The writing had been on the wall for depositors, even before the botched Cyprus bailout had established a new precedent for the troika of the Eurogroup, the ECB and IMF in imposing haircuts on supposedly insured retail customers of failing banks.
The idea of a jointly funded Europe-wide deposit guarantee fund, supposedly the crowning glory of the banking union European leaders promised in June 2012, is quietly being abandoned.
In a speech in London in the same week that ended with Cypriot lenders closing for their prolonged bank holiday, Vítor Constâncio, vice-president of the ECB, tried to talk up the European Commission’s proposal, expected by mid-2013, that will provide “a harmonized framework” of national schemes.
Constâncio has tried to argue that a system of national schemes run on harmonized standards will improve depositor confidence. “This means that a single European scheme is not an essential component of banking union in the short term,” he says.
The message hasn’t quite got through. In a speech in Frankfurt today, Christine Lagarde, managing director of the IMF, urged European leaders to complete banking union. Lagarde says: “Full embrace of this Union-wide architecture is needed to ensure durable financial stability, but also to sustain the currency union and the single market for financial services in Europe.” And she includes in the to-do list: “setting up the resolution authority and insurance fund with access to common backstops.”
The IMF in its recent evaluation of the European financial sector still persists with the fantasy that a common deposit guarantee scheme (DGS), with common backstops should naturally follow establishment of a single supervisory mechanism and a single resolution framework. But it looks increasingly unlikely to happen.
Reinhard Cluse, economist at UBS, explains: “It seems unlikely now that a pooled European deposit insurance system will be pursued as a priority. Concerns about mutualization and other national sensitivities [and lobbying, not least in Germany] were arguably too strong, so ambitions have been scaled back.”
Unfortunately, depositors in Cyprus quickly discovered the worth of a national deposit insurance scheme when the sovereign state providing it cannot meet its obligations.
The immediate bank debt market reaction to events in Cyprus was subdued. Senior financials widened by nine basis points and subordinated financial debt by 15bp when markets reopened.
It seemed extraordinary that senior bondholders in Cypriot banks should escape a haircut just because they accounted for such small sums. Almost as unsettling as the complacent bailing in of the man-in-the street was the casual abandonment of the creditor hierarchy.
“The way in which they have disrupted the seniority waterfall in Cyprus is very surprising,“ says Michael Foggin, manager of the Pyramis Global Credit Fund at Fidelity Investments. “Senior bail-in is right back at the top of the agenda now. Playing with the seniority waterfall can have serious adverse consequences. Haircutting guaranteed depositors before senior unsecured bank bondholders and potentially sovereigns looks inconsistent. Investing in the hope of a central bank put is not good asset management.”
Foggin adds: “The sooner the bail-in risks for senior bondholders in Europe is recognized, the better.”
So far, the fallout from Cyprus’s bail-in of bank depositors remains to be seen, says Matthew Mish, strategist at UBS. “Over the long term, one thing seems clear: the IMF and the northern countries will increasingly flex their ideology, which raises the prospects of bail-in across the capital structure.”
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| Willem Buiter, chief economist at Citi |
Depositors, generally speaking, rank pari passu with senior unsecured creditors. For all the Eurogroup’s talk of the unique and exceptional nature of the Cyprus bailout, Willem Buiter, chief economist at Citi, sees clear warning signs. “Prior statements by euro-area national political leaders, European Commission officials and central bankers that, after the unique and exceptional case of Greece, there would not be any further PSI and that senior unsecured bank creditors would be safe are not credible,” he says.
Rather, Buiter suggests: “The treatment of depositors in Cyprus is likely to lead to deposit outflows – probably even bank runs – in Cyprus as well as in other euro-area countries where either there are both excessively indebted banks and fiscally weak sovereigns [the EA periphery] or simply excessively indebted banks [in most of the EU, including the EA core].”
The ECB will continue to stand as the bulwark saving banks from the consequences of such deposit flight by providing funding against acceptable collateral.
Investors are hoping for a single bank resolution framework to be proposed by the Commission this year, passed into national laws in the middle of 2014 and to become operational in 2015.
With some grandfathering, investors hope that senior creditor bail-ins might not come into effect until 2018, giving bank debt capital market participants a whole five-year issuance calendar to adapt.
However, Buiter says: “Bailing in bank senior unsecured creditors will become part of normal practice for the recapitalization of systemically important banks that are undercapitalized but don’t have access to market capital, and we believe will do so soon, well before the 2018 date the European Commission appears to have in mind for this and probably even before the 2015 date that the new Eurogroup chairman Jeroen Dijsselbloem has proposed.”
While many investors had chased yield on bank debt in the benign conditions at the start of this year, drawing comfort that senior creditors were much less likely to face losses after Mario Draghi’s “whatever it takes” speech, nerves were clearly fraying at Euromoney’s bond congress last month.
“Our view is that if a bank gets into trouble, certainly its subordinated debt is fair game and it’s no surprise if holders take losses,” says Robert Kendrick, credit analyst at Legal & General Investment Management.
Peter Doherty, chief investment officer at Tideway Investment Partners, says: “Over the last 18 months, more and more events have chipped away at creditor rights so that I’m almost surprised senior creditors didn’t take a haircut on [failed Dutch bank] SNS Reaal. And we have already seen an enormous amount of covered bond issuers subordinating senior unsecured bondholders.”
Another investor says: “As a senior debt holder, you must expect your recovery given default to go down substantially. The senior debt market will contract anyway, as banks issue more for covered bonds and chase deposits for funding.”
Figures from Dealogic show that in the year to March 13, European FIG primary market volume had reached just $117.4billion, the lowest YTD total for five years since 2008 ($99.1 billion) and down 16% on the corresponding 2012 period ($139.1 billion).