The European credit curve has been flattening for much of the past year and this trend shows little sign of changing. This is great for Europe’s smaller peripheral banks which have been able to issue senior unsecured debt, which can ostensibly be bailed in, at levels close to covered bonds, which are excluded from the draft bank recovery and resolution regime.
The relative ease with which second tier banks have been able to access unsecured funding illustrates that investors are pricing in a very remote risk that senior unsecured debt holders will suffer a loss.
This was further underscored by survey conducted by Fitch in January. The survey showed that European investors do not believe that senior bank debt is likely to suffer a default as a result of the ECB’s comprehensive assessment. Senior spreads have shown no regard for bail-in, having done little but tighten — albeit with a few blips — over the past year and a half.
Fitch says the capital shortfalls identified under the ECB exercise will mostly be covered by private means. Banks unable to do this will turn to national backstops, which could trigger losses for junior bondholders. But for senior holders to suffer a loss, several conditions need to be met.
Not only would the ECB’s stress test have to reveal that the bank has failed, but its failure would also need to meet the affected country's conditions for resolution.
Moreover, that country would need to be unwilling or unable to plug the identified capital shortfall itself. And since regulations affecting the bail-in of senior debt do not need to be in place until 2016, taxpayers will continue to provide the necessary support.
As one banker put it this week, Europe has so far singularly failed to take any of the hard medicine and has instead chosen to sweep all the detritus under the European Central Bank's Long-Term Refinancing Operation carpet.
This status quo was illustrated over the weekend when Austria’s government sparred with the central bank and regulator over the wind-down of nationalised lender Hypo Alpe-Adria.
Anxious to protect taxpayers, Austria’s finance minister, Michael Spindelegger followed the advice of a government commissioned report produced by Oliver Wyman, which found that declaring the bank insolvent was the cheapest option for taxpayers. Spindelegger said that a declaration of the bank’s insolvency should not be ruled out.
However, Austria’s regulator, the Financial Markets Authority, has warned that such action would destabilise the country’s capital markets. The central bank and regulator are pushing for the creation of a bad bank, with the cost of the wind-down likely to be borne by the government.
When it comes to bail-in, Europe talks a good game, and many obstacles to the process have been removed — but the wrangling over Hypo Alpe-Adria merely shows that they have been replaced by new ones.