The spectre of bail-in risk across Europe

When Moody’s downgraded a number of Austrian banking groups last month following the proposed bail-in of Hypo Alpe Adria’s subordinated debt, which if approved will void long-standing statutory deficiency guarantees of the Austrian federal state of Carinthia, it looked a timely response to the twin risks to European banks from declining government support and potentially worsening exposures in central and Eastern Europe.

Moody’s argues that the unprecedented nature of the government’s decision to place taxpayers’ interests above the rights of creditors who had previously benefited from a public sector guarantee indicates that Austrian authorities are now generally more willing to countenance bank resolutions in which losses may also be imposed on senior creditors.

Markets had seemingly been less rational in the run up in assessing Austrian banks’ high emerging market exposures. Loans to borrowers in Central and Eastern Europe account for around 40% of the combined lending of Erste Bank, RBI and Bank Austria. The NPL ratio for these loans is high at 12% and rising by one to two percentage points every year. A substantial slice of this €200 billion of aggregate exposure relates to borrowers from Russia and Ukraine. And there is now a systemic banking crisis unfolding in Bulgaria. Indeed HAA was nationalized in the first place on account of its bad emerging market loans.

Now that is thrown into reverse. Fitch warns that Austrian banks are vulnerable to short-term disruption of access to funding and rising cost. The question is how far spreads on Austrian bank bonds will widen and how far concern will spill over to other European banks’ bonds not just over their exposures to risk from emerging markets to the East but on the imminent move to an era of bail-in.

Bigger concern

Local government guaranteed sub debt from issuers such as HSH Nordbank, BayernLB, Nord LB and Helaba could be at risk of a negative read-across from rating agencies. BayernLB, which still holds €2.3 billion of subordinated HAA debt converted from its former majority equity stake in the troubled Austrian bank before its nationalization, is most immediately exposed. But the bigger concern for bond investors is the reliability of sub sovereign guarantees on other German banks.

Bail-in risks have not been priced into the markets for European bank bonds where issuers have been busily selling subordinated debt, new forms of AT1 capital and senior debt this year. The real risk on those AT1 deals is coupon deferral, which could come much sooner than any breach of capital ratio triggers, if loan losses were to mount.

Similarly, coupons on bank senior debt are now so low that you have to wonder whether they protect adequately against bail-in risk, which will be enacted next year and come into effect in 2016. Banks have big deposit gathering capacity, which they have ramped up since the financial crisis to reduce dependence on wholesale funding and which they cannot easily turn off, even as loan demand remains sluggish. So many banks are cutting their wholesale funding plans and not rolling over maturing senior unsecured bond issues. That sounds prudent. The problem is that as remaining senior unsecured bond debt becomes a smaller proportion of banks’ total balance sheet liabilities, so it may become a riskier asset for investors to hold.

Banks’ deposit bases remain de facto senior to bond debt. Come any sudden and large losses from emerging market loan exposures, litigation charges or any other unforeseen problem such as a return of the eurozone sovereign debt crisis, if bail-in haircuts are applied over a relatively narrow sliver of senior unsecured bond debt, then losses to holders of those bonds could be severe.