, it would be important to ensure consistent application at the international level as regards form and timing," says Dhanani at HSBC. "Inconsistency may risk introducing competitive distortions."
As this report went to press in late September, the latest indications were that regulators may opt to only prescribe a so-called mini bail-in. This approach, one that Canada has promoted, would limit bail-ins to equity and subordinated debt. The decision to extend haircuts further across the capital structure would then be left to local regulators discretion.
"The Basel approach is less flexible than a straight bail-in," notes AFMEs Strub. "But the Basel approach and a bail-in may not be mutually exclusive. Some local regulators might choose to go further, and it is also possible the European Commission will go further."
AFMEs enthusiasm for this approach "we think loss absorbency in capital instruments is a good start. We will be encouraging the committee," also reflects its constituency. "A number of our members do not support the application of bail-in to senior debt," Strub acknowledges. At least one large bank declined to sign the associations influential recent report on bail-ins for this reason, according to sources.
"We are not averse to what I would call a mini bail-in. It is better than the status quo," says Credit Suisses Ervin.
Supporters of this version welcome its ability to side-step the sharp controversy over haircutting senior debt. While many question whether most banks stock of subordinated debt is sufficient for it to "change the game", as Ervin puts it, some bankers note that almost no recent bank failure (Anglo Irish Banking Corp is one exception) would have exhausted both equity and regulatory capital.Even a recap of Lehman, which Credit Suisse and AFMEs worked example shows imposing a 15% equity swap on senior debt holders, could have been confined to the junior tiers of its capital ($25bn of equity and the same volume of sub debt/preferred stock) though clearly any successful bail-in must deliver sufficient capital to both absorb the banks losses and allow it to re-enter the market as a credible going concern.Additional reporting by Hélène Durand
Learning from Lehman and Ervin
Bail-in could improve the financial systems health. "If we can solve the problem of bank resolution, we end up with a stronger and more resilient financial system. That is healthy for us and our customers since it is very hard for banks to perform their proper role in a dysfunctional financial crisis."
Equally, bail-in avoids use of public funds. At a time of austerity this has clear political benefits, going some way to address public anger over the socialisation of bank risk. "It is a way to be a healthy part of society. We get that it violates a fundamental principle of fairness if banks are seen to only take the upside. We are trying to find a way for banks to be responsible, by accepting the downside as well as the upside."
More generally, banks role in economies carries an inevitable risk of failure, Ervin notes. This makes effective resolution vital. "While we hope that the current bank reforms will make banks stronger, they cant eliminate the chance of failure entirely. There have been hundreds of banking crises in history, and it is difficult to outlaw human error," he says. "And, if we try to make banks so ultra-safe that they never fail, then theyre not doing their job for their customers they exist in part to provide risk capital to the economy so failure, though remote, is possible."
"We havent tested bail-in in a real crisis. But we have tested Chapter 11 in hundreds of industrial situations, so we know recapitalisation can work in the real world. If we can create a soft landing through a Chapter 11 for banks that activates moments before seizure and takes the problem of cross-border bankruptcy off the table, that could make banking much safer and much more like a normal industry."
Bail-in should form part of a broader recovery and resolution package, he argues, along with resolution authority. It should feature a strong liquidity plan and regulatory endorsement of the bail-in process. It could also include contingent capital and living wills, as well as provisions to protect against arbitrage or gaming the new rules.
Ervin emphasises the breadth of the bail-in initiative. Contributors include senior UK and EU regulators, who have "really advanced the thinking on resolution options"; Mark Flannery and the Squam Lake group of US academics responsible for "an incredibly interesting and thoughtful piece on contingent capital"; and the IIF and AFME industry groups, which "helped clarify thinking about triggers, liquidity, and legal issues, among others".
Investor perspective: opposition and reflection
|Some investors are strongly opposed to bail-ins, especially any version that hits senior debt. "The view that senior could effectively take a loss in a bail-out situation is, in our view, a complete non-starter," says Ed Farley, portfolio manager and head of European investment grade at Pramerica in London. "In our view, senior bank funding should not be a poor relative to corporate debt where your rights are equitably treated in an event of default. It will also increase the cost of raising this type of debt dramatically, which would be counterproductive."|
"We feel that with increased speculation around bail-ins, senior debt should be cheaper. It is hugely concerning from an investor point of view," adds Simon Blundell, senior fund manager at Aviva Investors in London.
A common further argument is that investors would be unable to buy bail-innable debt, due to its potential for conversion to equity. Their investment mandates typically limit them to pure fixed income, though some sources dispute how difficult changing these to anticipate restructuring would be.
"The message from investors is mixed," says Mauricio Noé, managing director and head of senior and covered bonds at Deutsche Bank in London. "Some dont know if a product that converts to equity falls within their investment mandate. There is a good chance that a meaningful segment of the investor community could not buy it or would have to change mandate significantly to be able to buy it. This clearly favours products such as covered bonds which are unlikely to be affected. Others are more relaxed and expect the triggers to be sufficiently remote to make the bail in pretty unlikely."
Bail-in proponents can be quick to dismiss investor concerns. "Theyre just mourning the loss of the implicit state guarantee. They enjoyed quite decent returns on the worlds next-safest instrument after government bonds and they dont know how to price them now," scorns one.
Others make the case by citing worse potential outcomes. "The market should consider the possibility of a bail-in or conversion in the context of the exercise of other resolution powers, i.e. sale, bridge, or liquidation, in terms of its impact on the cost of funding and the risk return profile," argues Gilbey Strub, managing director at the Association for Financial Markets in Europe (AFME). "If investors look at it relative to a bailout, the returns will naturally be less. But greater if compared with a liquidation."
A number of institutions are receptive to this line. "It was outrageous how senior bondholders in bust banks were bailed out in the crisis that has just passed," says Tamara Burnell, head of sovereigns, financial systems and financial institutions at M&G in London. "The bond market needs to be taught that it cannot rely on lazy assumptions about national champion banks being too big to fail or senior debt being sacrosanct. The mindset of many bond investors needs to change and investors need to become more discriminating about which business models they are willing to finance. Otherwise the financial crisis we have just had will happen again and again."When the regime around senior debt is settled and plans are clear, we might want to come back and buy those instruments at a price. Right now, it would be crazy to go in and buy something like a seven year senior unsecured bank instrument," she judges, while also noting concerns over UK covered bonds. As it is technically senior unsecured debt until the point of issuer default, "a covered bond would not necessarily be safe in a resolution regime"