The spectre of bail-in has been hanging over the market for so long now that it was almost a relief when Dutch finance minister Jeroen Dijsselbloem used it as a tool to recapitalise SNS Reaal in February.
Subordinated bondholders saw their investments expropriated — essentially confiscated — by the government, and Dijsselbloem only stopped short of writing down senior bondholders because he was afraid that doing so would prevent other Dutch banks from accessing the funding markets.
In the UK, the failure of Co-op Bank was averted by negotiating with subordinated bondholders, ending in a debt to equity exchange for some and a restructuring of the terms for others. The process may have been convoluted and messy — and it was eventually overshadowed by increasingly outlandish revelations about Paul Flowers, the bank’s former chairman — but it was basically a bail-in.
The message is loud and clear — it is no longer politically acceptable for the government to bail out banks using public funds. We’ve known that for a while, but 2013 was the year that message got hammered home.
So, bank debt no longer benefits from implicit government support. But at the same time, stringent new regulations are making banks safer to invest in, says Gerald Podobnik, head of capital solutions at Deutsche Bank in London.
“We have seen that if the political will exists to bail investors in, then that is what will happen,” he says. “But at the same time, investors must understand that with increasing capital ratios they are getting much safer banks than they would have been 10 years ago. It’s become a lot more about which credit you buy.”
That’s all very well, and many would argue that investors should not be buying a bank’s senior or subordinated debt unless they’re confident they will get their money back. But a risk is a risk, and the risk of bail-in needs to be evaluated like any other.
It’s clear that the message has got through on subordinated debt. However, market participants are divided over whether investors have fully come to terms with senior unsecured bail-in just yet.
Too many cooks
One of the problems is that the rules are still not finalised. European policymakers are still completing the Bank Recovery and Resolution Directive, and the European Commission has proposed a new set of common rules for resolving failing banks. Called the Single Resolution Mechanism, it is one of the pillars of banking union. It’s undoubtedly important, but it’s yet another challenge for investors and issuers to think about.
With so many regulations being discussed at the same time, it is difficult for investors to see through the web and decipher the signals, says Podobnik.
“Two things are currently being negotiated in parallel — the Recovery and Resolution Directive and the Single Resolution Mechanism,” he says. “Some points from the RRD discussion are making their way into the negotiations around the SRM, like minimum eligible liabilities, and that sometimes creates confusion. What is positive for a global level playing field is that the Financial Stability Board is now looking to make bail-in a global mechanism, so it will not be unique to Europe for much longer.”
Under the European Crisis Management Directive — the 2012 document that is now being called the RRD — bail-in is supposed to come into force at the start of 2018. But there is pressure to bring its implementation forward to 2015 or 2016, especially after the events surrounding SNS Reaal, Cyprus and Co-op Bank.
Germany, the Netherlands, Finland and Austria are all trying to push senior bail-in forward to 2015. But France and Italy are resisting, and neither of them have their own version of the resolution regime yet. The Bank of Italy, for example, highlighted the legal rights of subordinated bondholders against bail-in in its latest financial stability review.
If the SRM is ready for 2015, then bail-in will likely apply from then. But bankers consider it likely that the SRM will be delayed by another year — and let’s face it, that’s not surprising given the EU’s track record — which would probably lead to bail-in being implemented in 2016.
Wake up and smell the danger
But when will investors actually start to take notice? Ultimately, it may be the ratings agencies that decide. Moody’s, Standard & Poor’s and Fitch have all been downgrading banks’ subordinated debt ratings because they see the asset class as receiving less state support than it used to. That same dynamic will affect senior debt — but perhaps not until the legislation is finalised.
Moody’s has said it will make its move only once it has full clarity on when bail-in will be implemented, but S&P and Fitch are keeping their lips sealed.
“We still don’t know how extensive changes to rating criteria will be and whether or not the ratings agencies will all move together,” says Khalid Krim, head of capital solutions at Morgan Stanley in London. “We also don’t know if and by how far they will downgrade senior debt. This could be the biggest negative for the market — we need to find out.”
Richard Thomson, senior credit analyst at Henderson Global Investors, agrees, saying the market is yet to account for the impact of bail-in.
“Everyone accepts that bail-in is here for sub debt,” he says. “It’s just a question of what happens to senior debt. The senior market is not yet pricing in bail-in, but investors will focus on it more when ratings agencies start cutting ratings, which should happen in 2014.”
Issuers are already on the case when it comes to protecting their senior spreads from the impact of bail-in. Although some heads of funding are sceptical about the price benefits, some European banks — Rabobank, for example — have publicly stated that they want to build up a large buffer of tier two debt to adequately protect senior bondholders. Sub debt issuance increased 23% in 2013.
That’s all very well for banks that have access to the tier two market at viable pricing levels. But while spreads have tightened considerably over recent months, subordinated debt is still out of reach for many smaller lenders, says Alberto Gallo, head of European macro credit research at Royal Bank of Scotland.
“Large banks are issuing more tier two to create a buffer below senior and some are also calling less tier one debt,” he says. “The Coco market will continue to grow and we’ll see more equity issuance from large banks. But small banks cannot issue a lot of capital, and if they can it’s expensive. It’s a catch 22 — until investors see losses being properly recognised at those small banks they will hesitate to put capital into them.”
However they raise the capital, the looming threat of bail-in means that in addition to fine-tuning their common equity tier one and tier one capital ratios, banks will also have to focus on their total capital ratios. The result could be a tightening differential between senior and sub debt, according to AJ Davidson, head of capital solutions for EMEA and APAC at Royal Bank of Scotland.
“The attachment points for senior and tier two are theoretically different,” he says. “Whereas point of non-viability loss absorption in tier two is meant to come before bank resolution and thus bail-in on senior debt, this may not actually occur in practice.
“In 2014 we will see senior investors starting to focus on this more than in 2013. We may even see a squeeze in the senior-sub spread differential in due course and issuers may start focusing more on protecting their senior spreads by making sure there’s enough capital below senior to avoid a hair-cut.”
The EU has said that insolvent banks must bail in 8% of their liabilities before they can access resolution funds from 2018 onwards, and many issuers and investors are now doing that calculation to work out the likelihood of senior bail-in happening.
RBS conducted its own ‘stress-tests’ using these parameters (see diagram) and concluded that while the risk of bail-in actually happening to senior debt was low, repricing could well occur.
“Most banks in our stress test have a large enough buffer of earnings, equity and sub to absorb future losses, which could offer protection to senior bondholders,” said analysts at RBS. “Even without a senior bail-in in 2014, which would encounter strong political opposition, senior debt from banks without a large enough buffer of bail-inable liabilities may be vulnerable to downgrades and repricing.”
Senior bail-in still has a long way to go before it is a fully workable feature of Europe’s regulatory framework. But it won’t stop at Europe — the Financial Stability Board wants it to become a global framework. It’s only going to get more real from here, so we’d better get used to it. |