Torrid time ahead for financial as bail-in chat restarts

LONDON: Any revival of the European senior FIG market could be cut short in the autumn by the publication of a European Commission legislative proposal on banks resolution and bail-ins. This would be a blow for the market which has not seen any issuance since June as a result of the Eurozone peripheral crisis and is a much-needed funding avenue for banks.

The publication by the UK Financial Services Authority (FSA) of a consultation paper on Tuesday on recovery and resolution plans for financial institutions was a timely reminder that regulators are still focused on finding ways to avoid bailing out the banks in the future.

"While investors are certainly aware of the bail-in debate and in some cases would claim that the "bail-inability" of UK bank senior debt has already been assumed by the market, my gut feeling is that the additional clarity that would come with a formal bail-in framework would cause investors to rethink their risks," said Emil Petrov, head of capital solutions at Nomura.

"As such I would not exclude the possibility of increased senior debt costs as a result of the introduction of new bail-in legislation."

Meanwhile, in a note published on Wednesday, analysts at Lloyds Bank said the upcoming EC paper was going to be very important.

"We continue to believe that the crisis resolution regulations for the banking industry that are due from the EU in the summer (which suggests publication is due very soon), are the single most important piece of regulatory change for the industry," they wrote.

"On Tuesday the UK FSA released a consultation paper on resolution and recovery, which is likely to prove a good sign of the way the EU, is thinking; bail-in including senior unsecured debt is prominent."

A spokeswoman for the European Commission contacted by IFR said that the legislative proposal for the EU crisis management framework was down to is out for post September 2011.

The proposal follows a consultation by the EC and will be examined by the Council of Ministers and the European Parliament.

It is impossible to estimate how much more banks will have to pay to fund once the presumption of a senior bail-in has been established, although it is likely to vary between banks and jurisdictions with top borrowers from core territories less vulnerable to an increase because of the remoter risk of their deals being triggered.

Issuers in Denmark where senior debt has been bailed-in have had to pay an estimated premium of around 30bp.

"It's not huge but it's a material number, although any premium for the UK should level out as resolution regimes are put in place in other jurisdictions," said Petrov.

According to Markit data, UK banks five-year CDS have spiked in recent days, although it is difficult to say whether this is as a result of the FSA paper or the heightened volatility in financial markets.

Five-year CDS for Royal Bank of Scotland closed at 321bp on Wednesday, up more than 20bp versus the previous day. Lloyds's five-year CDS also widened out by more than 20bp in the same time period while Barclays's was out by 26bp.

Interested parties have until November to respond to the FSA papers. In the meantime, market participants are eagerly waiting to see whether the EC will opt for a targeted or comprehensive approach. The two options were outlined in its initial paper on the subject in January, will be adopted in its resolution guidelines.

Market participants are unwilling to predict which of the two approaches will be adopted, but one capital specialist believes the comprehensive, statutory approach, with all senior debt exposed to the risk of a bail-in, and would be best for the market.

"Not only would it be simpler to apply, but if all senior debt is potentially subject to a bail-in, the loss severity will be much reduced in the event of it being invoked. A new class of bail-in able debt would simply act as an additional layer of capital and would still leave taxpayers vulnerable if an event occurs before sufficient reserves of it have been built up."

One banker specialising in resolution regime planning at one of the UK pilot banks working with the FSA agreed that the Commission's next update will be key, adding that the consultation paper published this week is a fair reflection of common thinking and no surprise to banks that have been providing input on the subject since 2009.

"The UK Banking Act remains an adequate framework for us to do all the things we would need to do to resolve a bank," she said. "The statutory powers are there already in the UK but what we need is for the exact mechanism to be established and for that we await guidance from the European Commission."

Market participants also await full clarity on the trigger point at which bail-in able senior bonds will be invoked.

Nomura's Petrov said a specific trigger would make it easier to put a price on the risk of bail-in, a necessity for the market to function smoothly.

"The FSA suggests that 'an obvious candidate [for the trigger] would be the high-level conditions already specified in the Banking Act 2009 for a stabilisation power to be exercised', i.e. a gone-concern or non-viability trigger," he said.

"Given that according to CRD4 5.125pc Common Equity Tier 1 is a sufficient going concern trigger, it would not be unreasonable to assume that, in this context, gone concern corresponds to a breach of the 4.5pcCET1 minimum requirement. However, 4.5pc is so low that one would expect the bank to be deemed non-viable for different reasons before a breach of the 4.5pc level. As a result, it seems inevitable that where non-viability triggers are concerned, investors will have to base their judgment on a wide range of factors such as the bank's access to liquidity or exposure to certain risks."

The publication of the European Commission's paper in January sent the financials market into panic mode, with the Senior Financials index reaching a record spread over the Main of almost 90bp and some observers predicting the death of the senior market.

Bankers now take a more measured approach, while acknowledging that investors are likely to demand greater spread for the increased risk. But if the capital structure is respected, the enhanced equity base envisioned under Basel III should, many believe, limit the cost implications for most issuers.

Copyright Reuters, 2011