The Economic and Monetary Affairs Committee this week voted in favour of the Recovery and Resolution Directive granting depositors greater protection by placing senior unsecured bondholders below even uninsured depositors in the pecking order when things go wrong. Until now the two constituencies have been treated equally.
As a consequence, senior unsecured will lose yet more of its appeal as a low-risk investment, and will be treated in much the same way as subordinated debt.
This is because the relative size of a bank’s deposit base compared its liabilities is many times larger than the size of assets that are encumbered. With deposits now set to be ranked ahead of the senior unsecured creditors, their claim would be substantially subordinated.
It doesn’t make much difference whether you’re standing 100 yards or 200 yards from a nuclear explosion. And in future it probably won’t make much difference whether you’re invested in a bank’s subordinated or senior debt.
Banks are so leveraged that if uninsured deposits are going to take precedence over debt, most of the capital structure will have to go.
A study conducted this month by the European Commission and which looked at the impact of introducing depositor preference in the Bank Recovery and Resolution Directive came up with some fairly devastating projections. Protecting bank depositors from losses would increase haircuts on senior bondholders of small banks to 80%.
For large banks the haircut would rise to 89%, assuming that overall losses were equivalent to 25% of assets.
Until now the senior unsecured asset class has been protected and this has justified the premium at which those bonds trade over subordinated debt. Now it all looks different. Prospective bank failures would imply a near-certainty of substantial losses at the senior unsecured level, or at the very least a much closer correlation of both probability of default and loss given default of the two instruments.
Given that, investors may well decide that they are better off opting for the higher yielding subordinated debt.
For the moment, the surfeit of central bank liquidity that is swilling around the markets will be enough to ensure that the market can continue to misprice the capital structure of banks. But in future, when the top of the tree is firmly the realm of depositors and covered bonds, with a sliding scale of unequivocally loss absorbing debt — from senior unsecured through to tier one Cocos — underneath them, it ought to be different.
When senior bail-in and depositor preference take full effect — perhaps 2016, perhaps a couple of years later — senior should converge with subordinated, and move away from covered.
This will have an effect on bank funding — and the result will look rather binary. Investors looking for protection from insolvency will have to buy secured, whether covered or ABS. The only sensible alternative, if it’s yield they are after, will be subordinated debt.
And that doesn’t leave much room for senior unsecured.