By Alice Gledhill
Fri Oct 31, 2014 4:27am EDT
LONDON, Oct 31 (IFR) - The European senior bank debt market is yet to fully factor in the risk of bail-in despite an approaching deadline that will see some countries introduce burden sharing measures into local laws as early as 2015.
The Bank Recovery and Resolution Directive (BRRD) adopted by the European Parliament in April requires that at least 8% of a bank's total liabilities must be bailed in before public funds can be tapped. That will ensure that unsecured bondholders, rather than taxpayers, foot the bill for failing banks.
Yet, European banks have seen their spreads plummet throughout the year, in some cases tightening by more than 100bp since January as seen in the case of Bankia's 3.5% 2019 euro senior bond.
"The market is not yet differentiating between the varying capital ratios across different institutions," said Laurent Frings, co-head of EMEA Credit Research at Aberdeen Asset Management.
"The French and Austrian banks have very little Tier 2 capital which is protecting the senior investors. This hasn't been priced in."
His view was echoed by Simon McGeary, head of the new products group at Citigroup. "I think it is priced in to some degree, but not completely yet. There was a bit of a move as far back as 2010, when people started to change their assumptions about governments stepping in to support banks in distress."
So far the market has been proven right. There has been a reluctance to bail-in senior debtholders as the cases of SNS and more recently Banco Espirito Santo showed, when subordinated debt was wiped out but senior left untouched.
But while some governments could struggle to introduce the BRRD before the January 2016 deadline, others, including the UK, Austria and Germany, have fast-tracked it and will implement the measures alongside other BRRD provisions from January next year.
Frings said the unpredictability of future legislative changes added a further dimension of risk.
"The market should be more circumspect as legislation can be brought in very quickly. There is almost too much confidence that senior debt is safe until January 2016."
That sense of security has not been helped by distortions in the market. The introduction of the TLTRO has seen issuance from European banks fall sharply.
Since the beginning of September 2014, 14.5bn-equivalent of senior debt has been issued by European banks, significantly less than the 27bn-equivalent issued over the same period in 2013.
Meanwhile, even though a recent Moody's report suggested that changes in spreads on bonds eligible for bail-in were evidence that markets are already pricing in the potential bail-in of European banks, not everyone agrees.
Bankers and investors felt the bail-in mechanism was just one of many factors driving spreads, not least the ECB's third covered bond purchase programme.
"The markets are starting to give thought to it, but covered bonds diverging could be down to a number of things such as anticipated ECB buying. The market is so compressed, it's hard to discern," said Citi's McGeary.
A seven-year covered bond issue priced this week for Credito Emiliano showed how far spreads have tightened. The deal came at 25bp over mid-swaps, making it the tightest pricing for a peripheral covered bond since the crisis.
LINE OF DEFENCE
How pricing of senior bank debt evolves will likely be down to the market's growing awareness of where that debt sits in the liability structure, and therefore how much of a line of defence lies before it.
The Moody's report emphasised that the extent of losses would depend both on the thickness of the debt tranche which bondholders inhabit, and the amount of more junior debt that would be bailed-in first.
"For a given loss in terms of banks assets, the more you have subordinated to you, the better off you are. By the same notion, the more people you have alongside you, the better off you are," said Colin Ellis, chief credit officer for EMEA at Moody's.
While the European bail-in regime is playing on investors' minds, something bigger could be coming down in the form of the Total Loss Absorbing Capacity (TLAC). That would require banks to hold an additional safety buffer equivalent to 16% to 20% of their risk-weighted assets
While it is very much up in the air as to what is included, senior debt is far from being off the hook; being "bailinable", it could be used to fill some of the TLAC requirements. (Reporting By Alice Gledhill, Editing by Helene Durand, Julian Baker)
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