June 4th, 2013
Before the financial crisis began in 2007, banks created and invested in trillions of dollars of complex securities such as collateralized debt obligations. Many of these investments subsequently defaulted or lost the top ratings given to them by ratings companies. With investors suspicious of anything valued or rated using hard-to-fathom models, markets in CDOs and similar securities are today only a small fraction of their former size.
Bonds issued by banks on the other hand mostly performed well during the crisis. Aside from Lehman Brothers, Washington Mutual and a few Icelandic banks, none of this debt defaulted. Of course it wasn’t allowed to, since governments backstopped too-to-big-to-fail institutions out of fears that any default would jeopardize the financial system.
In response to a backlash against taxpayer bailouts, those same governments have pledged to ensure that holders of bank debt share in the burden when banks become insolvent in the future. The result has been plans for so-called bail-in provisions in bank debt.
The idea behind bail-in is that it’s a kind of hyper-accelerated version of bankruptcy restructuring where creditors end up with stakes in companies, avoiding the need for liquidation. The idea would be to avoid drawn-out spectacles like Lehman, which is still suing counterparties and working out how much to pay out on defaulted bonds after exiting from bankruptcy protection last year. Unlike Lehman, bailed-in bank bondholders would find out in the space of weekend what they stood to receive.
As Bank of England deputy governor Paul Tucker said in a speech on May 20, the impact of bail-in has been “nothing short of a revolution in thinking”. For the first time, regulators are trying to plan for the collapse of large banks in advance. For the first time, borrowings of such banks are being analysed in a way similar to structured securities – by examining their seniority, collateralization and linkages.
For a start, investors will need to spend more time valuing bank assets in advance of any crisis, and not be lulled into complacency by accounting rules that mask declines in loan asset quality before impairments get recognized. Regulators are likely to do that according to Tucker, by “engaging advisers needed to help determine the firm’s losses, and so the size of debt write-down”.
Investors also should learn about whether regulators plan on converting the creditors of a bank holding company into shareholders while trying to leave operating subsidiaries untouched – that’s called the ‘single entry point of resolution’. Or for a bank consisting of a bundle of financially distinct regional entities, they might bail-in bondholders in multiple jurisdictions simultaneously. That’s called the ‘multiple point of entry’ approach. For investors in the debt of multinational banks issued under a particular national jurisdiction the distinction could be crucial.
Even more important is the debate over collateralization. Since the financial crisis, banks, especially those in Europe, have become more reliant on collateralized forms of funding, according to a report by a Bank for International Settlements working group published on May 27. An increase in a bank’s proportion of pledged or encumbered assets reduces the amount of unsecured debt that can be issued with bail-in provisions.
In a sample of 60 European banks analysed by the BIS, the median ratio of encumbered assets was 22.5 percent, with some institutions (such as Swedish banks) pledging over 50 percent of their assets. Although that doesn’t sound that much, the picture changes when you consider deposits as well.
Legally speaking, deposits are unsecured liabilities of banks. In practice things are different. Retail deposits are typically insured, up to a 100,000 euro limit in the euro area. In principle, that means regulators would fence off an equivalent portion of an insolvent bank’s assets to back those liabilities. Until recently, bank deposits above the insured limit were a gray area in Europe.
The bailout of Cyprus by euro-area countries in March highlighted the difficulties with deposits. Cypriot banks had depended heavily on deposits to fund their expansion into Greece and elsewhere, and when it came time to restructure the banks, there weren’t enough bondholders to absorb the hit. After several iterations, a bailout was agreed in return for Cyprus imposing a tax on depositors above the 100,000 euro limit – a bail-in in everything but name.
Since then, the International Monetary Fund and the European Commission have lobbied aggressively for so-called ‘depositor preference’, which means placing uninsured depositors above unsecured creditors such as bondholders in an insolvency. In the U.S., the Federal Deposit Insurance Corporation has imposed depositor preference since 1993, and the European Commission argues that this reduces taxpayer exposure to collapsed banks.
The question follows, where does that leave holders of bank debt? If you assume that bank deposits are effectively pledged like secured debt, then the average European bank has 70 percent of its assets encumbered, according to the BIS working group report. Two banks in the study had 92 percent encumbrance under this measure.
Like the CDOs from before the financial crisis, unsecured bank debt is getting transformed into a junior claim on a shrinking pool of collateral, under the bail-in plans mooted by regulators. As with CDOs, there’s little disclosure by banks on levels of asset encumbrance or published stress testing being done by regulators. The surprise is that investors still buy bank bonds at all.
(this post was published in the Bloomberg Risk newsletter last Friday)