A push to implement general depositor preference across the EU could see banks increasingly use senior preferred bonds to build loss absorbing buffers which, market participants say, could even render the senior non-preferred asset class redundant.
Spain is the latest EU country to consider introducing general depositor preference, whereby all wholesale deposits rank above senior unsecured liabilities in a bank resolution.
Should Spain’s draft law succeed, it will join the likes of Italy and Portugal, where depositor preference is already in force.
The idea of introducing depositor preference across the EU has support in the European Commission, which is currently reviewing the ranking of deposits in insolvency.
Bankers stressed it is unclear whether depositor preference will be implemented in Spain, let alone across the EU, noting it would require a major effort to harmonise national insolvency regimes. But the idea would fit with the aim of developing a banking union.
“Do we have political momentum? Yes. Do we have the will? Yes. But we also have an extremely full agenda,” said a DCM banker.
The implications of EU-wide depositor preference for bank issuance would be most profound at the senior level.
While ranked above the SNP asset class, introduced in 2016, banks are allowed to count some of their senior preferred bonds as part of their MREL buffer.
However, market participants say resolution authorities may hold back from imposing losses on senior preferred because, in many countries, the bonds sit at the same level as deposits in the creditor hierarchy.
Excluding deposits from bail-in but including senior preferred bonds would risk legal challenges under the so-called No Creditor Worse Off principle, which dictates no creditor should suffer higher losses in resolution than in insolvency.
Depositor preference shifts senior preferreds to a new layer and thereby strengthens a resolution framework. In the case of Spain, Fitch said it would increase confidence in the effectiveness of senior debt bail-in, enhancing the credibility and feasibility of a resolution.
THE PRICE TO PAY
While bondholders would be put at a higher risk of suffering losses if depositor preference is introduced, the risk would at least become easier to judge.
Nikos Maragopoulos, associate researcher at the European Banking Institute, said that under the existing regime it is in some cases impossible for investors to fully analyse the likelihood of a bank’s senior preferred bonds being bailed-in.
This is because European lenders – except for G-SIBs – are not currently required to disclose the amount of other liabilities, such as uncovered corporate deposits, that rank pari passu with the bonds.
Such factors would affect the resolution authority’s decision over whether to exclude senior preferred bonds from bail-in in order to avoid breaching the NCWO principle, he said.
“Thus, [investors] cannot assess the risk of incurring losses and accordingly cannot price properly the issuance,” he said.
Harmonisation of insolvency rankings, through the introduction of general depositor preference, would therefore provide investors more clarity while also aiding resolution authorities, he said.
“The introduction of a eurozone-broad depositor preference would have the advantage of instilling some clarity and consistency across different European jurisdictions,” said Filippo Alloatti, senior credit analyst at Federated Hermes.
“This would have negative credit consequences on preferred senior, increasing Loss Given Default in resolution outcomes, but perhaps this is the price to pay to advance towards a fully functioning banking union.”
REDUNDANT?
In Spain, Fitch said depositor preference could result in banks favouring senior preferred issuance over SNP for their MREL needs, in particular medium-sized banks.
Many European banks have already been issuing senior preferred bonds to fill MREL buffers under an exemption.
The senior preferred market is easier and cheaper to access, with euro senior preferreds trading 28bp tighter than SNPs, according to iBoxx indices.
If depositor preference applied across the whole EU, the funding plans of all banks that do not have a holding company would be affected, bankers said.
“If you want to have a very extreme view, the SNP market could become redundant,” said Cecile Bidet, head of DCM solutions and advisory at Credit Agricole.
“Banks could meet even their subordination requirement with senior preferred.”
In this case, banks could replace SNP bonds with senior preferred, with the two instruments filling the same regulatory role.
The first banker said it would remain to be seen if senior preferred bonds would then trade differently depending on their individual features, or if the entire asset class would converge.
The impact would also depend on a potential redesign of banks' capital buffers below the senior level, he said. Banks' buffers have come under the scrutiny of regulators this year.
Bidet said that if banks replace maturing SNP bonds with senior preferreds, the spreads of the two could converge over time.
“But the convergence towards SNP may not be total, firstly because the SNP layer still exists, which banks may not use but could still be used, and secondly because the volumes [of outstanding bail-in-able senior bonds] would be bigger,” she said.
Another important factor would be the downgrade of senior preferred ratings, by one to two notches, while banks’ funding mix of SNP versus senior preferred would also come into play, she said.