Farewell senior debt … it’s been fun

6 min read

IFR Editor-at-large Keith Mullin

IFR Editor-at-large Keith Mullin

The concept of removing implicit government support to failing banks and getting taxpayers off the hook is clear. But here’s the question: is the cost of dispersing the pall of moral hazard a cost too far?

Whatever the final outcome of the EU resolution regime, it will alter banks’ capital structures and make the cost of capital much more expensive for many banks to the extent that it undermines their ability to be ROE-positive. Senior debt as we know it today could be consigned to the history books.

This is serious stuff. Alas, debate around the impact of making senior debt bail-in-able is getting drowned out or sidetracked amid the general cacophony around whether the EFSF or ESM can directly recapitalise banks as well as the grand discussions about future EU-level banking and supervisory union –including harmonised bank insolvency and deposit-protection regimes and mutually-supportive EU resolution funds – as key planks of broader fiscal union.

The fate of Spain and its bail-out lite (i.e. that perilous bank-only bailout with no macroeconomic conditionality) is also hogging attention.

Bail-in demands an open and clear debate. It’s not a new subject, for sure, but now we’ve reached final EC draft stage, it’s going to be hard to make major changes or fight rear-guard actions. On the basis of the sheer amount of political will being expended on making at some level senior debt bail-in-able, the rules will make or break the senior unsecured bond market; to what extent contingent merely on the nuances and specifics of the final rules.

I keep hearing about this fabled new investor class that’s going to appear like magic to buy up all this ‘no longer quite so senior’ senior debt. I don’t see it.

The EC could unwittingly undermine banks’ ability to secure efficient funding in sufficient volume to finance their operations at acceptable cost. ROEs are already under severe pressure. The loss of a major funding market that could easily emerge if senior unsecured debt is polluted with bail-in language could have a dramatic impact on banks’ business strategy and dramatically impede their ability to conduct business that covers the cost of funding it.

In normal times, banks set their strategic courses and secure funding to underpin and support their business models. The tables have been turned in the current crisis. Access to and conditions of funding are increasingly dictating bank strategy.

In an environment in which ECB liquidity is a mainstay of European bank funding; where interbank markets are dysfunctional; where channels such as securitisation are closed as viable sources of volume funding, lawmakers need to tread extremely carefully to avoid disrupting the senior unsecured market, a bread and butter term funding market for banks.

Covered bonds are the new senior’ is an oft-uttered slogan these days, but lawmakers shouldn’t put undue pressure on the instrument and assume they will carry the day. Issues of asset encumbrance and pool transparency will only become more pressing. With banks pledging assets as collateral in all manner of ways (central banks, derivatives trading, repos etc), issuance of covered bonds with high-quality cover pools is far from limitless.

Short window

The senior unsecured issuance window is running dangerously short. Banks wanting to issue five-year senior debt that matures before the bail-in regime kicks in in 2018 only have until the end of this year. Given current market dislocation, that maturity is already likely to prove elusive for many banks.

Senior bank investors are adamant they won’t touch bail-in-able debt or contingent convertibles even if such debt doesn’t write down or convert until equity and subordinated debt have been wiped out – unless they get paid handsomely for it.

It’s unclear how all of the resolution tools – bail-in, bridge bank, asset separation, sale of business – will interact, if there will be any formal tool sequencing, and whether tools will be invoked on a going concern or gone-concern basis. It’s also unclear if the bail-in triggers will kick on the basis of regulatory diktat or some other metric. If regulators want to maintain high levels of discretion, including timing and selection, over the use of resolution tools, particularly ahead of formal insolvency proceedings, that will put senior unsecured debt even further beyond redemption as an asset class in the eyes of senior creditors.

It’s all well and good for regulators to demand that banks maintain a layer of loss-absorbing-cum-bail-in-able capital, but then again they don’t have to concern themselves with the thorny issue of who is going to hold it and at what price. This issue goes beyond weaker banks improving their overall credit profiles to demonstrate to potential creditors that the likelihood of bail-in is unlikely or remote. For investors, it’s not a credit issue; it’s an issue of principle.

I keep hearing about this fabled new investor class that’s going to appear like magic to buy up all this ‘no longer quite so senior’ senior debt. I don’t see it. The EC also speaks of hybrid capital structures creating a new layer of subordinated debt that sits between senior and proper capital-absorptive subordinated debt that protects senior creditors.

I’m sure product innovation will solve specific problems of specific banks. But I just don’t see a whole new type of senior-subordinated debt emerging in what can be called an asset class.

Lawmakers will have to figure out what they want and be clear about the consequences. And sooner rather than later.

(See also: Top bankers back EU resolution moves )

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Keith Mullin with border 220