Europe Imposing Losses on Bondholders Will Penalize Weaker Banks

A European Union plan to impose losses on bondholders during bank rescues means borrowing costs for weaker banks will rise unless they bolster their finances, said analysts and fund managers including Simon Adamson at CreditSights Ltd.

“There’s going to be more differentiation of banks based on their standalone financial situation,” Adamson said by telephone from London today. “Banks with weaker capital levels or profitability will find it tough to get financing or at least will pay a higher price.”

European finance ministers agreed today that creditors should be liable for bank failures before taxpayers as they worked to overcome the euro-area debt crisis and break the link between governments and lenders. Bond investors will help support regulators in pushing banks to boost capital because they will reward the strongest, said Adamson and Ingo Frommen, an analyst with Landesbank Baden-Wuerttemberg in Stuttgart.

“Banks will be looking to set aside reserves for stress scenarios,” said Frommen at LBBW, which recommends investors weight European banking stocks neutrally in their portfolios when compared to a wider index of equities in the region. “This may also help regulators go some way in solving the issue of too big to fail.”

Risk Premium

The ministers’ agreement requires regulators to write down creditors, in order of seniority, until 8 percent of the distressed bank’s liabilities are wiped out, before they grant exemptions and turn to national backstops instead. The deal offers some wiggle room for regulators, after notifying the European Commission, to exempt some creditors and shift the burden to others.

“The bail-in threshold will increase the premium asked by investors to fund riskier institutions,” said Angelo Drusiani, who helps manage about 3 billion euros ($3.9 billion) of securities at Banca Albertini Syz & C. in Milan. “I also expect a marginal impact on senior debt, now included in the bail-in.”

The cost of insuring against losses on senior bank debt fell for a third day, with the Markit iTraxx Financial index of credit-default swaps dropping 2 basis points to 166 basis points. Financial shares declined, with the Stoxx 600 Index of banks sliding 0.9 percent at 2 p.m. in Frankfurt.

Frommen and Adamson, who recommends investors hold European bank debt, said investors will have to wait to see how the plan is implemented to get a full picture of how it will affect bond prices.

Alberto Gallo, an analyst with Royal Bank of Scotland Group Plc, said he doesn’t expect to see yields on senior debt rise as most banks will be able to cover the 8 percent of liabilities with equity and subordinated debt.

“It’s balanced and I don’t expect negative reactions,” said Gallo. “This is a positive agreement overall.”

Senior unsecured debt issuance won’t dry up, though Europe’s leaders need to ensure that banks keep selling bonds that can be written down in case of failures, Adamson said.

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