Bank bondholders
Burning sensation
Taxpayers should not pay for bank failures. So creditors must
Jul 21st 2012
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“THE only way to deal with moral hazard is to take out bank bondholders and have them shot,” says a hedge-fund manager. By “shot” he is not recommending actual executions, but saying that investors should suffer losses when the banks whose bonds they hold need rescuing. To date during the financial crisis this has been a rarity. Bondholders have been the Scarlet Pimpernels of finance—investors who prove elusive every time a bank’s losses are divided up.
The era of impunity is coming to an end. In the short term some creditors of Spanish banks may be forced to suffer losses as a result of a planned euro-zone rescue of that country’s financial system.
Over the longer term regulators in Europe and America are rewriting rules to “bail in” bondholders by converting debt to equity. These moves may have a far-reaching impact on the price banks pay to borrow, and thus on what they end up charging for credit. And the transition to a system designed to protect taxpayers from expensive bail-outs may be a bumpy one.
To understand how bank bondholders ended up in their privileged position, you need to look at the capital structure of banks. Imagine a cake of many layers, each representing the bank’s liabilities. At the very bottom is a thin sliver of costly equity.
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This is the money that a bank’s shareholders have put into the business. Next comes a layer of “hybrid” or “junior” debt that is supposed to pad out the equity layer but is made of somewhat cheaper ingredients. Above that come various layers of debt that make up the main body of the cake.
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The thickest slices are bank bonds, or “senior unsecured debt”, and bank deposits. The icing on top is its “secured” debt, such as covered bonds or other loans and derivatives, where creditors can grab hold of assets if their loan is not repaid.
Dessert storm
These layers serve two purposes. When money is collected by the bank it is first paid out to those in the upper tranches, usually as fixed-interest payments on deposits or bonds. If anything is left it trickles down to the shareholders. But when losses are incurred, bites are taken out of the cake from the bottom first. In return for taking a chunk of the profits in good times, shareholders get wiped out in bad times.
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This system worked very badly in the financial crisis. The first problem was that the equity layer was far too thin, and that banks were wary of imposing losses on holders of hybrid debt. There was not enough loss-absorbing capital in the banks to cope with the losses they incurred. So more equity had to be found.
The second problem was that this money tended to come from taxpayers. Senior bondholders were repaid in full in all but a handful of cases. Ireland is the most egregious example of a country plunging into debt in order to repay its banking system’s bondholders. This was partly for legal reasons: in many countries bank deposits and senior bank debt were in the same layer of the cake, so that one couldn’t take losses without the other also doing so, a politically unthinkable prospect. But the bigger reason was that regulators were terrified that if they imposed losses on bondholders they would cause a wave of panic across the financial system that would hit funding for all banks.
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The pendulum has now swung. This is evident in the Spanish bail-out, where euro-zone governments are reluctant to put their own taxpayers’ money at risk while seeing Spanish bondholders and holders of hybrid debt being repaid in full. Holders of the lowest layers of debt in bailed-out banks are likely to see their debt converted into equity and to take losses. This is particularly controversial in Spain, because many of the holders of this type of debt are unsophisticated retail customers: horror stories are emerging of illiterate customers signing up for risk-bearing debt with their thumbprints.
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Imposing losses on junior debtholders is one thing; trying to bail in senior bondholders is quite another. In a significant U-turn, the European Central Bank (ECB) has reportedly proposed imposing losses on bondholders in Spanish banks that collapse. That idea was rejected by European finance ministers because they worried it would spook markets.
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It is only a matter of time. In Britain, Switzerland and the European Union rules are either now in force or being drafted that will force banks to ensure that at least some of their debt can be turned into equity in a crisis.
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Some of this debt may take the form of convertible bonds that convert at a specific trigger-point: Credit Suisse issued SFr3.8 billion ($3.9 billion) of this sort of debt on July 18th. Most will be ordinary bank bonds that can be converted by the regulator. Rules empowering the Federal Deposit Insurance Corporation to take over failing American banks achieve much the same result.
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Yet imposing losses on bondholders risks unintended consequences. The first is that the cost of bank debt may rise a lot more than it has already. A decade ago big companies paid more to borrow than banks did. Now the opposite is true (see chart). This gap may widen further as investors price in the risk that governments will do all they can to avoid bailing out banks (although higher equity levels, the thicker bottom slice of the cake, also offer bondholders more protection from losses).
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A second risk is that senior bank creditors will respond to the potential for losses in a way that makes the system less stable. They may make sure their loans are secured—which in turn increases the losses inflicted on the remaining unsecured creditors and thus the price they will demand.
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Or they may plump for short-term debt so that they can pull their money out in a flash. Such dangers underpin the case for a gradual transition to a bail-in regime, but do not undermine its desirability. A world in which bank bondholders expect to get shot is one in which taxpayers are safer.
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