On the face of it, it is difficult to see how anyone would want to launch an impassioned defence of the name “non-preferred senior debt”.
It is never particularly elegant to define something in terms of what it is not, making the whole construction come across as a late addition to George Orwell’s ‘Newspeak’, the totalitarian language in 1984 where words end up meaning their opposite.
But talk to enough bank capital experts, and you are bound to come across someone who thinks the label “non-preferred senior” is actually quite beautiful.
After all, some corners of the industry fought very hard for it to become an official term.
The label describes a new type of bond in Europe, ranking between ordinary senior debt and subordinated tier two capital in a bank’s hierarchy of creditors.
Structurally these new instruments closely resemble normal senior bonds, but they differ in one very important aspect — they give European banking authorities a clear legal basis for imposing losses if the issuer fails and is put in resolution.
This gives it something of a similar role to subordinated debt, which can be used to absorb losses as soon as a bank is no longer considered viable by regulators.
The beauty of labelling the new asset class as non-preferred senior is that it emphasises its similarities with ordinary senior bonds, while drawing away from its similarities with subordinated debt.
Terms like ‘tier three’ and ‘subordinated senior’ may not have had the same effect had they won out as alternatives.
Plus ça change
Take, for example, an innovative transaction from the UK’s Yorkshire Building Society earlier this month.
Yorkshire was able to buy back an old series of its tier two bonds and replace them with a new issue of non-preferred senior debt.
Market participants praised the issuer’s efforts to make its capital structure more efficient, suggesting that it had saved on spread by switching into a new £275m issue of six year non-call five non-preferred senior bonds at 215bp over Gilts.
But in a relatively small financial institution such as Yorkshire, this kind of cost-saving exercise should not really have been possible.
Though there are some minor structural differences that make non-preferred senior debt inherently less risky than tier two, the real concern for investors when pricing a new deal in either of these asset classes should be their chance of losing principal.
The failure of Spain’s Banco Popular in 2017 proved to the market that if any second tier financial institution ended up collapsing, the extent of the losses suffered by the firm would mean that the chance of recovering money on subordinated paper was likely to be close to 0%.
In Yorkshire’s case, an investor switching a slice of tier two capital for a slice of non-preferred senior paper wouldn’t be getting away from this reality.
Indeed, the size of the firm’s buffer against financial losses would remain the same, with only the names of the different bonds involved having changed.
A new fight
The Australian Prudential Regulation Authority (APRA) turned a few heads last November when it said that it wanted domestic banks to meet international requirements for loss-absorbing debt (TLAC) by issuing tier two capital rather than any ‘bail-inable’ form of senior bond.
GlobalCapital understands that Australian financial institutions have now pushed back against APRA’s proposals, complaining that it would make them the most prolific issuers of subordinated debt in the world.
According to David Marshall, a senior analyst at CreditSights, “the banks are trying to persuade APRA to let them issue non-preferred senior with contractual and statutory bail-in”.
These arguments rest on the idea that it would be more expensive to issue tier two for TLAC than it would be to follow the rest of the world and invent a new type of senior debt for the same purpose.
Branding something as ‘senior’ within the creditor hierarchy, however loosely defined, can make all the difference for some fund managers, whose investment mandates prevent them buying ‘subordinated’ products.
But this does not change the fact that creating more and more layers of debt on a bank’s balance sheet may not do anything to protect one tier of bondholders any more than another.
While it is unclear whether APRA will end up kowtowing to the banks in Australia, it is increasingly apparent that labels, just as much as the details of loss-absorbency, have power in the capital markets.
If the fight over whether a new class of European bank debt should be called ‘non-preferred senior’ or ‘tier three’ seemed petty three years ago, it shouldn’t now. The labels have power — and real cost impacts.