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Contractually or not, senior is bail-inable

Investors in bank senior unsecured bonds have sailed through most of the crisis believing they are safe from haircuts if the bank fails. They’ve been wrong before, and as time goes on, it should be ever more clear that they face real credit risk.

Some investors in bank senior bonds are suffering from ostrich syndrome. Their conviction that credit losses cannot touch them derives partly from a belief that, when politicians and regulators express outrage at taxpayer bailouts of banks, and vow that private investors must henceforth bear the entire risk of privately run financial institutions, their words amount to no more than politically expedient suspirations.

In reality, investors tend to believe, no regulator would put the future of its financial system at risk by forcing haircuts on senior unsecured investors.

In the dim and distant past before the crisis, senior unsecured bondholders were supposed to be pari passu with deposits and operational liabilities. The idea of changing that by regulatory diktat understandably scares and angers some bondholders — their terms have changed without so much as a consent solicitation.

But why should the status of creditor and depositor be on the same footing? Banks are systemically important, not because they have bond investors, but because the real engines of growth — consumers and companies — keep their money with them. Senior unsecured investors are just that: investors. Deposits are the true form of funding that make a bank a bank.

Many market participants were shocked when, in early March, the German treasury published a draft law that would subordinate senior unsecured bondholders to secured and operational liabilities in the case of a bank’s insolvency. Some view it as a ‘nuclear deterrent’ never to be used. It may also be meant to help stabilise corporate deposits if perceived trouble arises. Blue chip corporations during the crisis were known to move their deposits at the prompting of internal models that showed a certain bank’s CDS spread widening.

Others see the Treasury’s move as a means of helping the country’s biggest bank, Deutsche Bank, comply with Total Loss Absorbing Capacity (TLAC) rules that are more difficult for European banks to implement than their UK and US counterparts. Some think other European countries are likely to follow suit if the law gets passed. 

This is not the first time senior unsecured investors’ sense of sacrosanctity has been violated by authorities. Senior investors have taken haircuts in the past. Those in Denmark’s Amagerbanken lost more than 40% of their principal. Senior investors in Austria’s Hypo Alpe Adria Bank be facing losses after the Austrian government declined to back the guarantees on them made by the state of Carinthia.

Perhaps what saved senior bondholders in Banco Espírito Santo, whose bonds were moved to the ‘good bank’ set up in the wake of BES’s collapse, was the convoluted nature of the bank’s intragroup exposures. It was probably just simpler from a legal perspective to ringfence them.

All investors’ agonising over these situations is missing the wood for the trees. For more than five years, the endgame of regulators and politicians has been to impose bank risk upon private investors. Canada has passed a statute to bail in senior bondholders. The UK seems intent on forcing contracts to include a bail-inable clause, though some worry that such explicit treatment would significantly raise the cost of senior funding for banks.

In the light of that overall thrust of policy, it really should not matter whether you hold a senior unsecured bond with a bail-in clause in the contract, or if your bond is issued from a holding company, or if there is a national statute rendering existing senior unsecured bonds legally bail-inable. Regulators will, when it comes down to it, treat you as they have said they would for years: as a private holder of bank risk.

Some of the hair-splitting is self-evidently foolish. As things stand, bankers say bonds with contractual bail-in terms would raise the cost of the issuer’s senior funding more than a generally applied statute which amounts to the same thing. That makes no sense at all.

The starting point for investors in any bank bond should be that they are at risk. The point at which they stand to lose money, the severity of those losses, and their chances of achieving any recovery differ between the different layers of capital and debt. These are differences of degree rather than fundamental nature.

Investors should be sophisticated enough to choose between these levels of exposure.

What regulators should do, for their part, is to make their messaging as simple as possible. If statutes and regulations were drafted to require bank issuers to make their bonds contractually bail-inable, investors would have no doubt about where they stood.

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