Uncertainty about when capital levels would trigger write-downs and which investors would take a haircut could jam liquidity in the banking system, according to those attending a conference held by the International Capital Markets Association on November 30.
Regulators are considering proposals to make senior creditors take a loss on their investments, on a going concern basis, if a bank runs into trouble. Known as “bail-ins”, the concept is designed to reduce the need for taxpayer support for large financial institutions.
But a lack of understanding around when a bank would be made to address its debt and capital structure by a regulator under such rules could cause liquidity to seize up just when a bank needs it most, said market participants. Bankers’ criticisms of financial assistance packages such as that currently being implemented for Ireland are frequently focused on the fact that they appear to address capital issues but without taking liquidity into consideration.
If senior creditors are exposed to potential cuts to their holdings when a bank needs to be “bailed-in”, then short term lending, of the sort used in large amounts prior to Lehman’s crash in 2008, would dry up, warned one speaker.
“I see a vicious cycle for smaller banks,” said Richard Shrimpton, head of capital markets issuance at Lloyds Banking Group. “Either they won’t be able to raise funding, or their cost of borrowing will go up so much they have to increase their own prices and they become uncompetitive. If we go back to just before Lehman collapsed in 2008, most banks had very high overnight borrowing amounts. Now, if regulations on haircuts for senior creditors come in, then in the same situation, banks wouldn’t be able to get that funding, because overnight investors would potentially be taking subordinated debt risk.”
One analyst said that the lack of regulatory clarity could reduce stability in the banking system: “If you try to apply all the regulatory mechanisms that have been proposed at the same time, it could have an adverse effect on the banking system,” said Roberto Henriques, executive director at JPMorgan.
“If you end up with regulatory capital instruments where there isn’t clarity on apportioning losses across investors, if you don’t articulate and explain things clearly, then the banking system ends up being less stable as at the first sign of distress access to the capital markets could be seriously restricted,” he added. “If you don’t know at which point it will trigger, then investors can’t assess the risk. Where there’s uncertainty, investors add a premium for that. I have grave concerns that these could be quite onerous.”
But one investment professional told EuroWeek that investors should have a clear idea of what is going on with banks they have interests in. “Portfolio managers and credit analysts should be aware if things are heading in a direction where a bank might get into trouble,” he said.