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Learning to live with senior insecurity

27 Sep 2011

As the heavyweight regulatory endorsements rolled in one after another this year investors have been increasingly forced to face the inevitable over bail-in. Institutions’ responses vary widely, though concern over the consequences for bank funding and profitability remains high, reports Julian Lewis.

What a difference a year makes. This time last year most investors in senior unsecured bank debt were implacably opposed to the product being incorporated into bank resolution and recapitalisation programmes. The idea of potentially taking losses on a key funding instrument for banks led to stern warnings from buyers laced with terms like "complete non-starter" and "hugely concerning".

Twelve months on, some leading institutions are notably more accepting of the idea, or at least resigned to it. The growing political consensus in most advanced economies that taxpayers and public funds must not be tapped again to rescue banks that get into trouble has played a key role. It has made opposition to bail-in — a system that shifts the burden to the busted bank’s capital suppliers, including senior creditors (in the full-blooded versions rehearsed by the EC, FSB and FSA this year) — increasingly irrelevant.

This shift in some investors’ stance is notable, says Wilson Ervin, special advisor to the CEO of Credit Suisse and a leading proponent of bail-in (see box). "On the investor side, there was a lot of initial reluctance. Investors had a logical preference for a regime where they were protected by governments. But many leading houses are now saying: ‘Change is coming. The bail-in system — if done right — makes sense. It may be less comfortable for investors than a world where bank debt is really government debt with a spread, but bail-in is the best of the private sector alternatives.’"

Some investors even treat the likely implementation of bail-in regimes around the world as an opportunity. They relish the prospect of an environment in which their credit analysis and skills should be rewarded and unpredictable external factors count for less. "During the last crisis, investors had to guess what the government was going to do," says Ervin. "That kind of political analysis is very hard work and outcomes were hard to predict. Bail-in should provide a much more stable framework, based on economics. That should benefit investors who know the fundamentals of their credits."

But by no means all buyers take such a benign view. Indeed, as an increasing number have shunned the product for secured alternatives, some larger issues around bailingin senior debt — grandfathering, hierarchy of claims, exclusions, depositor preference — have intensified, not receded.



On Tesco’s coat-tails

Still, some leading voices are strikingly supportive. "I think we will be very confident holding senior debt under bail-in, though I feel there may be a little bit of dislocation in the short term. But we have no fundamental problem investing in the instrument," says Roger Doig, credit analyst at Schroders Investment Management.

"There should be plenty of demand from investors. Bail-in puts you on the hook to lose money if the bank fails, ensuring that creditors take the pain, not taxpayers — the same as if Tesco fails and goes into insolvency," adds Robert Kendrick, credit analyst at Legal & General Investment Management. "Once investors get their heads around that idea, they will realise that it is not such a bad thing."

Some investors are less positive, however. The reduced likelihood of government bail-outs is resulting in bank downgrades. Some investors complain that they will be able to allocate less capital to the asset class if its ratings fall, and lament that this reduces their appetite for one of the capital markets’ few higher rated, longer dated instruments.

"As for whether insurers and others invest less in the asset class, they may be just bluffing. But if that is a genuine concern we have to be aware of it since senior is already hit for liquidity," Doig notes. He characterises secondary liquidity of bank debt as "quite significantly impaired" as a result of risk weightings dissuading banks from buying other banks’ paper.

Still, banks too anticipate potential buyers for bail-inable senior. "There is clearly a market for subordinated debt, so I think there will be a market for senior debt of that type too," says Vinod Vasan, head of FIG capital markets at Deutsche Bank. Indeed, initial deals could offer good value to investors who are confident in the issuers, as they will have to price in extra subordination risk.

But they will not be emerging soon: Vasan expects no new issues of bail-inable senior this year as the product carries no first-mover advantage and "investors won’t thank you for it". The time necessary to enact bail-in regimes in national law could even postpone the product’s debut to 2013.



Seeking security

In the meantime, a significant proportion of investors have responded by spurning senior unsecured for secured instruments, notably covered bonds. "We have tried to avoid senior as we didn’t want to be exposed to a weakening sector subject to structural subordination and bail-in," comments Bryn Jones, fixed income investment director at Rathbone Investment Management. "The idea of bail-in is that you are no longer pari passu with depositors as a senior holder."

The UK asset manager has come to prefer "more interesting" covered bonds, he notes. Rathbone bought its first sterling covered bonds this year. It discerned value in triple-A Nationwide covered paper at 150bp over swaps versus lesser rated senior unsecured issues at similar levels, such as triple-B Experian at 160bp over.

"From an investor perspective, there has been a much greater focus on bail-in and a clear shift away from unsecured to secured instruments — covered bonds and even asset-backed securities — that avoid it," agrees Christoffer Mollenbach, head of FI debt capital markets at Lloyds Bank Corporate Markets. This "clear preference" was particularly evident during recent periods when many smaller banks were only able to access capital markets via covered bonds, notes Hans Lentz, head of FI syndicate at Lloyds.

This strong shift to secured financing has big implications for banks and their creditors, investors warn. "There is clearly an incentive for banks to look at covered bonds, given dynamic pools and asset quality deterioration. That is potentially quite dangerous, particularly for deposit-taking institutions. Regulators need to think about the consequences that can have," says Doig.

While Schroders does not view current covered bond outstandings as problematic, "one or two years hence encumbrance could be more and more of a problem," he says. Besides encumbrance, the ability of cover pools to suck in additional collateral as house prices fall concerns investors as other creditors would be left with worse LTV loans.

Simon Adamson, CEO and senior analyst, European financial services at CreditSights, doubts that any banks are close to the limit of their covered bond programmes. But he acknowledges that this could become problematic if secured funding continues to grow as a proportion of their total debt stock. "The rating agencies will track it and banks will have to be careful."



Pricing potential

Few institutions regard the prospect of bail-in as reflected in the trading spreads of banks’ senior unsecured bonds yet. "Bail-in is not fully priced in to senior yet. People have been more worried about sovereign exposure and stress tests," believes Jones at Rathbone.

Uncertainty over the final shape and scope of bail-in regimes adds to this. "There are a lot of different responses from banks. They are all saying different things, which makes it very difficult to value bonds," he reports.

Even so, "bail-in is already having quite a big impact on where bank debt trades, not least as the rating agencies are having to respond and the market is trying to anticipate that," notes CreditSights’ Adamson.

The impact on spreads varies across jurisdictions according to the authorities’ perceived commitment to imposing losses on holders. "UK banks, even ones in good shape, trade quite wide relative to similar banks in, say, France or Italy," notes L&G’s Kendrick. "Investors recognise that they need to get paid for being a step closer to being forced to endure losses. The fact that the authorities in France and Italy are particularly opposed to bail-in definitely provides a reason that their banks trade as they do," he adds.

German banks trade at tighter levels than their UK peers despite the country’s similar resolution laws. This suggests their investor domestic base is more inclined to support its national champions.

Investors highlight an important further differentiation between stronger and weaker bank credits. "Good banks will see demand for bail-inable senior debt, but not banks where you could lose capital," says Jones at Rathbone.

He anticipates that senior unsecured spreads will move out once terms are confirmed. "People are only pricing in the potential of bail-in, not the whole likelihood," he says. "There has been a 20bp-30bp widening of senior debt, but we would expect some more. If it were to be implementable on a global basis you would see more widening."

However, Doig at Schroders views senior unsecured as quite attractive. Pricing may exaggerate the product’s risks, he judges — particularly at a time when banks are reinforcing their capital. "We’re getting paid a higher spread for the same probability of bankruptcy," he says.

Similarly, Rathbones’ Jones sees potential relative value. "If you’ve done your due diligence on the bank’s asset quality and other fundamentals, its senior may be trading on a yield wider than they dictate."

Schroders is positive on tier two of banks in countries with resolution regimes in place (Denmark, Germany and the UK, most notably) and expects its pricing to converge towards that of bail-inable senior. "Under bail-in, senior is just a version of tier two. At the point of non-viability it is just bailed in after tier two. So we would expect a convergence."

Basel III’s significantly greater capital requirements could mitigate the impact of bail-in increasing subordination and limit the increase in banks’ funding costs, investors concede. However, their timings are quite different. Resolution regimes are likely to be in place in the next couple of years, whereas Basel III is to be implemented in 2018-20.



Point of no return

For some investors, the key question is when regulators can require a bank to bail in its creditors. L&G is open to buying bail-inable bonds, Kendrick affirms — "as long as it really is at the point of non-viability". He defines this as involving the failed bank being taken over by the authorities and run down, with management dismissed.

At the same time, he insists that bail-in should not apply to banks that are still going concerns. "Then you become a form of contingent capital and would need to be paid a considerable amount more. The question is under what conditions would losses be imposed? How sick would the bank need to be and what would be the consequences for management?"

Kendrick uses the examples of RBS and Dexia. "After those kinds of massive losses regulators shouldn’t be bailing in to allow the banks to continue. Their sole concern should be to minimise disruption to the system," he says. "Once bail-in happens the bank is essentially dead and bail-in helps to ease the burial."

Vasan at Deutsche also notes concerns among investors who have lost the security of a possible government bail-out to help senior debt. A key one is that regulators could exercise their resolution powers too quickly. Scepticism on this will lead them to charge a premium for bail-inable senior, he judges, citing the "fairly severe" price action when the EC published its consultation paper at the start of the year.

Even so, he raises the important principle that no bailed-in creditor should be worse off than in a liquidation. "If the market accepts that, the impact would be much lower."



Grandfathering and gaming

Nonetheless, investors remain concerned by other significant uncertainties around bail-in too. Besides the inclusion of senior unsecured, these include grandfathering of existing debt, the system’s eventual hierarchy of claims, its exclusions and the role of depositor preference.

"It does seem like regulators are very keen to soothe the market by saying only new debt issued after 2013 will be bail-inable. Our view is that this might be the case on a contractual basis but regulations as they stand in the UK and Germany, and as the EU proposes, would allow for statutory bail-in to be imposed beyond the point of non-viability to achieve recapitalisation by forcing losses on to bondholders," says Kendrick at L&G.

Even so, fears are high that the measures could be retroactive (as FSB anticipates — see box). "That is one of the big issues. Investors fear that legislators will tinker with the start date if their banks get into trouble before the actual EU implementation," says Deutsche’s Vasan. "For an orderly market it is important that investors know what they are getting and what the risks are," adds Adamson at CreditSights.

But if existing debt is excluded a buffer of new bail-inable securities will not be constructed immediately. "If bail-in is purely contractual, it will take time for the debt stock of banks to get recycled," Kendrick notes. The average weighted maturity of banks’ outstanding senior debt is some four years, according to L&G.

Banks have mostly favoured a contractual and targeted approach over a statutory and comprehensive bail-in system. Some, though, see the latter as the lesser evil. For example, Lloyds regards a regime of contractual senior bail-in as the worst case. A statutory regime enforced consistently across Europe would be an easier sale to investors, Mollenbach argues.

Investors view the choice between the two, which regulators including the FSB have indicated may be a false dichotomy, since they could be compatible with each other, in a less partisan way. "As investors we are largely indifferent over which approach is taken, though they clearly have different consequences," notes Doig at Schroders.

But if the approach is statutory and comprehensive investors "urgently need clarity on exactly how regulators envisage re-ranking of senior obligations," adds Doig. "The grey area of a large number of different instruments being senior and not clear has to change, making it extremely clear where senior sits versus covered and versus repo, for example. We’re pretty sanguine that senior ends up at the bottom of the pile. As investors we recognise that resolution tools are intended to subordinate senior unsecured holders. But we would like to see clarity. We know the fact of that subordination, but not by how much."

"We would be surprised if it applied to repo or other short dated funding of less than six months or a year," Kendrick says. The idea that secured debt might also be included in bail-in is impractical, judges Deutsche’s Vasan. He too hopes that short dated liabilities will be excluded.

Deposits, particularly those covered by government insurance schemes, become an important factor here. Some of the resolution powers under discussion become open to legal challenge without a formal differentiation between deposits and senior unsecured, for example. This leads to the growing focus on depositor preference.

Important issues over the differing treatment of domestic and foreign depositors still need resolving, however. "We oppose discriminatory depositor preference laws that discriminate against foreign depositors because that will be an impediment to cross-border resolutions of G-SIFIs," affirms Gilbey Strub, managing director at the Association for Financial Markets in Europe.

Depositor preference’s fairly rare adoption outside the US is also a potential obstacle to harmonisation of bail-in regimes and a potential influence on the composition of banks’ funding. Schroders’ Doig notes its significant conflict with senior secured funding. "Covered bonds are granted a right over assets that are not available to depositors as a result," he says.

Kendrick at L&G doubts that covered bonds would be included in a bail-in. "It is reasonable to exclude covered bonds. Holders will get their money from the collateral anyway."

Investors are seeking clarity over how the deposit/secured interplay would work, as well as the status of CP and swap counterparties. "These are very complicated issues and it is a problem that nobody is taking a lead on," Doig says.

Moreover, investors suspect that banks will game any new regime — particularly if derivatives are exempt from bail-in. "We are likely to see funding tools exploiting the exemption of swaps. Of course banks have an incentive to do that. We think we are likely to get a period in which banks are able to take advantage and regulators do not put macro prudential tools in place to limit the consequences," says one institutional buyer.



Funding fundamentals

"One of the most interesting questions from issuers’ point of view is the role of senior in their funding," adds Lentz at Lloyds. "They can’t just keep replacing it with covered bonds, due to structural subordination, but the investor base will not simply replace it with bail-in bonds as these have significant risk and are not the same as senior," adds Lentz at Lloyds.

"The biggest problem is this exclusion of the largest part of the traditional investor base. They buy senior as a relatively safe asset paying a decent spread. So where will banks get funding unless they can convince investors that bail-in is extremely remote?"

This leads Lloyds’ Mollenbach to conclude that bail-in, in tandem with the identification of SIFIs, is pushing investors towards national champions and forcing bank concentration. "But that is the opposite of what regulators want," he notes.

One country where smaller banks have minimal market access is Denmark, the Lloyds pair note. The country’s burden-sharing regime — similar to the FSB’s proposed bail-in model — has left investors unwilling to take exposure to all but the largest credits. This has led Moody’s to downgrade smaller Danish lenders, which makes market access a remoter prospect.

Against this background, Adamson at CreditSights anticipates "potentially fundamental changes for the senior funding market", noting that in the past banks have launched senior deals quickly and without roadshows. In a bail-in environment, investors may well require more contact with bank issuers as part of an expanded due diligence effort. This could also involve demands for more disclosures than European financial institutions normally give.

"Buyers will have to do more credit work on the underlying credit of the bank than just relying on ratings," he argues. The time this will take makes investors likely to seek higher spreads to compensate — especially when combined with the near-certain removal of bail-out support and, as a result, lower ratings.

One obvious potential impact is that senior unsecured becomes a much smaller part of banks’ funding mix. Deposits and covered bonds might fill some of this gap, alongside bail-inable senior. A possible solution is for banks to issue extra amounts of bail-inable tier two subordinated debt, Mollenbach suggests. This could reassure investors by creating even bigger capital buffers than the Basel III rules require.

But questions remain over banks’ systemic role. If they are no better — and perhaps worse — rated than corporate or public-sector borrowers, their ability to intermediate funds profitably could decline significantly. "It is very hard to see how they would finance all of those clients," Adamson says.

This could mean a shift to a US-style system with a far larger corporate bond market. Moreover, the damage to banks would be considerable, he foresees. "They would be struggling to do the same amount of business and profitability would be lower than in the past due to higher capital requirements and funding costs and lower growth."

Ultimately, "perhaps some investors won’t buy banks at all and others only when they are very well compensated, while others will still be comfortable with the sector," he concludes.

   
 

Godfather sees bail-in gaining traction

  Some 20 months after co-authoring the Economist article that first raised the issue publicly, the godfather of bail-in believes his approach to bank resolution is winning the day. "The regulatory world seems to be moving pretty strongly in the direction of bail-in within resolution. I think that is constructive," says Wilson Ervin, special adviser to the CEO of Credit Suisse. "It is the only system that looks like a practical  contender."

Similarly, despite the concerns of some of its member firms, the Association for Financial Markets in Europe remains "a strong supporter of bail-in within resolution provided it is commenced only as a last resort after the failure of all other recovery measures designed to prevent a SIFI from becoming non-viable," adds Gilbey Strub, managing director at AFME.

Heavyweight political and regulatory endorsement this year from the European Commission, the Financial Stability Board and, most recently, the UK Financial Services Authority has enabled bail-in to gain significant traction. "We have moved from an initial concept to a broadly agreed regulatory initative," argues Ervin. "The key actors have signed off on the main architecture. The issues now are about implementation. Getting the details right is critically important, but at least we have the right features in basic design."

He particularly points to July’s consultative document from the FSB, ‘Effective Resolution of Systemically Important Financial Institutions’. "It represents something of a watershed in the debate. It was broader and more far reaching than a lot of people in the market expected — the clearest regulatory statement on this topic to date."

Ervin highlights the report’s fairly unexpected inclusion of outstanding debt (‘Bail-in powers within resolution should enable resolution authorities to... write-off up to all of the subordinated or senior unsecured and uninsured creditor claims against the firm’: Annex 2 — Elements for inclusion in the Key Attributes). "That is something not everyone has taken in yet."

He notes a shift in market perceptions of bail-in, particularly over its application to senior debt. This was highlighted by a report in May from the International Institute of Finance, which represents over 400 banks and financial firms (including investment managers). Where a year ago some leading banks refused to endorse an AFME report that supported this full-blooded version, the recent IIF report was prepared to countenance bailing senior debt in — although only as a last resort and subject to additional restraints on regulators’ discretion.

"The bailing-in of unsecured senior debt should occur only in the special circumstances, that this is necessary as a last-resort alternative to winding-down or liquidation, with certain requirements imposed on authorities if they wish to use these supplementary senior debt bail-in powers," IIF said in the report’s introduction. The chairmen of Credit Suisse and Deutsche Bank and the chief executive of Standard Chartered each signed the report.

Ervin served on IIF’s working group on cross-border resolution, which prepared the report. He acknowledges concerns over the impact of senior bail-inability on funding spreads, but counters that "if you’re pushed to consider the logical endgame, you will take bail-in over the alternatives at that time. That’s essentially what happens in corporate restructurings."



Consistency, not contracts

Ervin is sceptical about expecting every aspect of regulation to apply universally and uniformly. "I certainly don’t think we are going to move to a perfectly frictionless world and if you want to wait for a perfect global bankruptcy process, I think you’re going to get very old first," he says. However, he does favour a statutory bail-in environment. "The FSB talks a lot about consistency and doing as much through statute as you can. If everything is in idiosyncratic, contractual language, it gets harder for the market to understand how Bank A will be treated versus Bank B, or how debt issued in one year might be treated versus another vintage. It makes investing much simpler if the regulations are broadly consistent."

He anticipates and accepts some national differences in implementing the FSB model. "Local variations are not fatal by any means, as long as there is some consistency on general principles. It would be problematic if some jurisdictions decided to go for explicit government support, for example. This would essentially protect a few local banks and exacerbate funding pressures for everyone else.

"But other variations are acceptable as long as you’ve done the work to make sure they work all the way through, including cross-border implications. There also needs to be a clear understanding in the market of any differences — we need to avoid surprises."

Some bank investors still hope that they would be bailed out in the future. But Ervin doubts that the political consensus in Europe or North America would permit this and sees governments as committed on the point. "I wouldn’t like to be the central banker who has to explain that he or she wasn’t able to solve this with the new reforms. If they have to ask taxpayers to bail-out banks again, the politics would probably be even uglier than last time."

One concern in the current resolution debate is the "broad toolkit" approach exemplified in the FSB report. The uncertainty over which tool might be used could have negative consequences, he judges. "One of 2008’s lessons is that you need a strong and consistent plan that you are willing to stick to. If you have four or five different options, investors will look to the worst case. If everybody is looking at a different worst case, that can create an unstable situation and exacerbate the pressure for bank runs."

He contrasts this uncertainty with a "clear and transparent" regime where "investors know the basic game plan for how a bank in distress would be recapitalised, perhaps with a couple of fall-backs." Clarity on the basic plan is particularly important as bank crises are "thankfully rare". That means there will be less benefit from precedents and case law that informs investors subject to more common processes like Chapter 11. That means clarity for bank resolution will have to be built in manually.

Ervin also frets about jurisdictions where the resolution regulations only apply to systemically important banks. Again, this limits the potential to establish precedent — unlike in Denmark, for example, where the imposition of losses over the failure of the small local lender Amagerbanken leads investors to expect a larger institution to be treated the same.

He remains sceptical to the idea that a good bank/bad bank separation helps resolution of a bank in serious difficulty. "It doesn’t add capital or liquidity — it just separates a bank into two entities. It is like trying to do Siamese twin surgery at the same time as you’re trying to resuscitate a critically ill patient. There may be good arguments for it, but I haven’t heard them."

Conversely, he commends depositor preference — an approach largely unknown in Europe but now coming into focus. "Protecting depositors, certainly insured depositors, seems to be universally agreed to be critical for preserving stability and avoiding bank runs. If that is essential for stability, then you should reflect it in the legal framework, and rank deposits as more senior. The machinery works better if legal mechanisms reflect economic requirements."    
27 Sep 2011