Barnier had delayed this key feature of the regulatory overhaul amid the financial panic at the start of the year. His plan now is to iron out the final details of how creditors will bear the costs of recapitalizing banks and to put final proposals to the June G20 meetings of heads of state.
No sooner had Barnier announced his determination to finalize quickly the remaining key questions of the triggers and timing for applying debt write-downs, which debts should be written down and to what extent to ensure restoration of banks’ essential functions, as well as the hierarchy of creditor claims, than the key pillars supporting benign financial conditions in the first quarter began to falter.
Weak economic indicators at the start of April revived fears of recession and with them the burden of bad debts on banks. Sovereign-risk fears revived and financial markets saw more risk-off days. Citi economists now suggest Spain could need a troika deal to ease it through a temporary pricing out from private debt markets this year.
Once again, investors in bank debt face concerns that closed the funding markets to bank issuers last year: their de facto relegation below not only depositors but also secured creditors in banks’ capital structure at a time when bank balance sheets are ram-jam full of doubtful assets. For as long as uncertainties abound over bail-in procedures and structural subordination, the market for wholesale bank funding cannot achieve any stability.
The Institute of International Finance (IIF), the banks’ own lobbying group, in its April Capital Markets Monitor, points out that the ECB’s three-year LTRO, while appearing to restore banks’ access to wholesale markets, exacerbates the problem of structural subordination for bank bondholders. To access the ECB’s liquidity facilities, banks have had to pledge more assets even as the amount of collateral also being pledged in collateral swaps, covered bonds and repo transactions has risen significantly. European banks have some 20% of their balance sheets encumbered, although there are wide national variations, with the largest recent increases being for those banks most dependent on ECB liquidity. Much of that encumbrance – especially as it applies to covered bonds that are a prominent feature of funding for banks in Greece, Spain, Ireland and Portugal – will be of better-quality assets.
The IIF says that encumbrance has been exacerbated by the emergence of other forms of collateralized funding. Some market practitioners report that funding backed by inventories or commodity-related receivables is now more commonplace. This greater reliance on secured funding leaves less collateral to satisfy unsecured creditors if a bank hits trouble, at a time when bail-ins would further subordinate them to other unsecured creditors, notably depositors. Credit analysts at Citi draw a comparison between bank bondholders today and investors in CDOs before the financial market crisis of 2007/08.
Investors thought they were buying into a fat, well-rated super senior tranche. But it now looks like they are in a thin sliver of quite risky mezzanine exposure. Even if eventual draft legislation on bail-ins ranks bondholders notionally pari passu with depositors, the expectation now must be that regulators would make the rules up as they go along and not treat bondholders the same.
So, even though the LTRO has bailed out bank creditors today, by ensuring that banks won’t fall over due to a lack of funding options in 2012 or 2013, the price of this relief and reduced likelihood of default in the short-term might be a much higher loss given default in the long term.
There is, meanwhile, no appetite among banks to improve creditor protection by raising equity when their shares are still trading at discounts to book value and managements are targeting low double-digit returns on equity but delivering low single-digit returns.
The amount and cost of wholesale funding available to banks remains uncertain, even as they struggle to grow deposits. Bank issuance of senior unsecured stalled again in April. It is a reasonable bet that the amount available is likely to go down and the cost to remain elevated. And that raises its own disturbing questions over the economics of banks’ core lending businesses and their very raison d’être.
