Slipping down the ranks

Germany took the market by surprise when it raced ahead last year with a proposal to subordinate senior unsecured debt in the insolvency of its banks.

For all its simplicity, other countries have not followed suit, creating a patchwork of different bail-in regimes across Europe that is proving a nightmare for investors wanting to invest in the region’s bank debt.

Germany passed the Resolution Mechanism Act in November 2015, subordinating senior unsecured bonds to deposits and derivatives but keeping them senior to contractually subordinated debt, such as Tier 2 capital.

The new law, which will be retroactive when it takes effect on January 1 2017, ensures that institutional investors rather than the taxpayer shoulder the losses in future banking crises.

“It is clearly one of the simplest and clearest solutions, to clarify the ranking of senior unsecured bonds versus other excluded liabilities,” said Christoph Hittmair, head of European FIG DCM at HSBC.

It sets out a bail-in hierarchy that should provide clarity and legal certainty in insolvency.

Furthermore, by being applicable retroactively, it has effectively removed the need for German banks to raise billions of euros of additional loss-absorbing debt to meet European and global regulatory requirements.

Globally systemic banks such as Deutsche Bank must have 18% of their risk weighted assets in so-called Total Loss Absorbing Capacity (TLAC) debt by 2022. That debt needs to be either structurally, statutory or contractually subordinated.

Thanks to the German proposal, Deutsche Bank was able to report more than €110bn of TLAC in a recent presentation to investors, €26bn above the 2019 TLAC requirements, while banks in some other countries are still waiting for regulatory clarity.

Divisive

However, Germany’s solution is not without its problems. The legislation is seen as one of the most aggressive in Europe towards senior debtholders, who complain that their senior unsecured holdings, originally sold to rank pari passu with other senior instruments, were suddenly bumped into the subordinated category.

“The subordination of senior unsecured debt instruments will increase the loss severity for senior debt instruments, offering lower protection for senior bondholders,” Moody’s analysts wrote as the agency downgraded seven German banks by a notch in January.

The solution is said to have divided the opinion of German banks, with some warming to its simplicity and others objecting to the increased funding costs.

“The German frontrunning in terms of BRRD implementation has had a strongly disturbing effect not only on secondary markets for German FIG senior but also for the primary markets,” said Thomas Cohrs, head of syndicate and origination at Nord/LB.

It is hard to quantify the impact the proposal has had on German spreads, given they are impacted by any number of factors, although most agree the market has widened.

A €1.5bn March 2025 senior bond issued by Deutsche Bank widened by around 75bp between March and June last year, before retracing some of those losses. Landesbanken, however, benefit from state support and have widened less than Deutsche Bank or Commerzbank.

Still, Cohrs argues that the widening has made it particularly difficult for new issuers, such as Nord/LB, trying to establish benchmark curves.

“In order to attract more foreign investors, we had to bridge not only the expected spread gap between domestic and non-domestic investors but also expect them to swallow a statutory subordination that not even most German investors fully comprehend,” he said.

Crossroads

Since Germany’s proposal, a number of other countries have set out changes to their own bail-in regimes.

No jurisdiction has replicated Germany’s approach, although Italy has come the closest. Whereas Germany opted to subordinate senior unsecured debt, Italy instead proposed to elevate the ranking of large corporate customer deposits above other senior claims.

Theoretically, that should leave a thicker tranche to absorb any senior bail-in losses equally, including interbank and derivatives liabilities, along with senior unsecured debt securities.

CreditSights analysts pointed out that while the probability of loss would be as great at a bank with equivalent risk in Germany, the loss given default should be lower in Italy.

France is pushing for a different solution altogether. Its finance ministry proposed in late December that banks should issue a new class of “junior senior” debt that would sit between existing subordinated and senior debt.

Ignazio Visco, governor of the Bank of Italy, has since voiced support for this type of solution.

“A targeted approach, with the application of the bail-in to only those financial instruments with a specific contractual clause to that effect, and a sufficient transition phase, would have allowed banks to issue new liabilities subject to express bail-in conditions,” he said in a speech in January.

Spain could follow a similar route to France, given its lawmakers have changed the ranking of claims to enable its banks to issue so-called “senior subordinated notes” or “Tier 3”.

Whether this could help Spanish banks tackle their TLAC targets is a point of contention within the market, however, largely because the language of legacy Tier 2 debt could preclude another layer of instruments between Tier 2 and senior.

Banks in the UK and Switzerland have ramped up senior unsecured issuance out of their holding companies, which would take the hit ahead of senior operating company debt in resolution. They have also undertaken liability management exercises to buy back operating company debt, to be refinanced over time with holding company paper.

Other markets such as the Netherlands and Ireland have yet to give clear guidance as to which route they will adopt.

Relief

The French and Spanish proposals were welcomed by investors who were fearful of another retroactive solution, which could have been particularly punishing given that French banks in particular are heavier issuers of senior unsecured than their German peers.

The creation of a new type of debt also skirts potential legal challenges from disgruntled investors, who could try to sue German issuers if their holdings are bailed in given the terms of the bonds were changed.

There are now questions as to whether some institutional investors are still willing to put money to work in German senior, said Michael Hunseler, managing director at Assenagon Asset Management.

“Some investors are more comfortable holding a Deutsche Bank credit-linked note, which is safer under the bail-in regime than its senior debt.”

But a key downside to issuing out of a holding company or via a new instrument is how to price that debt - an issue that the German solution neatly sidesteps, as new bonds can simply be priced off a bank’s outstanding curve.

Syndicate bankers have called the emerging legislative patchwork a nightmare for pricing new senior bank bonds.

“It totally changes the dynamic of what senior is; how can we have an integrated European senior market when you can’t compare apples with apples?” said one.

What premium holding company senior should offer over the operating company curve continues to be a major point of debate. There will also be considerable price discovery to be done when France or Spain issues their first “Tier 3” bond.

However, the process should become easier as increasing volumes of issuance provide more reference points.

“Over time, there should be a more uniform approach to how these instruments get priced up,” said HSBC’s Hittmair.

Minefield

The discrepancies between different European bail-in regimes are threatening to transform the formerly homogeneous senior bond market into a mishmash of differing rights and claims.

“It’s horrible – it’s like going back to multiple currencies,” said Denis Rath, a syndicate official at Commerzbank.

“Now we might end up with a Europe where you have different kinds of liability structures in different countries - it’s going to get very tricky and complicated.”

Market participants warn that investors will have to invest considerable time and energy into scrutinising local insolvency regimes as well as the structure of each issuer.

The Bank of Italy’s Visco said in January that the changes in European legislation had been “rapid” and “sweeping”. A more gradual transition period would have enabled investors to become fully acquainted with the new rules and adapt their choices to the new regulatory environment, he added.

To make matters worse, isolated events such as the disputed resolution of Austrian bad bank Heta and losses imposed on select Novo Banco senior bonds mean investors are lacking faith in the rules.

“Senior debt is something of a moving target, you just need to look at what happened with Novo Banco and Heta. It’s not always about what is written in the law but more about what the regulators do and politicians’ credibility,” said Assenagon’s Hunseler.