Ever since the FDIC and the Bank of England (BoE) revealed their joint thinking on the resolution of globally active, systemically important financial institutions (G-Sifis) in December, the position of unsecured senior debt issued at the holding company level by these firms has been under question.
At the heart of the regulators’ proposals is the single point of entry approach, whereby resolution is enacted at the holding company level. This means that in a distressed scenario, unsecured debt held at the holding company level will be written down to cover losses remaining after the equity has been exhausted.
This potential bail-in raises crucial questions for the banks as to how they should be structured and crucial questions for investors as to whether holding company debt is where they want to be. “There has been a lot of focus on the Orderly Liquidation Authority (OLA) from the FDIC, and this is a very big deal,” stated the head of financing at a G-Sifi bank in London recently. “It converts senior unsecured debt into contingent capital.”
Twelve of the 28 G-Sifis are headquartered in the US or UK, so the fact the FDIC and the BoE are coordinating their approach is significant. It is far more likely that holding company debt will become the resolution buffer, and therefore that minimum levels of such debt will be mandated. What such a level might be is unclear, but there could be plans to introduce legislation in the US calling for banks with more than $50 billion in assets to have subordinated long-term debt equivalent to 15% of assets. This raises the question of who needs to issue and who doesn’t.
CreditSights has tackled this in a recent research report. It looked at levels of equity and holdco debt at the large banks to establish what level of cushion exists. The brokers are most comfortable with both Goldman Sachs and Morgan Stanley having 26% of total assets in this form. At the lower end, the ratio for Citi is 17%, Bank of America Merrill Lynch (BAML) 16% and JPMorgan 15%. CreditSights therefore concludes that three US firms – Citi, BAML and JPMorgan – might need to issue holdco debt if the OLA regulation goes ahead as anticipated. But the amounts would be manageable: $30.1 billion over 2.8 years for Citi, $18.5 billion over 1.3 years for BAML and $82.7 billion over 3.7 years for JPMorgan.
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If this structural subordination of holding company senior unsecured debt goes ahead, then it will effectively be transformed into contingent capital – a very different risk prospect for the buyer. As such it should be substantially more expensive than it is and the spread differential with senior unsecured opco debt should widen substantially. According to CreditSights, at the single-A level the differential is usually around five basis points to 10bp and at the triple-B level around 15bp to 25bp for a 10-year maturity.
“We believe that given the emerging requirement to issue higher amounts of holdco debt as part of a buffer for orderly liquidation that the holdco/opco spread differential should be wider,” the analysts say – 15bp to 20bp at single-A, 25bp to 50bp for triple-B.
The sting in the tail of this process could, however, be its impact on G-Sifi ratings. If banks need to issue greater volumes of subordinated debt to meet OLA requirements, it could have a negative impact on holdco ratings.
“The transmission mechanism for these changes is the rating agencies,” noted the London-based banker. “Banks could be downgraded because of this. In a one-notch downgrade, Citi and BAML would go to Baa3 at the holding company level and that is a scary place to be.”
However, in its recent fixed income investor call, Citi commented that in its view it was well-positioned for any eventual debt requirement resulting from OLA requirements. The rating impact from these changes might therefore not be as acute as some have predicted.
