The financial markets are by now well versed in what happens to bank capital if a bank is in trouble. Losses are taken and the risk of that happening ought to be priced into the instrument. But what about the treatment of funding? Just a few years ago, the idea that senior unsecured debt might have to absorb losses was unthinkable.
That has all changed now. The European Union’s Crisis Management Directive set out in 2012 the first Europe-wide rules for bailing in bank debt — forcing losses on bondholders when banks are failing, avoiding the taxpayer bail-outs that became such a feature of the financial crisis.
The transformation of funding into capital is revolutionary. Progress has been slow, but since bail-in was first mooted in late 2010, investors have come a long way to accepting it.
Under CMD (now often referred to as the Resolution and Recovery Directive, or RRD), tier two debt will be bail-inable from 2015. Senior debt was supposed to be from 2018, but recent bank failures in the Netherlands and Cyprus have accelerated the process and the European Parliament is pushing for implementation in mid-2016.
That tier two debt can be written down to recapitalise a failing bank is no longer an outrage. When SNS Reaal was on the brink of collapse in early 2013, Dutch finance minister Jeroen Dijsselbloem didn’t take long to expropriate the subordinated bondholders, effectively confiscating their bonds, with zero chance of recovery.
The UK’s Cooperative Bank now plans to bail in its subordinated debtholders, converting their holdings to equity and transforming the institution into a listed bank.
Tricky process
Bailing in senior debt is trickier and a lot more delicate. Dijsselbloem stopped short of senior bail-in at SNS because he was afraid of the impact on other Dutch banks’ access to funding.
If losses at a bank necessitate senior bail-in, regulators want to get the figure right. Too big a haircut, and bondholders get spooked; too little, and you might have to go back for more.
“If you impose too much burden-sharing on the investors, they will no longer be willing to be a counterparty, and the bank will not be able to continue to fund itself,” says Khalid Krim, head of European capital solutions at Morgan Stanley. “Bail-in is part of the toolbox, but regulators will be very careful about how they use it.”
Banks need to continue to fund and refinance themselves, he says. “You cannot go out to the markets that are providing liquidity and impose losses that are over and above the amount of recapitalisation the bank needs, just for the sake of being conservative.”
To protect senior bondholders, banks are expected to load up on tier two debt, possibly even above the ratios required under CRD. A bigger tier two buffer will help to protect senior bondholders from losses. But some capital structurers are going further, working on specialised notes to sit between tier two and senior debt.
These bonds — which have been called senior subordinated notes (SSNs) or priority bail-in notes (PBNs) — would be designed to be cheaper for issuers than tier two, but absorb losses before senior unsecured. It’s a nice idea, but not everyone is convinced.
“When the early drafts of the RRD were proposed, bail-in was a source of anxiety for the unsecured investors,” says Peter Jurdjevic, head of balance sheet solutions at Barclays. “But markets have moved a lot since then. Yes, they can back up again quite quickly, as we’ve seen. But, investors will accept bail-in, and the scarcity of the senior unsecured product will make them pursue it, without issuers having to create a new tier in the capital structure.”
The development of such a market could depend on whether the regulator forced losses on holders of SSNs or PBNs before other senior holders. The legal niceties could be awkward. The cost benefit is also questioned.
However, it could help an issuers’ ratings, says Jurdjevic. “For banks on the cusp of a ratings band in senior unsecured, like BBB- or BBB+, it could be seen as a kind of enhancement to keep them in the category.”