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Cyprus Bailout Fueling Bank Funding Concern on Bond Losses

Cyprus Bailout Fueling Bank Funding Concern on Bond Losses
Lawmakers raise their hands to vote on the nation's banking crisis inside the Cypriot parliament in Nicosia. Photographer: Simon Dawson/Bloomberg

The European Union’s decision to recapitalize Cypriot banks by inflicting losses on depositors and senior bondholders is triggering investor concern that bank funding across the region will be hurt.

Cyprus qualified for its 10 billion-euro ($13 billion) bailout by agreeing to close Cyprus Popular Bank Pcl, also known as Laiki Bank, the island’s second largest lender, the EU said in a statement. Uninsured depositors and senior bondholders will be “bailed in,” staying in a so-called bad bank.

“This has implications for any weaker banks that get into trouble,” said Chris Bowie, the London-based head of credit portfolio management at Ignis Asset Management Ltd., which oversees about $110 billion. “We’d expect to see some deposit flight and a shift in funding towards a combination of covered bonds, real equity and quasi-equity.”

With the exception of Denmark in 2011, senior bank bondholders, like depositors, have avoided losses in the EU’s financial crisis. In February 2011, Amagerbanken A/S collapsed and senior creditors initially lost about 40 percent. It was the first time senior bank bondholders in the EU underwent a so-called haircut in an orderly resolution and the event left most Danish lenders shut out of wholesale funding markets.

Default Swaps

The cost of insuring against losses on financial debt surged over the past week amid concern senior bondholders will be included in future bank bailouts. The Markit iTraxx Financial Index of credit-default swaps jumped 41 basis points during the period to 184, the highest since Nov. 16.

Swaps extended their rise today after Reuters reported that Dutch Finance Minister Jeroen Dijsselbloem said euro-area nations with large banking industries must look to restructure and reduce their overall size.

Banks typically fund themselves with some combination of deposits, equity, senior and subordinate notes and covered bonds, which are backed by a pool of high-quality assets that stay on the lender’s balance sheet.

The consequences of the Cyprus bailout could be that banks will be more likely to use contingent convertible bonds -- known as CoCos -- to raise money as their ability to encumber assets by issuing covered bonds reaches regulatory limits, Bowie said. CoCos are designed to be converted to equity or written down if a lender’s capital ratios fall to a stated level, helping preserve taxpayers and more-senior creditors, including depositors, from loss.

‘Historic Context’

“The action Cyprus has been forced to take with regards to its banks is considerable in a historic context,” Eva Olsson, an analyst at Mitsubishi UFJ Securities in London, wrote in a note. The measures could have “serious consequences” for investors in “weaker banks throughout Europe,” she wrote.

The Cyprus bailout sets a precedent that is likely to influence future banks resolutions, according to Moody’s Investors Service.

Rising pressure on sovereign balance sheets strained by recession bodes ill for senior creditors of troubled banks, London-based analyst Sean Marion wrote in the firm’s bi-weekly Outlook. The strain has made them more willing to risk the fallout from aggressive measures to share the cost of bailouts, showing that the “landscape is shifting to the detriment of senior bank creditors,” he wrote.

“The authorities’ willingness to endorse losses, including insured deposits is a significant evolution in policy,” he wrote. “The change in policy could yet cause contagion and may increase the cost and reduce the stability of funding in other euro-area banking systems.”

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