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Tuesday, 24 October 2017

Reshaping the future of funding

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The European Commission released on June 6 a set of proposals aimed at eradicating the “too big to fail” concept and force bondholders to share the burden when banks run into difficulties. “Bail-inable” bonds will reshape the bank funding market, but only gradually.

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Senior unsecured debt used to be cheap for banks to issue as investors focused on the bonds’ seniority, overlooking the fact that they were unsecured. Under proposals put forward by the European Commission, the senior unsecured debt of a failing institution could be converted into equity, significantly reducing the benefits of seniority while making unsecured debt particularly vulnerable relative to other types of debt, notably covered bonds.

“The introduction of bail-ins is understandable given the scale of the financial crisis,” said Sebastien Domanico, head of FIG debt capital markets at SG CIB. “This is a political move aimed at comforting investors to continue and invest in bank paper while ensuring that everybody shares the burden, including creditors.”

In his view, however, this tool is unlikely to be used since European banks that run into difficulty usually fall victim to a liquidity crisis rather than actual losses.

But, according to the European Commission, a new resolution regime with extended burden-sharing is needed. The Brussels-based body pointed out that the level of state support to ailing banks deemed “too big to fail” has been unprecedented since the outset of the crisis and “it is clearly undesirable for public funds to be used in this way at the expense of other public objectives”.

The Commission published on June 6 its long-awaited Crisis Management Directive draft, which is supposed to provide both more comprehensive and effective arrangements to deal with failing banks at national level, as well as complete arrangements to tackle cross-border banking failures. For holders of senior debt, the documents clarified several key questions that had been left open in previous consultation papers.

Precise timing

The timing, in particular, is slightly more precise. The Commission indicated that the bail-in tool should apply as of January 1 2018 to “all outstanding and newly issued debt”, both senior and subordinated. Over the past months, market participants had been debating whether the Commission would make all the existing stock of debt bail-inable.

“Confidence and stability in the financial system will be enhanced when major banks that get into difficulties can be put through an orderly, internationally co-ordinated process to resolve their insolvency or illiquidity without creating destabilising systemic shocks”

If this had been the case, investors feared that the measure could have kicked in well before 2018. But 2018 is more a suggested deadline rather than a starting point. BNP Paribas analysts noted that the phrasing of the proposal suggests that bail-in powers “could potentially be used as early as 2015, although the EU authorities recommend that they be used by 2018”.  

The Commission also recommended that at least 10% of liabilities be bail-in-able, but the final say will remain with each national regulator.

At the big-picture level, the Commission’s proposals are viewed as broadly positive. Participants at the Institute of International Finance spring meeting in Copenhagen on June 7 suggested that these attempts to harmonise the EU’s banking resolution rules might reduce the need for other regulatory measures, in particular requirements that larger institutions hold greater levels of capital.

“This is an opportune moment to consider whether there should be a pause in adding further to the aggregate of regulatory reform already in place and in train,” said Douglas Flint, chairman of HSBC, who also chairs the IIF.

“Confidence and stability in the financial system will be enhanced when major banks that get into difficulties can be put through an orderly, internationally co-ordinated process to resolve their insolvency or illiquidity without creating destabilising systemic shocks,” he said.

At a more micro level, things do not look so good because bail-ins will affect banks’ cost of funding and modify the characteristics of the bonds, thereby potentially reducing the universe of investors allowed to invest in the new, bail-inable bonds.

Keval Shah, head of FIG syndicate at Citigroup, described back in April this debt write-down tool as “the elephant in the room that the market has largely tried to ignore”.

Shah warned that the debate over bail-in created uncertainty and this in turn could bring volatility. “It is possible that many funds may not be able to hold bail-in bonds simply because it is not within the remit of the managers to hold bonds that risk losing capital if the point of resolution is not clearly defined and understood, or the hierarchy of the capital structure is not respected,” he said.

Higher cost

Moreover, higher risk should mean higher cost for issuers. The European Commission conceded that its proposals might make unsecured bank debt less attractive to investors, estimating the extra cost 5bp to 15bp on average. “Subtracted from the expected benefit in terms of GDP of a lower probability of systemic crises, this translates into a net yearly benefit of 0.34%–0.62% of EU GDP,” the Commission claimed.

“Admittedly, we have no hard figure to contradict the EC but we would be surprised if it were to be that limited,” SG analysts commented.

HSBC analysts think the incremental cost could be around 150bp, and the total cost of issuing the bail-inable debt for the bank even higher. In March, JP Morgan analysts estimated the incremental risk premium at about 345bp, using notes issued by Rabobank as proxy.

In a more normal and stable market, a mild repricing of longer-dated debt should probably have occurred following the release by the European Commission’s proposals. But 2018 looks quite distant when the situation in countries like Spain and Greece changes so fast.

“The proposal is more or less as expected, with a long period before implementation rather than formal grandfathering,” said Robert Montague, senior investment analyst at European Credit Management. “This may steepen the curve for maturities after 2018 and reduce the incentive for issuers of undated or long-dated subordinated debt to exercise calls.”

But so far, little is happening. Few banks have long-dated senior bonds outstanding and the issuers in question are often among the strongest ones. One trader also pointed out that the limited new supply and large amounts of cash available make the technical backdrop unfavourable for a repricing. But more fundamentally, the market now focuses on the very short term and 2018 is a long way off, he said.

BNP Paribas analysts expect some price action earlier. “If our understanding that bail-in could apply as early as 2015 and at the latest by 2018 is correct, then we could see further steepening of the curves before 2015 and after, especially from 2018 onwards,” they said in a report.

How much debt?

It is far from clear how much senior bail-inable debt should be issued. On the one hand, it is not known for sure what will count towards loss-absorbing capital; on the other hand, new instruments may reduce the need for issuing senior debt.

On the first point, HSBC analysts noted that the key is whether deposit guarantee schemes (DGS) can loss-absorb. In their view, “if they can, it’s good for banks. But we think the bail-in of DGS might be politically unacceptable”. 

Based on ECB data, for the eurozone (plus UK domestics), HSBC estimated that a 10% target of bail-inable capital (Tier 1, Tier 2 and bail-in liabilities) equates to around €3.6trn. In turn, after allowing for existing Tier 1 and Tier 2, this would imply the need for €1.1trn of eligible bail-in liabilities. However, if each country’s deposit guarantee scheme was bail-inable, then the picture changes radically as HSBC estimates that deposits covered by DGS stood at almost €5.5trn as of March 2012, more than five times its estimate for required bail-in liabilities.

But these schemes are not currently pre-funded, so a bail-in of a DGS today would essentially require taxpayers to in turn bail-out the DGS, HSBC noted.

On the second point, the Commission’s draft explicitly makes allowances for banks to issue specific subordinated debt instruments that would absorb losses after regulatory capital but before any senior debt. The debt would be different from Tier 2 and Additional Tier 1 under CRD4.

Bankers are hopeful the asset-class could grow substantially and make up a large part of the subordinated debt market which has ground to a halt due to regulatory uncertainty and reduced investor appetite. 

“The draft Directive allows for a new class of bail-inable bonds which could be issued in significant size,” said AJ Davidson, head of hybrid capital structuring at RBS.

“Given that the maturity could be between one and five-years, in theory, it could be cheaper than Tier 2 debt that needs to have at least a five-year maturity. Banks could use this layer as part of their funding and capital management strategy.”

His view was echoed by Gerald Podobnik, co-head of capital solutions at Deutsche Bank. “The extra layer between a bank’s own funds and its senior debt should protect the latter and therefore allow banks to build a cushion which should make senior debt less risky and therefore less expensive.”

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