Last updated: November 4, 2013 7:07 pm

‘Bail-in’ jitters for bank bond investors

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“Burden-sharing”, “bail-in” or “haircuts” – call it what you like. The prospect of bank creditors sitting in the line of fire is causing jitters among bond investors ahead of stress tests by European Union regulators.

EU finance ministers have already raised concern among senior bondholders, agreeing in June rules to force losses on creditors in failed banks, a move Moody’s described as “clearly credit negative” for unsecured investors.

So far the impact on banks’ cost of funding has been muted. After hitting a year high in late March, the cost of insuring banks’ senior debt – a key measure of riskiness – has fallen 85 basis points, according to the iTraxx Europe Senior Financials index. The cost of subordinated debt insurance has fallen by 146 basis points.

But, as the prospects of bail-in grow nearer that is going to change, warn analysts. As it becomes clearer exactly how bondholders will be required to share the burden in future bank rescues – or even as a result of the forthcoming bank stress tests – the effect on funding costs could be significant.

“For core banks bail-in is not priced in . . . should it be a salient feature? Absolutely,” says Richard Ryan, director of fixed income investments at M&G. “We can’t have a world where senior bondholders believe they are immune from resolution because it’s never happened before . . . it’s called unsecured lending for a reason.”

Conventional wisdom states that bail-in fears are concentrated in the eurozone’s “peripheral” states, where most of the weak and undercapitalised banks are located.

Europe’s big banks need to raise about €47bn to meet capital ratios required by regulators, while between 15-20 mid-tier banks could fail the EU’s stress tests altogether, according to estimates by the Royal Bank of Scotland.

Those numbers could increase if European regulators apply different risk weightings than banks when assessing the riskiness of their balance sheets. Then some national champions could be in for a shock.

“The biggest concern for the [European Cental Bank’s] asset quality review is that the tests reveal notional capital shortfalls that would have to be plugged on a precautionary basis, which might trigger contractual or statutory losses for bondholders,” says Oliver Burrows, banking analyst at Rabobank.

“It’s not just banks in Spain and Italy, it’s also banks in Germany who could be potential losers.”

In response, banks have tried to defray bail-in risks by issuing more subordinated debt, taking advantage of investors’ hunger for yield to bolster capital buffers protecting senior unsecured creditors. Subordinated debt would be the first to go in a bank default; senior unsecured debt is a mainstay of most banks’ funding.

However, a lack of regulatory clarity is making life more complicated.

“There are discussions between authorities about whether there should be more predictability on bail-in in terms of what creditors can expect or more flexibility in terms of using tax money,” says Oscar Heemskerk, senior credit officer at Moody’s.

Now that it is set to become the direct supervisor for the region’s biggest banks, the ECB has adopted a nuanced approach to bail-ins, arguing against a forced conversion of junior bondholders’ debt into equity in some cases.

In a July letter that puts it at loggerheads with the European Commission and Germany on the issue, Mario Draghi, ECB president, argued that there could be good reason to allow a bank to accept what amounted to state aid without forcing a bail-in of bondholders, as long as the institution was not failing.

While the ECB chief has made clear he expects some lenders to fail the combined health checks and stress tests that will be conducted over the coming year, he outlined cases in the letter where a bank with a viable business model might have sufficient capital at a given point in time but be found to be in need of extra capital in a stress test.

If such an institution cannot raise private money in a “precautionary recapitalisation” and is then forced to bail in bondholders, it could impair the subordinated debt market, leading to “a flight of investors out of the European banking market which would further hamper banks’ funding”, he wrote.

On the other hand, there is still firm support at the central bank for bail-ins of institutions that fail to meet the regulatory capital ratios at a point in time and are in resolution.

The problem is that there could be a grey area between the two scenarios. The ECB has said it will not publish separate findings from the asset quality review and the bank stress test, but rather an overall assessment of the lenders – making it that much harder to spot which ones meet and which fail this bail-in threshold test.

“I like to think of the bail-in tool in terms of [Russian playwright] Anton Chekhov,” says Mr Burrows. “If there’s a gun on the table in the opening act, you know it’ll be fired in the final scene.”

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