It is comforting to see Michel Barnier, Europe's commissioner for internal market and services, confirm that the European Commission is reaching the end of its deliberations over bank crisis management. Comforting, but also disappointing in that it is a reminder of how long it has taken to get to this point. At times it has seemed that the EC has been almost wilfully slow. Its priorities — leaving the crucial issue of bail-in until last — have seemed illogical.
The bail-in issue hung over the bank finance market for much of 2011 — at points it even threatened to close it. Its spectre has only been banished in 2012 by the ECB's long term refinancing operation (LTRO). If it disappeared from the market’s consciousness at any point during 2011, it was only because there were even more pressing issues at hand, such as the imminent collapse of Europe’s banking sector amid sovereign debt chaos.
Some market participants now seem to believe the issue of bail-in has gone away. In the summery LTRO afterglow, it is tempting to give in to such optimism. Tempting, but foolish. Exactly how bail-in will affect the senior market is still completely unknown. This is not surprising, given that there has been precious little communication from the European Commission on when markets will be informed, let alone what such information might contain.
Morgan Stanley this week published a research note arguing that the rising cost of unsecured borrowing will force banks to curb corporate lending, paving the way for a US-style corporate finance market, where bond investors take up the slack left by the dying corporate loan market.
This forecast was predicated on rising costs in the senior unsecured market. A graph showed how since the start of the financial crisis — and especially over the course of 2011 — the ratio of borrowing costs to lending rates has become inverted. Syndicate bankers countered that senior spreads had much more room to tighten before they would reach pre-crisis levels, giving the borrowing to lending ratio plenty of space to normalise.
This is a fair point. The iTraxx senior financials index, which Morgan Stanley’s analysts used to measure the cost of unsecured bank funding, is around 150bp wider than it was pre-crisis. But bail-in could blow it clean out of the water.
Bail-in has the potential to change senior debt beyond recognition, by making senior debtholders junior to depositors and potentially another class of non-bail-in senior debt.
Even if it doesn’t do that, even the prospect of increasing subordination will at the very least make it a less attractive asset to hold. Spreads will rise as a consequence, which will in turn push up lending rates or force banks out of that market altogether.
At a time when the UK government has deemed it necessary to guarantee its banks’ debt in order to provide cheaper loan funding to SMEs, introducing regulation that threatens corporate lending — or, if you share Morgan Stanley’s perspective, merely accelerates its inevitable demise — would be inadvisable.
Almost as inadvisable, in fact, as proposing such radical changes and then spending well over a year putting together a draft proposal — as the EC has done. The Commission now has itself in a bind. If it introduces bail-in now, it scuppers the recovery in bank funding markets the LTRO has seeded. If it had introduced it at the start of the year, the recovery might never have happened.
Perhaps the only option left is to significantly soften the proposals, thereby rendering pointless a debate that gridlocked the market throughout 2011. Uncertainty is a killer, but it would seem that the longer the EC has delayed the proposals, the less seriously the market has taken them. The fallout from any resolution of the resolution debate could be worse in a couple of months' time than it would have been last year.