The bail-in of unsecured creditors of Bank of Cyprus earlier this year put bank resolution in the EU firmly in focus and has sped up efforts to establish an EU-wide banking union, along with a comprehensive bank resolution framework.
However, the Cyprus bail-in has created more uncertainty than it cured, with Dutch finance minister Jeroen Dijsselbloem being forced to quickly retreat from his suggestion that the Cypriot solution may be the EU’s model response to a credit situation at a systemically important financial institution.
While rating agencies have looked at the rising prominence of the EU’s Bank Recovery and Resolution Directive (BRRD) with some wariness, it seems unlikely that any of them will take the step of removing sovereign uplift from credit ratings in the near future. Indeed, a number of factors have led them to take the view that banks may continue to enjoy a ratings boost from sovereign support for longer than may be expected — even with the spectre of bail-in looming.
Several European countries — including Denmark, the Netherlands and Sweden — have already introduced some of these measures included in the BRRD at the domestic level, with none of the big three agencies feeling the need to remove government support from credit ratings in response.
Indeed, the bail-out of Dutch lender SNS Bank in February provides a recent instance of national regulators proving reluctant to employ the full scope of resolution tools available to them.
Government documents show that the state considered the bail-in of senior debt and covered bonds, but ultimately restricted itself to just subordinated instruments to avoid instability and creating funding difficulties for other Dutch banks.
Practical concerns
European economies are continuing to struggle to achieve sustained growth and deal with high levels of indebtedness, while the continent’s banks are still in a period of recovery and restructuring following the weaknesses exposed during the global financial crisis. Put bluntly, as much as sovereigns may want to avoid having to prop up struggling institutions it simply may not be feasible to rely on other solutions at this stage.
“We believe that EU governments with sufficient financial resources will continue to support senior creditors of systemically important banks at least until economies and bank balance sheets recover, and structural reforms are implemented to make banks more easily resolvable,” says Richard Barnes, senior director in financial services ratings at Standard & Poor’s.
“There are differences in view that leave it unclear precisely how much flexibility governments will be accorded when the bail-in tool is introduced. Until these uncertainties are resolved, Standard & Poor’s is of the view that it is not yet clear whether the directive will materially reduce the interdependence between bank and sovereign creditworthiness.”
The most recent development on the interplay between bank resolution — particularly the bail-in tool — and credit ratings came in August when the Swedish National Debt Office announced the completion of a framework for the implementation of the BRRD.
No ratings action has yet been taken, but Moody’s judged the announcement to be credit negative for Swedish banks as it increased the likelihood of creditor bail-ins. All Swedish banks — numbering about 270 — will be subject to the resolution tools introduced by the debt office, but the impact will be felt most strongly at the four largest institutions: Nordea, Svenska Handelsbanken, Swedbank and SEB.
Sweden has historically been considered supportive of banks deemed to be systemically important. The Bank Support Act, introduced in 2008, created an assumption of very high systemic support for the four big banks, translating into a three-notch ratings boost from Moody’s.
Swedish authorities are still working on a framework for what debt will be eligible for bail-in for all institutions, and recovery plans for the four major banks are expected to be finalised by the end of the year.
Flexibility is the key factor
There remains dispute at the EU level of exactly how the resolution tools — particularly bail-in — will operate, meaning in turn that much of the impact that the incoming regulations will have on sovereign support has yet to be fully determined.
While EU writing on the subject has generally presented bail-in before bail-out as the rule rather than the exception, the rating agencies appear to be less confident, as a result of the fragile confidence among investors and depositors in the current environment.
The European Commission has been clear that a bail-in of junior debt will be considered a pre-condition of approving state aid for an institution and the rating agencies have ceased to factor in sovereign uplift to the rating of subordinated debt.
However, the status of senior bail-in is rather more unclear and has been identified by the rating agencies as a leading source of uncertainty surrounding the directive.
Fitch research notes that the BRRD proposals in their current form do not necessary rule out bail-out of senior debt even for banks that meet the conditions for resolution under the directive.
However, the European Council has proposed that for a bank to be able to receive public funds it must bail-in 8% of its funds and liabilities. Most banks would need to increase their holdings of junior debt to avoid needing to use senior debt as part of that bail-in.
“The big sticking point in the negotiations around the Bank Recovery and Resolution Directive is the flexibility for sovereigns to bail-out failing banks before imposing losses through bail-in,” says Johannes Wassenberg, managing director in EMEA banking at Moody’s.
“It just isn’t clear at the moment what will be decided. The core sovereigns are feeling less fiscal pressure and want more discretion to be able to bail out banks, but on the periphery they have a very different view.”
While the rating agencies are of the view that governments will still have the flexibility to bail out financial institutions — at least in the case of those that can continue operating — not all market participants agree. Elie Darwish, senior fixed income analyst at Natixis, argues that an overly generous reading of the directive has introduced a degree of flexibility that simply isn’t intended.
“Rating agencies so far seem to have treated the crisis directive as almost a non-event stating more clarifications were needed and reading in a degree of flexibility for sovereign governments to bail out banks — my take on it is that the directive will render it impossible for a government to use public funds to bail out its banks without bailing in senior bondholders,” he says.
Darwish does note, however, that national regulators may be permitted to use funds levied from its domestic banking sector to fund the bail-out of a failing institution.
Even if giving regulators the flexibility to bail out troubled institutions may keep credit ratings buoyed, it runs the risk of generating uncertainty. At least if bail-in is the norm, investors are aware of the likely outcome in the instance of a credit event. But how willing will they be to bet on the tendency of regulators to bail out rather than in?
“From a bank bondholder’s perspective, clearly they benefit from the expectation of sovereign support,” says Moody’s Wassenberg. “However, looking forward there is the concern that uncertainty created by the evolving resolution framework discourages investment in banks or at least leads to higher funding costs. Investors could take the view that the outcome in a credit event would be completely unpredictable and demand a high risk premium.”
There is even indecision on when exactly countries are expected to have implemented the bail-in tool in national legislation. While most of the provisions in the Bank Recovery and Resolution Directive are expected to come into force on January 2015, the status of the bail-in tool is rather more murky.
The European Council proposed that the tool should be implemented by 2018, while other parties — including the European Central Bank — have pushed for an earlier start date.
Unequal application
Should the possibility of bail-in begin to hurt banks’ credit ratings, it is unlikely to have an equal impact across all jurisdictions. Certain banking systems are able to derive more support from their sovereigns than others, whether because of stronger sovereign finances or regulators taking a more receptive view to intervention in the banking sector.
This is reflected in the debate surrounding how much flexibility that regulators have to bail out before they impose losses on senior bondholders, with weaker European sovereigns generally seen as favouring mandatory burden sharing.
“There is a definite dichotomy between the core with its strong public finances and the periphery,” says Natixis’s Darwish. “Banks in the core are benefiting far more from a sovereign uplift, institutions in Spain or Italy, for example, receive a smaller rating upgrade. The idea that sovereigns must bail-in senior bondholders before they can bail out banks privileges peripheral banks.”
German Landesbanks have been singled out as likely to see particular impact from a growing recourse to bail-in. Their unique ties to their respective states means they are considered as especially likely to enjoy support in the instance of a likely credit event.
Standalone strength
is improving
Even if sovereign support does lessen and result in a lower overall credit rating, the deterioration in support will take place against a backdrop that is largely seeing banks’ standalone strength grow.
“It’s worth bearing in mind that there’s also a lot going on at the moment that’s working towards improving the credit profile of banks, most notably the Basel III agenda,” says James Longsdon, co-head of EMEA financial institutions at Fitch. “I think it’s reasonable to assume that capital in particular will continue to improve: the EBA stress tests will certainly act as a stick to encourage this.”
So while there is a threat that the agencies may begin to lessen — or remove — the positive impact of sovereign support on bank ratings, there is also the hope that it will coincide with an improvement in banks’ standalone credit ratings.