German bank bonds were the focus of attention last week after the European Central Bank decided to cut senior bail-in debt out of its repo collateral framework. That matters more for Germany than any other country, because thanks to a change in its law, all of the senior debt its banks issue is subordinated and can be bailed in.
This will change later this year if, as expected, it passes a law putting it in line with other European countries, where senior bank debt is not subordinated by default.
For now though, market participants believe the rule change is likely to reduce liquidity in the market for senior German bank bonds, because collateral eligibility is an attractive feature for banks buying these products — like covered bonds and agencies but with extra yield.
One take on the rule change is that the ECB is simply looking to make sure its balance sheet is secure in the case of a bail-in: to get rid of the junk in case a bank goes kerplunk.
After the ECB got burned by Steinhoff’s collapse — it held notes from the South African company’s European subsidiary, bought as part of its corporate sector purchase programme — it may be more concerned about the risks hiding on its QE-inflated balance sheet.
But longer term, changing the repo criteria should benefit the system as a whole.
German banks tend to place bonds with domestic banks, and often within their own banking network.
According to Chiara Romano, an analyst at Scope Ratings, 56% of long-term debt issued by German monetary financial institutions (MFIs) is held by euro area MFIs, and DekaBank and Deutsche Bankhave the largest holdings of debt issued by major German banks.
It’s not just a German problem: the ECB revealed last year that credit institutions hold more than half the credit institution debt held in each Spain, Portugal and Greece. And in each of those four countries more than 90% of the credit institution debt held by credit institutions was issued by domestic lenders.
A high level of cross-holdings poses a threat to financial stability.
If one bank bails in its senior non-preferred notes, other banks in the same area will take a large hit. A narrow investor base also limits the strength of the market and its ability to absorb issuance: if the the market in one country freezes over, who will pick up the slack?
The European Banking Authority (EBA) agrees that the strength of a bank is somewhat compromised if it holds lots of bail-in debt issued by other banks.
It proposed in its final minimum requirement for own funds and eligible liabilities (MREL) report that a bank should deduct from its own senior MREL base the value of bonds it holds which are MREL-compliant, although only above a threshold, in order to ensure the development of the market.
A set of banks owning large amounts of each other’s bail-in debt must meet a much larger aggregate MREL total, therefore.
But from the evidence available, the disincentives for cross-holdings are not strong enough. Removing repo eligibility is a step towards pushing the risk of bank failure outside the banking system. Whatever the short-term liquidity effects, it is a welcome move.