Within the next two weeks the final wording of the Financial Stability Board’s proposed minimum Total Loss-Absorbing Capacity (TLAC) and the European Union's Minimum Requirement for own funds and Eligible Liabilities (MREL) will be known.
The two regulations make it clear that senior unsecured bondholders will be subordinated to retail deposits, SME deposits, and the operational liabilities of a bank, including most derivatives. A big chunk of a bank’s term funding will be eligible for bail-in.
Germany brought in its TLAC reform at the end of September, to go live from January 1 2017. Italy amended its bank insolvency law in early September, while France and Spain should soon follow.
This week, analysts at Société Générale estimated the increase in Loss Given Default (LGD) for senior debt at Europe’s major banks, based on the degree to which they depend on senior unsecured to meet their TLAC/MREL bail-in requirements.
They said Commerzbank’s five year cash spread should widen from 73bp to 102bp. Deutsche Bank, which they termed “the weakest of European universal banks,” should see its spread widen from 79bp to 94bp, while BNP Paribas should be 43bp wider in five year bonds if the French pass a similar law to the German TLAC law.
Intesa Sanpaolo and Monte dei Paschi di Siena are the most vulnerable in Italy, with potential widenings of 14bp and 76bp, while in Spain Caixabank bondholders face “significant spread under performance” from the introduction of a senior bail-in law. The Spanish bank’s low volume of outstanding senior debt implies a much higher LGD, and its senior spread should theoretically rise from 77bp to 129bp.
But senior spreads are actually going in the opposite direction. The Markit Senior Financials index stands around 70bp, down from nearly 100bp at the end of September.
The move is partly because of hopes of further stimulus and global central bank easing. After the People’s Bank of China cut rates 25bp to 4.35% last week, the ECB should follow in December, taking deposit rates further into negative territory, and expanding its quantitative easing programme. Japan may announce further quantitative easing as early as Friday this week.
But the euphoria in other market has not helped covered bonds, which sit at the top of the capital stack, safe from bail-in.
According to Markit, covered bond spreads are now at their widest in 14 months, and at levels last seen before the ECB announced its third covered bond purchase programme. With each primary deal, secondary spreads have widened and as the ECB has pushed out many investors, private sector liquidity is thin.
Once hope of further quantitative easing has been exhausted, the technical rally in senior unsecured bonds should fade away, credit will once again reflect fundamental value, and senior will widen against covered bonds.