Investors’ loss, the system's gain

In November 2015, the Financial Stability Board published its final Total Loss-Absorbing Capacity standard for globally systemically important banks. In the EU, the Bank Recovery & Resolution Directive set a minimum requirement for own funds and eligible liabilities for all banks and many other financial institutions.

The principle underpinning TLAC and MREL was that lenders, even senior lenders, must take losses in cases of extreme stress. Only by ensuring the state does not need to step in can the financial system become safer. But the process needed to be clear and specific to avoid litigation risk and ensure the wrong people - particularly depositors - did not carry the burden of losses.

Roberto Henriques, credit financial analyst at JP Morgan, said: “An important part of this process has been expectation management. During the crisis, it would not have been possible to bail in senior debt, it was taboo. This has been about overcoming that resistance, which these structures do because they are defined by the fact that they will be bailed in. That increases the credibility of the whole system.”

TLAC and MREL completed the work global regulators had began with Basel III.

“The immediate response to the financial crisis was Basel III, which came into effect in early 2013, increasing capital requirements. TLAC came later, in 2014. So it was a bit back to front; the architecture came first and the structure to bail-in senior debt came later, almost as an afterthought,” said Henriques. “It meant the Commission had to retro-fit TLAC to the Capital Requirements Directive.”

The FSB had offered three options countries could take to make senior debt bail-in-able: a structural approach, a contractual approach and a statutory approach.

Most banks that had a holding company structure, such as in the UK and Switzerland, took the structural approach, stipulating that all debt issued at the holding company level would be subject to bail-in, bringing them into line with US banks. Liabilities held at subsidiary levels are excluded, protecting depositors and derivatives instruments, for example. This allowed the relevant institutions to get a head start on other banks because there was no need for the legislative changes necessary for the other two approaches. Barclays became the first European bank to issue bail-in debt using this route in 2014.

Few continental European banks have a holding company structure, and creating one is problematic as it would have tax implications. The French therefore developed the contractual approach, under which new senior non-preferred bonds are issued, with documentation clearly stating their subordination to senior preferred bonds.

France completed the necessary legislative changes in December 2016, meaning the first French issuance had to wait until the end of that year.

Vincent Robillard, head of group funding and collateral management at Societe Generale, said the new law “ended the competitive disadvantage of banks with operating companies compared to banks with holding companies” in France.

The final, statutory, approach was favoured by Germany. It amended the Banking Act to change the creditor hierarchy and ensure senior unsecured bonds were legally subordinated. This meant German banks’ capital buffers were expanded overnight, reducing the need for additional issuance in a new market to comply with MREL.

France shows the way

“The problem with the statutory approach is it makes it impossible for banks to issue term funding. The contractual route is also more consistent with the structural approach in that neither option changes the creditor hierarchy,” said Henriques.

Simon McGeary, head of European new products at Citigroup, said: “The German model pushes all vanilla senior unsecured bonds below other senior creditors. That works well for the large banks in Germany, where banks tend to be deposit-rich. But the French and UK models give banks the choice to issue preferred or non-preferred, or holdco or opco, which is an advantage, especially for banks elsewhere in Europe that rely more on the wholesale market. Banks have different needs and different business models.”

Gerald Podobnik, co head of FIG origination at Deutsche Bank, agreed the structural and contractual approaches favoured by the UK and France look very similar in terms of achieving subordination in the end. “Issuing from the holdco looks slightly more risky because it relies on dividend streams coming up from operating subsidiaries, and this may be reflected by a small difference in price in the end,” he said.

While France and Germany have passed their legislation to allow their banks to issue bail-in-able debt, in many other countries politicians still have to take this step. France’s contractual approach looks set to provide the model for most of Continental Europe to follow once individual countries enact the required legislation, which could take years.

Unusually, Europe is allowing national governments to move forward while its own debates continue, which is adding to the fragmented nature of the market. Spain is pressing ahead with its own legislation, while Nordic countries and the Netherlands, among other places, show no sign of acting yet.

Even within individual countries, banks are at varying stages of readiness. MREL/TLAC requirements required that the largest and most systemically important had the tightest deadlines to comply with its requirements, meaning most issuance to date has come from the tier one banks. Smaller European banks are not yet under pressure to issue bail-in debt, but are also likely to enter the market in due course.

While a number of French banks will have to issue significant amounts of TLAC-eligible debt in the coming years to meet their 2021 targets, SG has limited needs as it already respects its 2019 TLAC ratio both in terms of RWAs and leverage, said Robillard.

In the UK, Standard Chartered operates largely out of emerging markets and had traditionally issued mainly from its holding company, with investors seeing the UK entity as lower risk than its operating entities based across Africa and Asia. It therefore has a large stock of outstanding debt that is now TLAC-compliant, putting it in a particularly strong position.

In the Netherlands, most banks have the usual continental structure and will therefore go the senior non-preferred route. But ING does have a holding company which it will likely issue from, meaning it can get started before other banks in the country.

In November, the European Commission moved to harmonise the approach taken by banks across the continent, amid concern about arbitrage between different types of structure and difficulties for investors wishing to compare securities across jurisdictions. While the approaches taken in France and Germany both had merits, it settled on the French option as its favoured approach.

It therefore looks likely that German banks will start issuing senior non-preferred bonds, with legacy issuance being grandfathered and pricing pari passu with the new bonds. But there is still some uncertainty given the European parliament has not yet had its say on MREL. It remains possible that Germany could have its own approach. Overall, banks do not yet have a clear picture of exactly what their requirement for bail-in debt will be.

Stepping into the unknown

There has been some uncertainty over how ratings agencies will treat this subordinated paper. Moody’s, which described the new non-preferred market in France as a “junior senior debt class”, said the relatively modest amount in circulation meant it was likely to be rated similarly to Tier 2 securities. In due course, this could change, it said, “as the liability structure changes sufficiently to provide a clearer differentiation of their relative risks”.

Increasing issuance of senior non-preferred and holdco paper will also likely have positive rating implications for senior preferred and opco paper, which will enjoy a greater buffer protecting them from losses.

The CDS market will also have to change, as it remains linked to senior preferred or opco debt. But as the supply of that paper dwindles, it will have to start being referenced to the more plentiful non-preferred and holdco debt. The same is true of the major bond indices. But they have already changed their methodology to account for new Additional Tier 1 capital bonds, and will do so again without too much disruption, once there is a critical mass of the new paper in circulation.

This will take time. Pete Mason, co head of FIG EMEA at Barclays, said: “We are still in the very early stages of this process; a number of countries haven’t seen any issuance of bail-in-able senior debt at all. Volumes are going to climb steadily as the stock of old senior opco debt is refinanced in bail-in-able form.”

Citigroup estimates major European banks have a €350bn funding gap to fill with MREL-qualifying paper from where we are now, in additional to regular refinancing. These banks have until around 2022 to meet that target. “The early pace of issuance has been positive and there should be no problem getting it done,” said McGeary.

So far, bail-in debt has only been sold to institutions to avoid a controversial situation where retail investors take heavy losses. But increasing issuance of non-preferred is likely to limit the supply of preferred paper, which could push up prices in the safer asset class, especially in the short term. Having a large buffer of non-preferred paper ranked below it should also make preferred paper safer, driving the spread between the classes wider.

Henriques said: “The name said senior, but senior non-preferred is not really senior, it prices more like Tier 2 debt. But the low-yield environment makes that more attractive for investors right now. And given there will be less issuance of the old stuff available, investors wont have much choice but to buy it.”

In the longer term, it is not clear what the new class of debt will mean for traditional senior preferred supply. Issuers now have three alternatives: TLAC instruments which are more expensive, the traditional senior unsecured that cannot be bailed in, or covered bonds.

“I can see issuers gravitating towards the first and last options and the second being squeezed out, certainly in the short term, but potentially permanently,” said Henriques.

Deutsche Bank’s Podobnik said: “We will have to be patient with the super-senior market. I think it will not take off for a while as banks issue non-preferred debt, but it will definitely pick up some time. It will be a valid option for some issuers to get cheap funding compared to the covered bond market because for that you need a cover pool.”

Mason said: “Opco and senior preferred debt is going to be less relevant going forward, but it won’t disappear completely, a more modest volume will remain. Its scarcity will make it cheap for issuers, and investors will want it because of its seniority. There is still a need for this kind of paper, especially for short-dated financing.”

Alexandra MacMahon, head of EMEA FIG DCM at Citigroup, said: “Demand for bail-in-able paper is extremely strong. This is partly because of the low interest rate environment; this paper is senior paper that offers a little more spread. There is also a floating-rate market developing, and callable structures are coming through.”

It remains to be seen how well bail-in works, something that cannot be known for sure until it is properly tested by a bank failure. Of particular interest will be how investors respond to an issuer that has imposed losses on its senior non-preferred creditors.

“The bail-in concept is a sensible approach and has been well thought out,” said Barclays’ Mason. ”It hasn’t been well tested yet - most of the situations we have seen in the last few years, in Italy, Portugal, the Netherlands and Cyprus, have had a very national flavour, they have been quite unique situations, not easily applicable for this emerging pan-European formula. But, hopefully, when this kind of situation emerges again, once there is more clarity around the regulation, it will prove itself effective.”