Battle With Bondholders Looms After G-20 Agrees on Basel Rules

Battle With Bondholders Looms
Angela Merkel, Germany's chancellor, arrives for the G-20 Seoul Summit 2010, in Seongnam, South Korea. “There may be a conflict here between the interests of the financial world and the interests of politicians,” Merkel said. Photograph: Yonhap News via Bloomberg

The next hurdle to bank reform is looming after U.S. President Barack Obama and other Group of 20 leaders endorsed the Basel Committee on Banking Supervision’s new rules in South Korea last week: the bond market.

Regulators worldwide, seeking to protect taxpayers from having to foot the bill for future bank bailouts and to cushion big lenders in times of stress, will now turn their attention to preventing the collapse of systemically important financial firms. Among the tools they’re considering are capital instruments that would force investors in bank debt to bear the cost of a bailout by slashing the value of their bonds or converting them to equity in a crisis.

That doesn’t sit well with buyers of senior bank bonds who prize the certainty they’ll be repaid in full. The 201 members of Morgan Stanley Capital International’s World Banks Index need investors to help refinance $3 trillion of bonds coming due by the end of next year, according to data compiled by Bloomberg.

“The flexibility that regulators want and the predictability that my investors want seem irreconcilable,” said John Hale, investment affairs manager at the London-based Association of British Insurers. “Basel III changes the rules of the game.” U.K. insurers manage about 1.5 trillion pounds ($2.4 trillion).

Merkel’s Plea

The debate over whether bondholders should suffer when lenders fail was ratcheted up in Seoul last week, when German Chancellor Angela Merkel said that creditors should bear more of the cost of bailing out banks and nations.

“There may be a conflict here between the interests of the financial world and the interests of politicians,” Merkel said. “We can’t constantly explain to our voters that taxpayers have to be on the hook for certain risks, rather than those who make a lot of money taking those risks.”

During the financial crisis, bond investors in New York- based Lehman Brothers Holdings Inc. weren’t bailed out, sending shock waves through the global financial system after the firm filed for bankruptcy in September 2008. Investors in the senior bonds of troubled European lenders have been paid the par value of their investments, apart from in Icelandic banks, according to an Oct. 15 note written by Morgan Stanley analysts including credit strategist Carlos Egea.

Wholesale funding -- the funds that banks have to refinance with bond investors, commercial-paper buyers and other debt providers -- accounted for 32 percent of European bank funding as of July, according to Egea. The precise scale of borrowing from bond investors isn’t known because the information isn’t disclosed by all banks, he said. U.S. lenders got 13 percent of their funding from wholesale markets as of July, most of which was made up of $1.7 trillion in bonds, Egea said.

Ireland, Greece

Irish and Greek lenders, struggling to access bond markets, are financing themselves through the European Central Bank. Irish banks’ borrowings from the ECB rose 7.3 percent in October to 130 billion euros ($177 billion) from a month before, according to Ireland’s central bank. Greek banks’ reliance on the ECB is declining, with lenders borrowing a total of 92.4 billion euros in October compared with 94.3 billion euros the previous month.

G-20 leaders endorsed Basel committee rules to triple the highest-quality capital banks need to hold, as well as liquidity requirements for how much cash and easily saleable assets they need to meet short-term and long-term liabilities. The committee, which is made up of central bankers and regulators from 27 nations, delayed implementation of the liquidity rules until 2015 at the earliest.

‘Wiped Out’

“The Basel committee can say it wants longer-term senior issuance to fulfill liquidity requirements, but that doesn’t sit well with senior bond investors concerned about being wiped out if the bank they lend to defaults,” said Oliver Judd, a credit analyst in London at insurer Aviva Plc’s investment unit, which oversees about 250 billion pounds.

In addition to approving the Basel rules, leaders including Obama and Chinese President Hu Jintao said in a Nov. 12 statement that banks and other institutions whose collapse would damage the wider financial system should have “higher loss- absorbency capacity.”

The Basel committee is working with the Financial Stability Board to develop additional capital standards for the largest banks that may include “bail-in debt,” which requires bondholders to take a pre-set loss when a lender collapses.

Swiss CoCos

The board, which the G-20 set up last year to find ways to rein in the world’s largest financial institutions after the worst financial crisis since the Great Depression, said on Nov. 12 that it will identify which firms will be subject to stricter rules by the middle of next year and how much of an additional cushion they’ll need by the end of 2011.

National regulators will be able to select from a menu of options, including straightforward capital surcharges, bail-in instruments and contingent capital, debt that automatically converts to stock under stressful conditions.

Swiss regulators proposed in October that the country’s two largest banks, UBS AG and Credit Suisse Group AG, both based in Zurich, consider issuing contingent convertible bonds, or CoCos, debt that converts to equity when there’s a triggering event such as a decline in an issuer’s capital ratio or its stock falling to a pre-arranged price.

‘Would You Invest?’

Banks transform the money they get from capital markets and depositors into loans they make to companies and households. Bond investors will make banks pay more to compensate them for the risks of contingent capital instruments, former Bank of England Deputy Governor John Gieve said in an interview.

“Having a systemic banking model where you have bonds that convert on a pre-agreed trigger certainly hasn’t been tried before,” Gieve, now a London-based senior adviser at hedge fund GLG Partners Inc., said Nov. 3. “We don’t know how difficult it will be to get investors into this kind of market. Initially one would expect there’d be quite a big premium over traditional bond finance.”

The new convertible-capital instruments being considered in Switzerland have qualities which make them more like equity than debt, said Roger Doig, a credit analyst at Schroders Plc, Europe’s largest publicly traded fund-management company by market value.

“We see such instruments as quasi-equity, not debt,” Doig said. “As such, we would only look to participate where the coupon was high enough to offer equity-like returns.”

‘Balancing Point’

Hale, of the Association of British Insurers, also says the new instruments wouldn’t appeal to bond investors.

“It might be more attractive to equity investors,” Hale said. “I wouldn’t put it past the wit of investment bankers that they might create something acceptable, but if you were a fixed-income investor and you were offered to be converted into equity or suffering a haircut, would you invest?”

Regulators and bond investors may spend six months to two years trying to find a “golden balancing point,” said Douglas Elliott, an economics fellow at the Washington-based Brookings Institution and a former JPMorgan Chase & Co. banker.

“You need an instrument that will convert to protect banks and deposit funds,” Elliott said. “At the same time, you need a low enough probability of conversion and sufficient clarity about when conversion would happen so that bond investors are prepared to buy the securities without charging an exorbitant interest rate.”

The success of Swiss banks in selling CoCos will be an important test, he said. “If they can make contingent capital work, then we will learn something in the rest of the world.”

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