Wednesday, 12 December 2018

​Bail-in uncertainty

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European banks’ funding costs could rise, with new EU bank laws seemingly giving depositors preference over senior bondholders

Bank bond issuers across Europe have faced a tougher task than usual to persuade investors to buy their paper in recent months as countries have imposed their own interpretations of the European Union’s bank recovery and resolution directive.

This major piece of post-crisis regulation is essentially designed to ensure that, if a bank needs to be rescued, private investors in its equity and debt will first be hit, by being wiped out or bailed in, before any public money from taxpayers is put at risk. 

This is designed to avoid the latter stumping up funds for a bank that might otherwise have failed and letting bondholders sail on untouched. Such bailouts were commonplace at the height of the crisis in late 2008.

Under the EU’s rules, these principles, agreed last year at an EU level, must be in place at a national level via new bank bankruptcy laws by the start of 2016. However, states that have already passed the legislation have come up with different interpretations of the guidance.

Some, in Germany and Italy for instance, seem to give preference to corporate and other large depositors over senior bondholders. While others, such as Spain, have suggested creating a new layer of capital between senior and Tier 2 debt.

“The big issue here is that senior unsecured debt is becoming more and more difficult to place due to the national transposition of the BRRD in the different countries and its bail-in-able status,” said an analyst.

“What is emerging is that it is being implemented in an increasingly fragmented manner in order to deal with different local insolvency regimes, which is quite a perverse outcome,” said Tom Grant, a partner at law firm Allen & Overy.

“Investors will need to use a magnifying glass in order to have a better understanding of local insolvency regimes and the structure of each issuer.”

And some syndicate bankers are calling the legislative patchwork a nightmare for pricing new senior bank bonds.

“It totally changes the dynamic of what senior is: how can we have an integrated European senior market when you can’t compare apples with apples?” said Robert Kendrick, credit analyst at Schroders.  

September strike

This confusion came to a head in September, when investors showed extreme reluctance to buy even senior debt of banks, which under the new rules would still be one of the last unsecured instruments to be bailed in if an institution needs recapitalising.

Commerzbank printed a €500m seven-year trade, short of the €750m it had hoped for, while Banco Popolare Societa Cooperativa found just over €450m of demand for a €500m three-year issue.

“The bail-in discussion was a major topic and there was a lot of push-back from investors. Some are not buying any German senior debt at all because of the subordination,” said a banker close to the Commerzbank deal. “We might have underestimated the impact of the proposed legislation.”

Part of the problem may have stemmed from investors noting that uninsured depositors might be given preference in a bail-in situation over such senior debt.

In March, Germany proposed that senior debt should rank below most other senior liabilities, increasing the chance of bail-in during resolution or insolvency. Italy is also going ahead with proposals ranking corporate deposits ahead of senior debt.

“We don’t like senior German [bank] debt – but not just German senior – because of the bail-in debate that is going on right now,” said Dierk Brandenburg, senior credit analyst at Fidelity. “We are not in the camp that we will never buy it, but right now the mark-to-market risk is high.”

The Commerzbank transaction was testing European investor demand for longer dated German senior debt for the first time since a €1.25bn 10-year Deutsche Bank transaction in March – and that deal had widened by more than 72bp since being priced at 53bp over mid-swaps.

As for Banca Popolare SC, it could not drum up enough support for what was the first trade since Italy pushed through its bail-in proposals earlier in September.

This was despite the bank bringing a three-year deal at 255bp over mid-swaps, an apparently generous level compared with its previous deal (a €1bn five-year transaction in July that was priced at 240bp over mid-swaps on the back of a €4.5bn order book). The July bonds subsequently widened by 10bp.

This widening has not just taken place in German and Italian debt. UK and Swiss banks opting to issue through their holding companies to meet new regulations have also seen a brutal move in their secondary bond prices.

A €1bn April 2022 issue that was priced at mid-swaps plus 75bp by Barclays in September last year – the first euro-denominated trade through its holding company – is more than 50bp wider. Similarly, a €2.25bn April 2022 priced by Credit Suisse in April at mid-swaps plus 100bp is over 30bp wider.

“Despite the initial view that it wasn’t going to be a problem, we have seen the gap between holding and operating company senior debt widen out, and this is the kind of risk we are trying to avoid,” said Brandenburg.

In September, Credit Suisse opted for a transaction through its operating company after it failed to issue a 10-year holding company bond earlier in the year and the pricing differential between the two types of debt continues to grow wider – going from around 40bp–50bp to 65bp.

One of the big issues for the two deals, from Commerzbank and Banca Popolare SC, was finding real depth of investor demand – with some accounts simply not interested in buying in size.

“I think it’s becoming increasingly a problem that the natural buyers shun the asset class,” said Michael Hunseler, managing director at Assenagon Asset Management.

Another banker close to the Commerzbank trade said that it was a topic brought up by investors during marketing.

“For some, a big question was around who will be the ongoing investor base for this paper. If they engage now, will they get burnt later? Will they have to sell? Given the question around seniority and the questions at the ECB, a lot of investors were hesitant,” the banker said.

“Many are concerned that senior in Germany sits just above capital instruments and that they are not getting paid for the risk.”

Investors’ worries are increased by the fact that ratings that are already low in some cases could be dragged lower if ratings agencies decide to take a more aggressive view on what the new bail-in rules mean for potential state support.

“The problem right now is not just a German one – it [affects] the asset class as a whole, which has become a much more complex sector,” said Fidelity’s Brandenburg. “Issuers need to understand that they need to protect senior with more capital and manage high total capital ratios.”

For some investors, it is not just an issue of capital, but that other types of bank debt – including contingent convertible bonds – now look a lot more attractive.

“I think more investors will rethink this asset class, and even CoCos might lose the perception of being kind of dodgy,” said Assenagon’s Hunseler.

“If not just spreads but also rates rise, then senior bonds may become the riskiest part of a bank’s capital structure to invest in, as the low running yield offers little buffer against losses.”

Market participants said the two transactions should act as something of a wake-up call, showing that access to senior funding has got that much trickier for some banks.

“How will weaker credits get a deal done? How much will they have to pay?” asked a head of FIG DCM.

Greek questions

Investors may get a better idea of the new scenario as Greece looks to reach agreement with the ECB over the coming months about how to recapitalise its beleaguered banking sector.

During the fraught negotiations in the summer with its creditors, Greece estimated that €25bn might be needed to fill this hole, more than previously thought after a run by depositors depleted the four major banks of liquidity, forcing their closure and the imposure of capital controls.

As part of the latest bailout agreement thrashed out on July 13, Greece was obliged to pass its own version of the BRRD measures into national law. However, it stated that the bail-in element for senior debt would only take effect from January 1.

Greece, under the aegis of the eurozone’s new banking regulator, the ECB, is now conducting stress tests on the banks to see how much capital is in fact required. The plan is then to decide how that should be raised and put into the four institutions.

If the €25bn of fresh money earmarked to recapitalise banks is used before the end of the year, then bondholders may escape.

“The big question is, are the authorities going to keep the [Greek banks’] existing corporate shells as they are and then bail in bonds and other liabilities as necessary or will they follow what was done with BES in Portugal, for example, and create a good bank/bad bank, leaving most of the liabilities, including many of the bondholders, behind in the bad bank?” said Stephen Phillips, restructuring partner at law firm Orrick.

“The latter might be the easier thing to do, as it gives a clean start for the good bank and might aid economic recovery as the new bank will start with a clean balance sheet. This will undoubtedly upset bondholders, who, with careful negotiation with the authorities and the banks, may well want to participate in new capital if a private sector solution was considered.”

The BRRD was supposed to harmonise the regime in Europe for banks in distress. It seems to be doing anything but. Unilateral decisions are creating an increasingly fragmented environment, making it difficult for investors to know what to compare with what.


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