Two Shades of German Seniors Show Bail-in Pecking Order

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The European Union put senior bondholders in line for losses when banks fail, and Germany is leading the drive to make them actually take the hit should the time come.

The German Finance Ministry has proposed measures that amend the order in which creditors are served if a bank becomes insolvent. The legislation would subordinate senior unsecured bonds to other senior liabilities such as unsecured deposits and derivatives, clearing the way for writedowns in a crisis.

After the European debt crisis turned German taxpayers into bailout masters, the country is trying to make sure more parties are on the hook for losses from failing institutions. The German bill is intended to facilitate the EU resolution law, which requires creditors to bear losses equivalent to 8 percent of a bank’s liabilities, including senior debt if necessary, before recourse can be made to rescue funds.

“It could be a model for Europe,” said Elke Koenig, the former head of Germany’s BaFin regulator who now heads the euro area’s bank resolution authority. “It is one idea really to make senior debt bail-inable,” she said in a March 30 interview in Brussels.

Rulemakers from the global Financial Stability Board to the EU, as part of its Bank Recovery and Resolution Directive, are developing additional buffers intended to make sure public money isn’t used to bail out lenders. The FSB proposed that the world’s 30 biggest banks have subordinated debt and other loss-absorbing liabilities equivalent to as much as a fifth of their assets weighted for risk.

Eligible Securities

The FSB proposals on total loss-absorbing capacity, or TLAC, prompted banks from Tokyo to London to warn the rules may drown the corporate bond market in new paper and drive up funding costs for all companies. Industry groups have called on the regulator to widen the range of eligible securities.

Other concerns raised include that the measure may discriminate against Europe by favoring banks with a holding-company structure, in which debt issued by the parent company can be bailed in separately, leaving the creditors of the operating banks untouched.

“The ability to bail in only senior debt instruments is not clear-cut,” said Francois Lavier, who helps manage 3 billion euros ($3.3 billion) of fixed-income funds at Lazard Freres Gestion in Paris. “Being sure that you can legally write down just senior bonds is very useful for resolution authorities.”

‘Neat Way’

That separation isn’t as easy for continental firms such as Deutsche Bank AG or UniCredit SpA, where liabilities that serve very different purposes may be all ranked pari passu, or treated equally in an insolvency procedure.

“We’d long argued that even under the BRRD, senior debt was extremely difficult to bail in as it ranked pari passu with other large blocks of senior liabilities,” Morgan Stanley credit analysts led by Greg Case said in a note on March 30. “The new German proposed law is an extremely neat way of getting around this practical problem.”

Retail deposits that exceed 100,000 euros, deposits from companies or other banks, untraded debt instruments like Schuldschein loans and debt based on derivatives are all among instruments that are ranked equal to senior unsecured bonds under current German law. But they could be more prone of causing contagion beyond the failing bank and therefore increase the threshold to bail-in creditors.

“Including those liabilities in the creditor bail-in could result in contagion and in risks for financial stability,” according to the ministry’s draft. “This would counter the resolution goal to prevent systemic risks.”

Market Lags

The FSB will carry out an impact study of the draft TLAC rule before completing work on it by the end of 2015. The proposal is due to be effective from 2019. The EU’s MREL is due to be implemented from next year, with details yet to be defined by the European Banking Authority.

The consistency of the proposed German rule with the EU’s bail-in approach creates more certainty for investors, while the market still hasn’t adapted to the new reality for bond investors, said Michael Huenseler, who helps oversee about $16 billion at Assenagon Asset Management SA in Munich.

“It’s consistent and means that the bail-in rules and the TLAC requirements converge,” Huenseler said. “The market conditions still don’t reflect that. The spread between junior and senior debt is too wide.”

The German plan to subordinate senior bonds to other senior could become a blueprint for Europe, he said. “The government made a good choice by creating the standard itself and thereby lead the EU discussion in a certain direction.”

Germany’s government invited stakeholders to send their comments to the law until March 27. The draft then goes up to the government, possibly amended and will be sent to parliament thereafter. It’s expected to come into force next year.

“Senior bonds are not a risk-free instrument but a funding given to a company,” Lazard’s Lavier said. “This will push investors to truly investigate and make their own due diligence on the quality of the banking issuer.”

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