LONDON, April 5 (IFR) - Are the European Commission’s debt bail-in proposals really a massive hindrance to fixed-income investor buying in bank new issues? Predictions of impending disaster are rife, but the view that burden sharing is already priced in is hard to ignore.
The debate was reignited last week by the release of a consultation paper on how to optimise the use of write-down features in senior debt. The document lists a series of possibilities and questions, but gives no clues on the Commission’s actual view.
Morgan Stanley analysts regretted that the Commission “is not showing its hand on what it is thinking and, in essence, it is leaving all options open as well as pushing the need to make a final decision further into the future.”
Many market participants assume that from the moment of implementation, new senior bank debt will become more expensive, because investors will seek greater protection against bail-in risk. If the Commission decides to make the existing stock of debt bail-inable, then the repricing could occur much earlier.
According to Keval Shah, head of FIG syndicate at Citigroup, this debt write-down tool is “the elephant in the room that the market has largely tried to ignore.”
Bail-in would impose losses on shareholders and creditors and the Commission said the tool could be used both in a going concern and a liquidation scenario. In the former, bail-in would be used to absorb losses and recapitalise the entity, while in the latter it would be used to wind down the entity.
The ultimate goal is be create a mechanism to “stop the contagion to other banks and cut the possible domino effect” without taxpayer money.
Shah warned that the debate over bail-in creates 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,” Shah said.
Excluding the existing stock of debt from burden sharing rules would help the market adjust to the new reality, Shah added.
“For new issuance, ratings too, will be a factor, as it could have a knock on effect on market depth. There are several downside risks and I‘m not sure the market has fully come to terms with them.”
Fitch gave an idea of what could be in the offing, indicating this week that currently more than one third of its western European bank ratings are at higher levels than they would be if bail-in legislation was in full force, in some cases by several notches.
Some bankers and investors who believe a repricing is on the cards point to Denmark, where senior debt holders have had burden sharing inflicted on them. They suggest Danish banks now have to pay up to 100bp more than other Scandinavian issuers for this reason.
JP Morgan analysts have more dramatic numbers. In March they estimated the incremental risk premium for contingent features at 345bp on average, using the differential between existing senior contingent notes and plain vanilla senior unsecured from the same issuer (Rabobank) as a proxy for the bail-in premium.
Edward Stevenson, head of FIG DCM at BNP Paribas, argues that the debate over bail-in is largely irrelevant. And he is not alone.
“It has already been mostly priced in by the market. The good banks that can access the market will continue to be able to do so with or without bail-in legislation in place. Spreads will be dictated by how robust market conditions are,” he said.
Investors who are really concerned that a bank may default simply don’t buy its senior debt, he added. Stevenson also cautioned against reading too much in the Danish case:
“The spreads required by investors to buy Danish bonds are as much a reflection of the strength of the banking sector in Denmark, the state of the economy and the banks’ ratings as the bail-in clauses.”
The level of investor disquiet over Denmark cannot have been lost on the Commission. How to create a tool that would aid a failing financial institution, without the need for a public bailout, but not destabilise the primary market for senior debt which remains highly vulnerable?
Bank of America Merrill Lynch analysts said there is much at stake: “In our view, this paper damages financial stability today and is unlikely to contribute to it tomorrow.” They point to two key areas of concern.
The first is the possibility that the existing stock of debt could now be touched by bail-in (despite previous protestations to the contrary), and that the priority of claims could be less clear if long-term debt gets structurally subordinated to short-term debt and bondholders’ claims get extinguished while shareholders’ apparently may not.
The Commission is now seeking feedback on the discussion paper and intends to make its proposals before the June G20 meeting of heads of state and government.
The proposed legislation is expected to be published later this year. Fitch thinks it would make sense for full implementation to happen around the same time as Basel III is due: in 2019.
The EU cannot really afford to get the balance wrong given how important the cost of raising new debt is for banks.
Exane BNP Paribas’ analysts argued in a report that most of the sector has a “breakeven” senior unsecured spread materially below the level at which credit markets are currently trading.
In other words, if the current credit spreads were to represent a long-term equilibrium and revenues and costs could not be improved, the majority of the European banking sector would be making less than their cost of capital, the analysts said. (Reporting by Jean-Marc Poilpre, editing by Alex Chambers)