Two types of bank issuer have taken advantage in the primary market. Banks from the periphery have sold senior unsecured bonds. Banks from the core have issued AT1, the new contingent capital deals that suffer either temporary write-down or conversion into equity if issuers breach triggers on their common equity tier 1 ratios.
Both types of deal have met heavy over-subscription in recent weeks and the kind of inflated order books reminiscent more of tech IPOs at the height of the internet boom.
Thats an obvious worry. But one reason why investors have been happy to take the risk of buying these deals: there is a strong feeling abroad that Europe is making good progress on the road to banking union, with a credible regulator in the European Central Bank soon subjecting banks to uniform regulation and chipping away at some of the fudges on asset quality that national regulators have previously winked at.
Are investors too sanguine? Credit analysts certainly welcomed as a big positive for financials the outcome of marathon, late-night negotiations between the European parliament and European finance ministers last month that allowed legislation on a single resolution mechanism (SRM) and a single resolution fund (SRF) to stay on track for early passage through the parliament this month.
It looked to be a bold step forward that the role of national government finance ministers in any resolution of a failing bank will now be limited, removing the danger of national interests and wide-ranging national vetoes making any decision hard to reach. Now with the ECB and the European Commission to take lead roles in a more streamlined process, the notion of a new type of banking resolution over the mythical weekend between close of US markets on a Friday and Asian opening on a Monday suddenly seems much more realistic.
It also sends a strong positive signal that the 55 billion SRF, to be subscribed by the banks themselves, will now ramp up more quickly than earlier envisaged, over eight years rather than 10. And although the fund will be built up initially in national components, most crucially of all fully 40% of the fund will be mutualized from year one and 60% from year two, with the remainder to follow over an unspecified period. Whats more, the fund will be able to borrow to boost its firepower in the early build-up phase. Meanwhile, it will still be possible that any financially stretched government needing to inject more capital into a failing bank than bail-in of creditors can supply, can access the ESM.
But theres one small quibble and a very big one. Its still not quite clear on what basis banks will be required to subscribe to the SRF and here there is potential for national conflicts of interest. If it is to be levied on the size of deposits, that might hit German banks hardest at a time when the ECB is proclaiming the inherent strengths of banks funded mainly through deposits. If subscription is calculated on total assets, that might hit the large French banks hard: if levied on risk-weighted assets, that might hit the Spanish banks, which have a higher RWA density.
The big worry is a simpler one. The mouse in the room is the small size of the resolution fund. Alberto Gallo, head of European credit research at RBS, points out that a 55 billion fund for a European banking system still three times Europes GDP and with 30.5 trillion of assets, still pales in comparison to potential bank losses in a 2008-like crisis. Today it would be enough only to rescue a single national champion bank even after bail-in, or two or three medium-sized banks.
So its far too optimistic to claim that the SRM and the SRF achieve their stated aim of breaking the feedback loop between sovereigns and banks.
To really reduce contingent sovereign liability from the banking system, banks either need to become much smaller or much better capitalized. Gallo suggests that while the European regulatory minimum leverage ratio is set at 3%, it needs to be at 5.5% to 6%, closer to the level US regulators are targeting. That would require banks to raise much more capital or reduce assets even further than they already have. And while talk of further deleveraging might seem unpalatable as policymakers hope banks are sufficiently restored to lend into recovery, its either that or a much bigger resolution fund.