The G20’s communiqué called on the Financial Stability Board to devise “methods to haircut unsecured creditors” as part of a resolution mechanism for systemically important institutions. The FSB itself said in its interim report to the G20 that it was exploring various means for creditors to participate in a going concern bank restructuring: “We are examining viable mechanisms to convert debt into equity: some of these may be contractual with the conversion triggers and terms set out in the debt instrument; however they might need to be buttressed by statutory powers in the resolution regime.”
Last Friday the Bank of England laid out similar options in its Financial Stability Report, arguing that market-led or supervisor-imposed debt for equity swaps could form part of the increased capital systemically important firms will be required to hold.
Regardless of the form creditor recapitalisation eventually takes, it is clear the assumption that senior bondholders are sacrosanct until insolvency will no longer be operative. EuroWeek presents the cases for and against this radical change of direction.
The case for:
As policymakers grapple with the seemingly intractable problem of systemically important financial institutions, the trickiest issue has been how to mitigate the moral hazard they bring to the markets.
Absent brute force methods such as absolute caps on bank size and interconnectedness, it is hard for the markets to believe that governments won’t step in to prevent the insolvency of large firms. At present, even tiny banks seem to be considered too big to fail by many governments — witness Spain’s willingness to prop up CajaSur, which held a grand total of 0.3% of the country’s banking assets.
It is this transfer of risk, explicit and implicit, from the private to the public sector as much as the economic malaise which is driving Europe’s sovereign debt crisis and threatening the very fabric of the eurozone.
In this context, a system of automatic haircuts and/or debt for equity swaps for unsecured, uninsured creditors before insolvency, would send a powerful signal that risk is being transferred back to the private sector. Indeed, this is the justification given by policymakers.
“The implementation of improved resolution capacity, and in particular its demonstration in the case of a large firm’s failure, will over time change the expectations of investors and creditors of [systemically important financial institutions] about the risks they bear in the event of failure,” argued the Financial Stability Board in its interim report on moral hazard. “This will lead to greater market discipline being exerted on these firms and hence help discourage excessive risk taking. The associated reduction in mispricing of risk and distortions in resource allocation will make our financial systems more efficient and resilient.”
Such a policy will not be without its cost. Investors will demand higher yields for senior unsecured bonds, and individual firms may find their access to the markets cut off more quickly than in the past. This will have a knock-on impact on the cost and availability of credit, and indeed may drive consolidation, potentially leading to more systemic risk.
But we do not live in an ideal world and in the real world, where orderly and fair liquidation of large cross-border firms remains a pipe dream, the stick of effective market discipline could prove one of the few effective tools to mitigate moral hazard.
The alternative, raising capital and liquidity requirements high enough to withstand any crisis, foreseen or not, would cripple banks’ lending capacity.
The very real costs of such an approach, however, provide further support for banks’ argument that the new regulatory framework needs to be introduced gradually so as not to present them with an insurmountable capital and fundraising burden. A robust framework implemented over time is better than a weakened one imposed in haste.
The case against:
The G20’s call for unsecured, uninsured creditors of banks to take a haircut and/or debt for equity swaps for before insolvency is a laudable one. It is also one of the few politically palatable solutions to “too big to fail”. After all, those senior unsecured creditors got off lightly, with the burden falling on the poor old taxpayer to rescue the banks.
Yet, regulators should look beyond the easy fix. For if one was looking for the perfect example of a primogenitor of unintended consequences, this is it.
First, such a move would instantly push up the cost of wholesale funding for the banks. And while some might argue that there is nothing wrong with that, any rise in funding cost would have an impact on where banks lend and to whom as they try to recoup their increased costs.
Second, it would likely lead to rating downgrades. Which in turn would also lead to higher funding costs.
Third, the unified call for unsecured senior bondholders to take a potential haircut is likely to descend into a messy cacophony of disparate regulations as each national jurisdiction decides on what the appropriate haircut should be. It could even vary within each jurisdictions depending on the size of each institution.
Fourth, as well as a generic rise in banks’ cost of wholesale funding, it would also reduce the size of the investor base for bank paper even further. Already, banks are more and more reluctant to buy each other’s bonds as liquidity coverage ratios pushes them to hold supposedly more liquid and less risky public sector-type debt. But by making a haircut explicit rather than a post-default possibility, regulators will ensure there are fewer investors willing to buy bank debt. Think of the insurance companies and pension funds that will have even less incentive then to buy bank debt.
Last, and perhaps most importantly of all, there is a good reason why subordinated bank debt was thought to be such a good concept — it was designed to provide a cushion to senior creditors by putting some debt holders further down the pecking order when it comes to insolvency. These subordinated debt holders assume that they won’t get all their money back in an event of default. In the case of hybrid tier one, they provided going concern loss absorption and helped recapitalise the banks. Bank of Ireland illustrated just this: debt holders have provided as much capital as equity holders to help the bank through taking a haircut on their debt.
Beyond the debate, there are also the practicalities. For example, where does the line get drawn? Of unsecured creditors, will it just be insured depositors who are made whole and the rest will have to fight over the remains of the banks once covered bond and ABS investors have had their fill of valuable assets on the balance sheet?
And would the regulators want to see large corporations that have deposits with the banks take a haircut? What should the trigger point be? Does the haircut happen in a going concern or gone concern situation? Would a writedown on the debt be considered a credit event?