Tim Skeet, Managing Director for RBS Financial Institutions Group
The degree of encumbrance is not just a theoretical concern. In the event of another crisis, creditors will want to know to what extent they are at risk of being bailed-in (in other words, having their debt written down in value or written-off completely). Secured creditors will be exempt from these provisions and given preferential treatment if a bank does fail. The example of the Cyprus rescue package has added fresh fuel to the debate.
European banks have increasingly used secured funding to raise wholesale liquidity, partly in response to investor appetite. Regulators are aware of the situation but, as the EBA made clear, measuring the extent of the collateral pledged remains incomplete. Overall, however, levels of encumbrance remain modest, although some investors are now calling for the extent of encumbrance in the banking system to be clarified.
The shift from senior unsecured funding to lower-cost secured funding has seen several sources of encumbrance being tapped. These sources include the covered bond sector and less visible forms of collateral-hungry funding options, such as repos, some aspects of securitisation, assets pledged against derivatives exposures, and assets pledged to central banks (including the Long-term refinancing operation, LTRO).
'Unsecured creditors face the prospect of being subordinated to lengthening lines of secured creditors.' As unsecured creditors face the real prospect of a future bail-in, they also face the prospect of being increasingly subordinated to lengthening lines of secured creditors, including the central banks. As a result, you might expect them to charge higher spreads and reduce their appetite for these risks. To complicate the situation further, an even greater potential source of subordination could result from proposed depositor preference rules which would put bank depositors ahead of other creditors.
Should investors be concerned and should regulators take action?An International Capital Market Association (ICMA) working group held a number of meetings with various investors, issuers and regulators last year to debate the topic. Broadly, the conclusions were that encumbrance levels should be neither a source of particular concern nor the subject of further regulatory action. However, the group noted that there were uncertainties surrounding the attitude of different banking authorities and concerns over the possible impact of arbitrarily determined encumbrance limitations.
The EBA has now had a preliminary stab at a common definition for encumbrance, and enhanced regulatory reporting, but there is no easy way for investors to calculate it from available public data. Still, several of the strongest banks in Europe, particularly the Nordic ones, have comparatively high levels of encumbrance, although these same banks enjoy strong access to the senior unsecured funding markets. Moreover, Nordic bank encumbrance levels reflect the traditional use of covered bonds, often through their domestic markets. This reinforces the point that encumbrance levels are dictated by business models and local custom. Any regulatory response needs to take account of these regional differences, different types of encumbrance, and the funding flexibility of individual banks.
However encumbrance is defined and measured, there remains the need for investors to assess the risk of investing on a senior unsecured basis. Investors will take comfort from the greater capital and liquidity cushions and closer regulatory scrutiny currently enforced, but they are likely to look for better disclosure levels. There is a strong incentive now for the strongest banks to publish useful measurements, such as the ratio of high-quality unencumbered assets to unsecured liabilities. Further discussions between the issuers, investors and regulators will help to clarify the best course of action and this will form part of the ongoing work of the ICMA.
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The views expressed are those of the author and do not necessarily reflect the views of RBS or ICMA.
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