Recent bailouts in Italy and Portugal confirm the long-standing view that bank resolution will more often than not receive state subsidy and threaten disruption to the wider financial system – despite regulators’ declarations to the contrary.
However, up until late last year, the proposed regime for resolving financial institutions through bail-inable debt – which imposes principal losses on bank securities outside the normal bankruptcy process – was not existentially questioned, aside from technical considerations. That is until February, when yields on AT1, also known as contingent convertible, or CoCo, bonds jumped by several percentage points in a few days, while the primary market firmly shut, and returns from the product were savaged.
The poor growth outlook encouraged investors to further downgrade banks’ structural earnings potential, and market technicals exacerbated the volatility. However, the gulf between senior and subordinated spreads reflects a crisis in one key area of bank capital: bail-in securities.
Senior bankers at eurozone financial institutions tell Euromoney issuance plans lie in tatters given the complexity of the AT1 instrument, and the disconnection between issuers – who emphasize its low-yielding debt-like characteristics – and investors now re-pricing its equity-like features.
What some missed in the violent sell-off was its roots in regulation, specifically, the move by eurozone banking supervisors to allow coupon payments from existing bonds to be deferred sooner than expected because of more-onerous capital requirements. It took a full two months for the ECB to clarify to the market how the rules should be interpreted.
Regulators say the sell-off represents the birth pangs of a nascent asset class, while missed AT1 payments and fully-fledged bank resolutions under the new regime should help the market to form a consensus on how CoCo securities work in practice.
But this sanguine stance won’t wash with investors confused by the technical complexity, and the supervisory divergence in interpreting bail-in rules – and it’s not just about the AT1 market.
Citing a clash between Fed and global rules, HSBC said in late February, it plans, for now, to issue its senior debt from its holding company, despite adopting a multiple point of entry approach to bank-resolution. The latter, in theory, means the market would have expected total-loss-absorbing-capacity (TLAC) issuance from HSBC’s multiple operating-units. What’s more, last month, the European Commission even recommended that the Minimum Requirement for own funds and Eligible Liabilities (MREL), Europe’s version of TLAC, be relaxed for smaller lenders, with national supervisory discretion in imposing standards and levels on an entity-by-entity basis.
With different supervisory takes on how to interpret global bail-in rules and in setting the quantum and structure of bail-in liabilities – from AT1 to gone-concern capital – even savvy real-money bank investors, let alone retail funds, are struggling to fathom how the new bail-in era changes the game for unsecured creditor claims, which is a prerequisite for a functioning bank-funding market.
To reform aficionados, the regulatory risk and the volatility of the bank securities market year-to-date underscore the clear risk of the post-crisis drive to force financials to issue loss-absorbing instruments while only marginally hiking their equity cushions: complexity and still-unabated fears over capital adequacy.