Recent events in Cyprus highlight the growing pressure on European senior debt and the risks which still exist across Europe. Senior financial debt in particular is the most at risk from a repricing of the risk premium in European assets due to bail-in legislation, depositor preference and rating agency reassessment of support notching methodologies. Since the GFC, the market and rating agencies have removed the assumption of Government support for subordinated and Tier 1 hybrid bank securities. However, this assumption of support still remains for senior debt, but for how long?
Events in Cyprus have prompted rating agencies to probably sooner rather than later reassess their support methodologies, and in combination with the Recovery and Resolution Directive (RRD, or bail-in directive) expected over the European summer, may be catalysts for repricing.
We have previously discussed in detail global banking reform, bail-in and its impact on investments (please click here for the full report). This report highlighted a variety of tools being implemented to share the burden of bank failure across the capital structure. The main tools in Europe are ‘good bank/ bad bank’ regulation giving regulators the power to separate clean and toxic assets through a partial transfer of assets and liabilities and ‘bail-in’ where creditors, including senior bondholders are to take a loss relative to their position in the capital structure. As the RRD proposal currently sits, good/bad bank regulation is to come into force in 2015, while bail-in is due 2018. The proposals are due to be finalised around June/July this year. However events in Cyprus demonstrate that senior debt is already at risk from good bank/bad bank powers.
Depositor preference in Europe
In Europe, senior bank debt has ranked equally with depositors (unlike in Australia where deposits rank above senior debt i.e. depositor preference). This means that if regulators/governments want to impose loss on senior bond holders, they would also have to include depositors – which is significant and has systemic implications. This therefore has supported the credit quality of senior debt in Europe, with rating agencies incorporating this into their models by providing notches of uplift to the ratings.
The RRD proposal as it currently stands still does not give depositor preference (although depositors are exempt from bail-in). However this may change when the RRD is finalised in June/July. Despite being stipulated as part of Portugal’s initial bail-out package, only a few developed countries including Russia, Switzerland, US and Australia have forms of explicit depositor preference (the UK plans to introduce depositor preference in 2015). While the most recent draft of the RRD did not have any explicit reference to depositor preference, it was included in earlier proposals.
A concern is that there is building pressure to include depositor preference. Events in Cyprus and the way resolution tools were implemented (discussed below) highlight the support for some form of depositor preference. The UK already has depositor preference as a key feature of the Independent Commission on Banking (ICB) proposed legislation. Some support for depositor preference was also voiced by the ECON (Economic and Monetary Affairs) Committee of the European Parliament.
Further to this on the 6 April, European Commissioner for Economic and Monetary Affairs Oillie Rehn said that RRD they are drafting would provide for "investor and depositor liability….be carried out in case of a bank restructuring or a wind-down". Rehn added that "there is a very clear hierarchy, at first the shareholders, then possibly the unprotected investments and deposits. However, the limit of €100k is sacred, deposits smaller than that are always safe."
Most compelling however is that last week European Central Bank (ECB) president Mario Draghi advocated full depositor preference “as applied in the US”.
The fact that politicians are still taking it seriously suggests senior unsecured bond holders should do the same. If senior debt was to no longer rank pari pasu with depositors it would expose it to higher risk (higher risk of loss and higher loss given default), which would need to be reflected in pricing and ratings.
Cyprus and bail-in
Regardless of whether explicit depositor preference is included in the final RRD, the current draft already contains a form of depositor preference in the guise of the good bank/bad bank regulations. Article 34 states that
“resolution authorities have the power to transfer all or specified assets, rights or liabilities of an institution under resolution…to a bridge institution without obtaining the consent of the shareholders of the institution under resolution” (EC Directive for Establishing a Framework for the Recovery and Resolution of Credit Institutions, June 6, 2012)
This has been illustrated in the case of Cyprus:
Cyprus bank Laiki was the first senior debt bail-in in the EU, outside of Denmark (Amagerbanken and Fjordsbank last year) and the first in a Euro-zone country. Without insured deposit preference, the workaround for protecting deposits below €100k was the good-bank/bad-bank split, rather than a straight liquidation. Given Cyprus does not have depositor preference or a funded generic deposit guarantee scheme, shifting deposits and secured funding to a good bank (i.e. Bank of Cyprus) was a way around the issue of senior debt and deposits being pari passu and is thus a form a depositor preference.
While the initial RRD draft last June allowed for the bail-in of senior debt from 2018, the events in Cyprus demonstrate that senior financial debt is already at risk from the good bank/bad bank powers which are already included in the RRD proposal. The power to move assets to a ‘good bank’ will come in the RRD from 2015 (and is already part of many existing resolution regimes in Europe). Bail-in therefore doesn’t necessarily need to be implemented for seniors to take losses in a resolution scenario and is therefore a risk for spread performance of senior debt.
Further to this German, Dutch and Finnish finance ministers have advocated bringing forward full senior debt bail-in powers to 2015. Some commentators (e.g. Morgan Stanley) believe this as well as depositor preference will be included in the RRD as “both these measures are easy political ‘wins’ on the path toward European Banking Union”.
Again, the most compelling evidence comes from ECB president Mario Draghi who last week suggested that senior bail-in should be bought in early “for example 2015” and advocated full depositor preference “as applied in the US”.
Ratings agencies
The 2015 implementation date of the RRD along with good bank/bad bank resolution (whether or not it includes full bail-in or depositor preference) brings us into the ratings horizon.
Moody’s was the first to remove support from ratings of subordinated debt in 2011, followed shortly thereafter by Fitch and S&P. Senior debt however continues to benefit from sovereign support considerations at all three agencies. The events in Cyprus suggest that the removal of support from senior debt ratings is now one step closer and the finalisation of the RRD later this year may be a further catalyst for rating agencies to reassess their sovereign support assumptions – which may lead to multiple-notch downgrades for senior debt across the board.
It is however very hard to assess how the agencies may adjust their models or manage any transition.
Recently and in response to developments in Cyprus, Moody’s stated that “policymakers’ willingness to endorse depositor losses and risk financial system disruption, in order to limit the overall costs of a bailout for a government whose debt burden they consider otherwise unsustainable, is credit negative for senior bank creditors across the euro area” and that “policymakers’ apparent view that short- and long-term contagion risks can be contained, or are worth bearing, is a significant evolution in policy towards eliminating or reducing support for bank creditors” (Credit Negative Consequences of the Cyprus March 25, 2013). This is in line with Fitch’s comments in which they stated that “the Cypriot crisis demonstrates that there could be a more rapid removal of support than they had previously anticipated” (Cyprus Stalemate Shows Dangers of Ad Hoc Crisis Response, March 21, 2013).
The U.S.
While rating agency support considerations of US banks have less of an immediate focus as compared to Europe, the agencies have clearly stated these will reduce over time. Most recently Moody’s ("Reassessing Systemic Support in US Bank Ratings, 27 March 2013), highlight how the challenges that remain surrounding the implementation of the Orderly Liquidation Authority (OLA) have to date led Moody's to maintain systemic rating uplift in its credit assessments of eight US banking groups (e.g. Morgan Stanley, Bank of America, Goldman Sachs). The rating agency however expects to update its support assumptions for these banking groups by the end of 2013 “either maintaining or lowering them”.
Possible impacts on individual banks
Estimated average senior ratings impacts of support removal
Source: S&P, Moody’s, Fitch, Morgan Stanley Research. Please note actual ratings cannot be disclosed to a retail audience.
Figure 1
Figure 1 illustrates estimates of the impact on average ratings if support was removed from all three agencies (please note that actual ratings cannot be disclosed to a retail audience). Banks that continue to have government capital support are colour grey; it is likely support considerations for these banks will remain at least until this aid is repaid. Note the extent of senior debt ratings “uplift” that exists for assumed government support, with most banks in Europe receiving a rating of two or three notches higher than would be the case if no support was assumed.
In the UK, the government plans to introduce legislation by May 2015 that would include bail-in powers and depositor preference. In a Moody’s report on Barclays (November 2012), the outlook for senior ratings is on negative outlook, reflecting the agency’s view of “lower systemic support for large UK banks over the medium term”. Given the pending implementation of this regulation and clear political intent to limit future state support, the UK may be one of the first jurisdictions to have support consideration removed from ratings. However for banks like RBS and Lloyds where the government continues to hold 82% and 39% of the companies respectively, support notching may remain until this is repaid.
There is also strong political sentiment in the Netherlands regarding future state support of financial institutions. In late January, Dutch finance minister Joeren Dijsselbloem stated that he advocated EU rules allowing all bond holders to share in future losses, saying that all types of bonds should fall under bail-in. Dutch bank support could also come under pressure in the short term, though we note that ABN and ING continue to repay state-aid.
In the rest of Europe, the finalisation of the RRD has the possibility of impacting support at all banks. It is also likely that this will have a bigger impact on banks which slide more towards the BBB range (e.g., French and Austrian banks). For example, if support were removed, Societe Generale’s senior ratings would fall 3 notches at one ratings agency, whilst its subordinated debt ratings would remain stable.
Senior financial debt therefore remains the most at risk from a repricing of the risk premium in European assets.
Alternatives and switch ideas
Figure 2
Despite the increased risk, senior European financial debt has performed very strongly over the last six months and in general terms there appears to be some complacency in the market given the plethora of negative macro conditions which still exist. This is consistent with our commentary detailed in the de-risk and diversify strategy paper produced in February this year. Figure 2 illustrates the performance of European financial bonds as illustrated by CDS (credit default swap) spreads. The lower the Bps spread the lower the perception of risk and the better the performance of the underlying bonds. You can see the improvement by this measure from around 300bps to around 200bps currently.
This therefore provides an opportune time for investors to consider rebalancing their portfolios given the risks which exist specifically for these particular bonds. Options available which remove some of this risk include switches into:
- Longer dated Australian infrastructure
- Government or state government bonds
- Domestic bank paper
- Inflation protected securities
Conclusion
For clients holding senior European financial bonds it is important to be aware of issues that would expose these to higher risk, and the subsequent impact on pricing and ratings. Whether or not full bail-in powers are bought forward or depositor preference included in the final RRD, the events in Cyprus as well as the apparent strengthening of political will and recent comments by rating agencies put more negative pressure on these securities. The removal of support considerations for senior debt ratings therefore appears one step closer and the finalisation of the RRD later this year may provide another catalyst for rating agencies to reassess their sovereign support assumptions – which may lead to multiple-notch downgrades and repricing for senior debt across the board. It is however very hard to assess how the agencies may adjust their models or manage any transition.
Despite these risks, A$ European senior debt from issuers such Societe Generale, BNP, Lloyds and RBS has rallied significantly over the past 6 months or so. We believe any investors that continue to hold such names should consider the relatively small upside but large potential downside from holding these bonds given the degree of regulatory and economic uncertainty that exists in Europe, contrasted with the stable economic and moreover regulatory conditions that exist in Australia. While not as immediate investors should also be aware of similar issues in the US, which have the possibility to affect names such as Morgan Stanley and Goldman Sachs.