The European Commission has released a “working document” that “seeks views on the technical details of a possible EU framework for the management of failing credit institutions and an appropriate class of investment firms.” There’s a press release here and an FAQ here.
The document contains a lot of sensible proposals that would lead to a common future European approach to dealing with failing banks, in contrast to the chaotic and disorganised approach that was seen during 2008-2009.
There’s plenty in the document worth discussing but, given the particular focus of this blog, it is clear that the most interesting aspect of the document is the annex starting on page 86 titled “Debt writedown as an additional resolution tool”. It’s worth reading in whole but here’s the basic idea:
Thus, to provide additional flexibility and to ensure that any write down power is sufficient to deliver the policy objectives, this consultation outlines two possible models for additional write down powers. Building on the minimum powers above, the first ‘comprehensive’ approach aims to make a broad range of senior creditors face the real risk associated with bank failure. The second ‘targeted’ approach aims to create a more focused tool for resolving in particular, institutions which have been assessed as likely to prove difficult to resolve with traditional resolution tools at a time of fast moving idiosyncratic or systemic crisis.
Resolution authorities could be given a statutory power, exercisable when an institution meets the trigger conditions for entry into resolution, to write off all equity, and either write off subordinated debt or convert it into an equity claim. However, in some cases this will not be sufficient to ensure that an institution in difficulty returns to viability so as to maintain market and creditor confidence when the markets next open. (For example, RBS’ balance sheet at the end of 2007 contained £38bn in subordinated liabilities, while losses before tax in 2008 amd 2009 amounted to around £43bn.
As is de rigeur these days the Commission argues that “Such a power would only apply to new debt issued (or existing debt contracts renewed or rolled over) after entry into force of the power.” In other words, existing European senior bank debt cannot take a haircut in this way.
However, the problem with this argument, as well its sovereign cousin (the idea that only post-2013 sovereign debt will be open to restructuring) is that it is subject to what economists call time inconsistency. As described by Wikipedia, “time inconsistency describes a situation where a decision-maker’s preferences change over time in such a way that what is preferred at one point in time is inconsistent with what is preferred at another point in time.”
Today, Europe has lots of troubled banks and some troubled sovereigns. Ideally, the powers that be would like financial markets to not worry about being defaulted on and to keep lending to these banks and sovereigns. No agreed EU resolution regime for banks or sovereigns is in place, so the authorities would like to reassure current lenders that they will be safe when such a regime is put in place and that it is future lenders who will take the hit.
However, when the future arrives, it becomes the present and future senior bank bond investors will consider a regime in which only they are subject to a resolution regime involving selective haircuts as totally unacceptable.
The time-inconsistency of the current sovereign debt proposals are clearly recognised by sovereign bond markets, which are pricing current Irish and Greek government bonds at yields that clearly indicate the likelihood of default. For banks that are already in trouble, it seems unlikely that these proposals will really comfort bond investors that they are genuinely safe from getting haircut by a future resolution regime.
60 replies on “EU Commission Document on Bank Resolution Framework”
Of course, if the EU does manage to kick the can as far as 2013, the time-inconsistency (lovely phrase) could then manifest itself as an official consensus that it the markets remain too delicate to endure any restructurings at present (which will then be 2013) but firm plans should be put in place to proceed with haircuts in 2016 or so.
– Richard Smith
On the other hand, the Austrian central bank head Ewald Nowotny is now calling for the ESM to be put in place before 2013.
I think it’s worth noting that other significant bits of information have been dumped into the Epiphany news cycle.
Anglo execs were cashing out of an insolvent bank, though Brian Lenihan had conveniently confirmed it solvent for another couple of months after the big payouts
http://www.rte.ie/news/2011/0105/drummd.html
The financial regulator foresees a bride of NAMA
http://www.independent.ie/business/irish/the-interview-matthew-elderfield-financial-regulator-2485662.html
The margin on the 1st EU installment to Ireland is bigger than the cost of funds
http://europa.eu/rapid/pressReleasesAction.do?reference=MEMO/11/4&format=HTML&aged=0&language=EN&guiLanguage=en
There have been a lot of raised eyebrows in the sov markets over the analogous suggestions for CAC-ed non-local law bonds to replace the current selection. I’m not going to re-hash them here but if you hunt around you will find the question of which ones in reality might be senior is not at all clear. It is quite likely you could cut and paste into the senior bond question much of that discussion.
In a perverse way it’s quite funny. Europe has a tradition of coming up with half-baked responses to events which the political and civil servant class have always managed to get past fairly apathetic and easily manipulated public opinion. Repeating a phrase or soundbite many, many times in order to make its content be accepted as true probably won’t work so easily with the continent’s bond desks.
It ‘s also a bit funny that some of us have bought and sold bonds on the understanding that there was credit risk attached to them. Further, that that credit risk varied according to where the credit stood in the capital structure of the issuer – and even been offered higher yields for holding more risky bonds in the same issuer.
We had no idea we were so ahead of the curve and that all these years later the EU would invent that very concept.
What a waste of time – till now we could have just looked at the redemtpion yield tables and bought whatever had the biggest number infront of the percent symbol!
At a recent meeting of the G20 the Asistant Deputy Ministers Finance of Canada and India were assigned the task of formulating a method of identifying countries who were heading for financial difficulty of a type that would cause them to adopt policies that would damage the economies of their trading partners. No doubt this will result in guidelines and policies covering prevention and cure for the G20 as a whole.
Two Infrequently Asked Questions:
1. If the Commision had devised a scheme of bank resolution to coincide with the introduction of the Euro in 1999, would they have suggested 2013 as the starting date, with taxpayer guarantees on bank debt in the interim?
2. Would they have suggested centralised bank resolution without centralised bank supervision?
Since these things seem to go in cycles, what we’ll find, I think, is that suppliers of funds in the international capital markets (both sovereign and corporate) will over-price risk, having previously seriously under-priced risk – in particular, in the peripherals. The varying abilities of the sovereigns and firms to offer the required yields probably means that the EU segment of this market will clear at lower volumes of supply than are required. This will drive even more austerity to encourage providers of funds to reduce the yields demanded. Not an inviting prospect.
This consultation on an EU bank resolution process feeds into this bigger picture. Similarly to the EFSF-related sovereign debt proposals this will raise the banks’ future cost of funds. But the sovereign bond market reckons that relying on the public purse (currently in the peripherals) to keep current bank (and pension fund) bondholders whole – though the bonds are under the water – will impair the ability of these sovereigns to service that debt. On the other hand, offering the peripherals some relief will require sovereigns in the core EZ to use public funds to shore up thier banks – with a similar impairment of their sovereign debt service ability. This is the kind of uncertainty that the sovereign bond market abhors and I would be surprised if they don’t keep the pressure on to force a removal of this uncertainty.
Whatever about imposing haircuts sometime in the future, the requirement for, and clarity on, haircuts in the present is becoming more pressing.
Karl,
I think it is worth pointing out that the time inconsistency could also work the other way: when it comes to 2013, continued difficult market conditions means that the new regime is not even applied to new borrowing. This is the soft budget constraint phenomenon — tough talk, but agents see that you do not have the incentive to follow through on your threats.
In any case, you are of course right that current yields indicate a large perceived default risk on outstanding bonds. Could another explanation be that potential investors perceive a large roll over risk if the new regime is applied? Under this scerario, it is not that the resolution regime is applied retrospectively, but the new regime makes it impossible to roll over maturing bonds.
John,
The new regime will a) create a new more risky class of senior debt with higher yields than current senior debt b) potentially result in a drop in the supply of credit partiularly to riskier banks (in the periphery?)
So the price of credit to the banking system goes up and the supply goes down-especially in the periphs. What do that do to the prospects of the periphery trading out of the current problems?
@ JohnTheOptimist
While an €18bn deficit is not good news in itself, people generally react more to bad news.
German imports in November grew at the highest monthly rate since 1950 – – good news?
@ All
There is no free lunch in this game.
Our Government is trying to get pensions funds to increase investments in sovereign bonds; it would be ironic if private sector pensions, already in dire straits, were to be hit in a restructuring while academic advocates of bondholder burning had their lavish pay-as-you go pensions protected.
“However, when the future arrives, it becomes the present and future senior bank bond investors will consider a regime in which only they are subject to a resolution regime involving selective haircuts as totally unacceptable.”
The name of the game is power. What is one man’s totally unacceptable is another woman’s strategically imperative.
This time inconsistency has the same ring to it as “no-bailout, no default, no exit” that is set out in Maastricht.
Does the commission enjoy building contradictions and inconsistencies into its agreements or is it simply the product of political compromise?
Anyway, this bank resolution framework, along with the sovereign framework, mean that extant Irish banks and the Irish sovereign will not be able to return to markets in 2013 and possible not until 2023. All of which makes a drastic rethink even more likely.
@Seafóid
Good point.
The woman I think you are referring to has very little motivation to really solve the banking or Euro “crises”.
Whereas the US has QE and China capital controls, the Eurozone has Ireland and Greece.
@ Karl
under this framework you’re looking at subordinated debt which can be wiped out on a margin call, a new form of senior debt “lite” which will rank below deposits, and contingent convertible’s which the markets are still trying to figure out both demand and ratings/risk for. The ultimate outcome, as Tull suggests, is a much higher cost of capital, and so a much higher consumer and business lending rate.
While i agree with this framework in principle, the outcome is going to have a pretty negative impact on an already struggling periphery. Not sure what the answer is, other than maybe some massive banking sector consolidation as a way of spreading risk more broadly, but don’t see this happening in the relatively short time frame envisaged.
@Bazza
For the moment it is Ireland and Greece but Portugal will join soon and Spain may also be sucked in. The EZ may not have a choice if Spain falls.
Nobody wants to rock the boat but that policy may become untenable. It may not be possible to keep bondholders sweet through 2011.
@JtO
As far as I remember, most of the criticism was about the goverments growth estimates that were published in the 4 year plan. And it was not just commentators here that disagreed: days after the 4 year plan was published, the commission published its own growth estimates for Ireland which were significantly below the government’s.
http://www.irisheconomy.ie/index.php/2010/12/12/the-eu-commission%E2%80%99s-view-of-ireland/#comments
Given your confidence in the government’s forecasting ability, it would be interesting to hear if you disagree with the commission’s forecasts, which are more than 1% below the government’s.
@Seafóid
I agree and that’s why I only mentioned Ireland and Greece. Spain and Italy would obviously pose an existential threat to the Euro and that’s why damage limitation has been the name of the (very risky) game.
My basic point is that the powers that be in German and Paris don’t give a monkey’s about us – in fact, if our problems weaken the Euro a bit, well, every cloud has a silver lining.
The EU are all over the place on how the banking system should work. No doubt each country has its own interests to protect, so finding a common platform is difficult. It reminds me of the saying that a camel is a horse designed by a committee.
Last September the EU announced a directive (?) that would see depositors guaranteed to Eur100k. But it appears that hitting seniors isn’t allowed. This is not consistent.
Why should shareholders of banks benefit from government guaranteed (and therefore cheaper) funds that are not available to other businesses?
If we’re operating a capitalist model, then let it function. Failing that, what exactly are the rules or will it always be a case of mañana?
Off topic, but we should be informed of exactly what level of support the ECB is willing to extend to the Irish banks? Mentions of NAMA II (Return of the Zombie) and bank contingencies in the EU/IMF bailout fund have me nervous.
@ Bazza
“My basic point is that the powers that be in German and Paris don’t give a monkey’s about us – in fact, if our problems weaken the Euro a bit, well, every cloud ”
Yes. I was reading over some of the stuff from this site from November earlier this week and what really stood out was the expectation from many quarters- before the IMF etc terms were announced – that the country would now be steered by responsible, competent authorities who would help Ireland get back on its feet and back to growth. And the NPRF was there in case of an emergency.
Instead what happened was the imposition of a further layer of shafting overseen by the EU/IMF with no interest in the patient other than securing the maximum wealth for bank bondholders.
I think that came as a shock to many people. It certainly did to me. The power game of the core versus the rest and Ireland isn’t at the core.
Portuguese 10 year enters the death spiral
http://www.bloomberg.com/apps/quote?ticker=GSPT10YR:IND
@colm mccarthy
“Two Infrequently Asked Questions:”
A more frequently asked one:
3. If you were designing a single market for financial services would you design regulation at the market level or at the local level?
@seafoid,
“I think that came as a shock to many people. It certainly did to me. The power game of the core versus the rest and Ireland isn’t at the core.”
During the ’70s and ’80s there was a limited political consensus in the core to expend treasure to help lift the peripherals out of backwardness and the residual impact of dictatorship, but it was handled at the EU-level without voters’ direct consent (even if they benefitted as well). The EMU project was pursued by the EU’s Grand Panjandrums with even less direct voter consent. The naive assumption was that all members would behave and be well-governed like those at the core. It looks like voters in the core are damned if they’re going to expend treaure to rescue the peripherals again – even if it is ultimately in their interests. And their politicians live in dread of presenting them with the bill.
It is politically and economically expedient to hose the peripherals in the short term. But they will have to bite the bullet sooner rather than later.
@Ahura Mazda
“Last September the EU announced a directive (?) that would see depositors guaranteed to Eur100k. But it appears that hitting seniors isn’t allowed. This is not consistent.”
Exactly. Spot the spoofing.
We all know that the German’s were bounced into a statement they would guarantee deposits by the Irish, back in 2008, and that they had no idea whether they could actually fulfill that if required.
I would argue there is a fundamental inconsistency between:
1. you are making statements (to very sophisticated investors who have always been aware of credit risk) which are aimed at trying to give the impression senior bonds shall not take a haircut, and
2. You are saying to less sophisticated investors that your savings are safe, but, lets be realistic about this – they can’t be guaranteed as such beyond 100K.
So are the markets more likely to beleive 1 or 2?
Ahura
“Off topic, but we should be informed of exactly what level of support the ECB is willing to extend to the Irish banks? Mentions of NAMA II (Return of the Zombie) and bank contingencies in the EU/IMF bailout fund have me nervous.”
Is the ECB acting outside it legal remit by refusing to accept eligible collatoral from the irish banks? Is the state going to take another hit by borrowing 20-30bn to buy bank assets off the banks and sell them at knock down prices to US hedge funds?
FYi, I’ve deleted JTO’s comments. They don’t relate at all to the topic of the post and they engage in whingy complaining about the contributors to the site, something which I have warned him and others about on numerous occasions.
The contributors to this site provide their input on a voluntary unpaid basis in their spare time while juggling other responsibilities. Repeatedly criticising them for not debating some issue you think they should is both unfair and delusional.
Anyway, my tolerance for whingy comments has evaporated. He can put that stuff on someone else’s posts if he wants and if they’ll put up with it.
The fact that the “debt writedown” tool will not be used on debt issued prior to 2013 does not mean today’s debt will not be wiped out under this proposal. The document allows for (and favors over a writedown) the creation of a bridge bank to transfer assets and liabilities from a bad bank, and then manage an orderly liquidation of the bad bank. So, you can leave today’s senior bondholders in the bad bank, and wind the bad bank down. All bonds outstanding today would get the recovery value, and that would probably be pennies for many troubled banks. So, under this proposal no senior bank debt is sacrosanct anymore. The waning political will to keep senior debt whole will soon get priced into markets – the more risky banks, and banks in risky countries, will be completely shut out of credit markets. The ECB will find it has ever more “addict banks”.
@ Paul
The paper is pretty categoric that what it is suggesting is not intended for the current crisis, whether in terms of asset transference, special manager appointment, or bondholder bail-ins. In theory legislation is already in place, or could be well before 2013, allowing senior debt loss imposition, but, as should not be ridiculously clear, in reality this seems like something they will try everything to avoid. We’re back to the theory vs the reality argument in terms of senior debt loss imposition. Its eminently possible, and its never going to happen.
“13. Is this work intended to solve the current crisis?
The financial and economic crisis has called for extraordinary measures to be taken in order to avert a potential meltdown of the global financial sector. However the measures included in this Consultation are aimed at dealing with future bank failures.”
NTMA report being unveiled at the mom, lots of comments coming out.
Caught my eye…*CORRIGAN: OPEN TO BKIR APPLYING FOR CAPITAL RAISE EXTENSION
@ Karl
“However, when the future arrives, it becomes the present and future senior bank bond investors will consider a regime in which only they are subject to a resolution regime involving selective haircuts as totally unacceptable.”
I don’t see this at all. Bondholders will know the deal at the time that they purchase. Reso bondholders will know they have a weaker security than Tradi bondholders. Their coupons will be accordingly higher to compensate for this difference. What bondholders and everybody else for that matter find unacceptable is retrospective changes to the rules of the game.
I remember when rating agencies gave a rating to senior bank debt that they always alluded to the “too big to fail” safety net and in effect rated systemic bank senior debt only a notch above sovereign. This has turned out to be a correct assessment, based on the systemic nature of the banking function and existing insolvency laws. Clearly this implicit sovereign guarantee represented huge moral hazard. Irish banks in particular flaunted the hazard to extremes. In future their access to such immense liquidity based on leveraging off an implicit sovereign guarantee will be greatly curtailed. To me that is a very good thing and will help to prevent a repetition of the credit bubble rather than resolve it when it does happen.
@ Karl
“The time-inconsistency of the current sovereign debt proposals are clearly recognised by sovereign bond markets, which are pricing current Irish and Greek government bonds at yields that clearly indicate the likelihood of default.”
I Wiki-ed this “time inconsistency” thing. It appears to mean assessing strategy A to be riskier than strategy B in ALL scenarios at time T but assessing B to be riskier than A in some scenarios before time T.
I can’t say that I follow your application of this concept to the current pricing of Irish/Greek sovereign debt. Can you elaborate?
I gotta say, if I’m reading this right then weaker banks are going to struggle to raise money – from anyone looking at it the way I see it. (My ignorance may show, so forgive me if it does.)
If I’m a potential lender I see no sovereign guarantee in the future – either explicit or implicit – and if there’s any problem then the money I lend to the bank will be used to pay off previous bondholders in preference and I’ll be stiffed while someone else walks away with my money. I become a subordinated bondholder in almost every way that counts. Either a funding blockage, high rates, or lots of covered/collateralised bond issuance.
Apart from that, the explicit unfairness to today’s taxpayers – particularly Irish taxpayers – is brutally exposed. Also, as someone already said above, more fool anyone who actually analysed banks creditworthiness in the past.
http://www.ft.com/cms/s/0/e1bf1138-1a41-11e0-b003-00144feab49a.html#axzz1AL80pgdP
Please respect FT.com’s ts&cs and copyright policy which allow you to: http://www.ft.com/cms/s/0/e1bf1138-1a41-11e0-b003-00144feab49a.html#ixzz1AMDtCJ1i
“Yields on Portugal’s 10-year government bonds rose sharply on Thursday to more than 7 per cent at one point, a level at which Fernando Teixeira dos Santos, finance minister, had previously said would not be sustainable. On Friday the yields rose another 18 basis points to 7.36 per cent.
The country’s public debt agency announced an auction of up to €1.25bn in government bonds next week. Some analysts fear Portugal will have to pay unsustainably high yields to attract investors to the sale of long-term debt. In a further setback for the government, Jornal de Negócios, a Lisbon business daily, reported on Friday that the SNB was refusing to accept Portuguese government bonds as collateral for investors seeking to raise funds in repo transactions. According to the report, Portugal’s credit rating did not meet the SNB’s requirements for its debt to be used as collateral. “
@ BW2
That seems to be a completely different definition of time consistency from the one used by macroeconomists.
Click on the Wikipedia link provided above for an explanation of time or dynamic consistency as the term is used in most of the economics literature.
But there’s no prohibition on default in Maastricht or Lisbon. Conversely, there are prohibitions on bailouts. So now, of course, we have bailouts and no defaults.
But after the Greek “rescue” it was completely foreseeable that we were going to be stitched up in the same manner if we allowed ourselves to be.
@ Karl
That link is to “dynamic inconsistency” which seems to describe behavioural instability. I Wiki-ed “time inconsistency” and got the description I produced above. Still not sure how either feeds into current Irish bond pricing but it is not important.
@ Hugh
the problem with greater and greater collateralised issuance is that this makes it less and less attractive for unsecured senior debt, as eventually there’s no assets left for them in the event of insolvency.
@ Karl/Hugh
looking at this from an overall level, what the EU is basically proposing is as follows: all future debt will be somewhat more subordinated than both current debt and historically how similar debt would’ve been ranked. As such, and coming after a massive banking crisis, this immediately means it will be significantly (massively?) more expensive. Further, this goes against what usually happens when an entity (sovereign or corporate) gets into difficulty – that the new debt will be senior to the old debt. This framework in fact suggests the opposite, the old debt becomes senior to the new. Odd.
Eoin,
In Sovereign land, will all bail out debt be senior to existing debt which in turn be senior to newly issued debt. Who would buy a new sovereign. All old bank debt senior to new. Where do the co-cos fit in.
Does anybody know what they are doing?
By the way Bernier and the EC are the smart guys wh dreamt up solvency II which seems to have the direct opposite effect to that intended. It appears to deter insurance companies from taking long term duration and credit risk to meet policy holders returns. I know BW2 is an actuary. Perhaps he has a view.
@tull,
“Does anybody know what they are doing?”
The Eurocrats are following their politcial masters’ instructions to work furiously on procedures that will be applied in the future to avoid a repetition of the current mess. The hope is that the sound and fury generated by all this banging and hammering will distract the markets for a while and they’ll ignore the large volume of dodgy assets that’s been ‘warehoused’ (a la Mr. Bond) in the core countries. There is also a hope that the peripherals will take their medicine and keep senior bondholders whole without too much grumbling and trade/restructure themselves into better shape.
It’s wing and a prayer stuff and I can’t see the sovereign bond market being distracted for very long.
@ Grumpy
“1. you are making statements (to very sophisticated investors who have always been aware of credit risk) which are aimed at trying to give the impression senior bonds shall not take a haircut, and
2. You are saying to less sophisticated investors that your savings are safe, but, lets be realistic about this – they can’t be guaranteed as such beyond 100K.
So are the markets more likely to believe 1 or 2?”
Well, at a guess, the markets need assurance that 1 can be delivered.
I’m always a little wary of referring to the market, as it fails to recognize the array of risk appetites. Though where are certain truths that apply to participants: 1. They don’t want to lose money 2. They want to win money.
I’m pretty sure that casino owners make the rules, not the gamblers. You could apply this to Ireland – now that the gamblers have got their chips back, they’ve fecked off and won’t be back anytime soon.
@ Tull
“Is the ECB acting outside it legal remit by refusing to accept eligible collateral from the Irish banks? Is the state going to take another hit by borrowing 20-30bn to buy bank assets off the banks and sell them at knock down prices to US hedge funds?”
I won’t speculate on the legalities, but I’d expect the ECB would find a way to force through their agenda. To me, it seems that the ECB wants to reduce its exposure to Irish bank assets. It’s hard to speculate exactly what would satisfy the ECB. If they’re happy to accept 100bn of NAMA2 bonds on the condition of a loss reserve of 20-30bn, it wouldn’t be the worst result for us (once the reserve isn’t prefunded and the assets going to NAMA2 didn’t have to be discounted). Though other options could prove very costly to us. I’m pretty sure the Irish authorities must have been told what is required.
On a more positive note:
http://ftalphaville.ft.com/blog/2011/01/07/452096/buiters-e2000bn-solution-for-the-eurozone/
@Eoin
It is rather like announcing that capitalism will be allowed to function from some date in the future.
@BW2
“I remember when rating agencies gave a rating to senior bank debt that they always alluded to the “too big to fail” safety net and in effect rated systemic bank senior debt only a notch above sovereign. This has turned out to be a correct assessment, based on the systemic nature of the banking function and existing insolvency laws.”
Thing is though that if you were thinking about buying senior bonds in Citi or the like, shrewdies did indeed factor in the likelihood that a bailout would be facilitated. If you were looking at the senior bonds of the Irish banks, in my view, you should have been able to work out that the state that might try to step in to bail them out was too small to do so – and priced the risk of the bonds accordingly. IMHO this is basic stuff. If you didn’t manage to work that out, those holdings in the portfolio you manage should have lost value and your mandates might migrate to a manager less likely to make the same error.
@Paul
“The document allows for (and favors over a writedown) the creation of a bridge bank to transfer assets and liabilities from a bad bank, and then manage an orderly liquidation of the bad bank. So, you can leave today’s senior bondholders in the bad bank, and wind the bad bank down. All bonds outstanding today would get the recovery value, and that would probably be pennies for many troubled banks. So, under this proposal no senior bank debt is sacrosanct anymore.”
This is more or less the idea I have now got bored of droning on about. My suggestion also included the political kicker of leaving behind in the old bank the work practices, pension liabilities, contracts that cannot be otherwise renegotiated etc – and allowing bank staff to apply for new jobs in the new bank (maybe even employ a few more non-members of expensive golf clubs, foreigners even?).
@ B_E_B
“Further, this goes against what usually happens when an entity (sovereign or corporate) gets into difficulty – that the new debt will be senior to the old debt.”
I am not sure this is correct Eoin. If banks could issue new debt senior to the old nobody would ever put any credence on the seniority of their creditor position. I accept that securitisation is a form of reducing the ranking of existing creditors but I presume so called senior debt has a contractual protection against debt being issued by the entity which would be more senior.
@ Tull
Solvency II? We don’t want to get off topic but can you elaborate your point a little.
@ Grumpy
I think you are making the case that Irish sovereign risk was underpriced. But a 25bp differential between systemic bank risk and sovereign risk has proven to be not too far off the mark.
Eoin:
Thanks – when they say this has nothing to do with “this crisis” I can feel the scissors getting sharpened. Aren’t we on to the “next crisis” in any case?
I think the key issue is these documents open up previous taboos. Now they can openly discuss how to burden share with banks, the technical details of default, etc. Not so long ago Trichet said default was “unfathomable” – no more! Default on senior creditors may well become the norm for troubled banks, rather than a taboo, after a few more months. Look at how (effective) default on subordinated debt is now taken as a given when a year ago that was taboo too. The lobby groups within the EU who want to see defaults/restructurings happen will continue publicly discussing and working on how to make it happen with the least pain. As they discuss it bond markets will fill with fear, and spreads will rise, just like they did the last 2 days. The ECB will need to provide more support – they will hate that. More people will decide default is the only route, etc. It could well force the whole issue very soon.
@ BWII
in fairness, i was probably a bit too categoric with my statement. What i probably should have said that it often goes in as more senior, and often goes in as equal ranking, but almost never goes in junior to whats there already. And it only goes in as more senior when an entity is clearly in a distressed situation and the lack of a capital raise would potentially lead to insolvency, so it’s not like they are stepping on creditors rights just for the hell of it. I can’t think of a situation whereby a distressed entity has looked for fresh capital to come in junior. If anyone has any examples, i’d be grateful to hear them.
Also, i dont think senior debt has a contractual protection, its unsecured after all, but it is simply a situation whereby for anything to outrank it, this would have to outrank depositors as well, which no regulatory authority would probably find acceptable. It would also screw up the entire funding market and freak a lot of investors out – if you can screw them once, you can do it again. So its a trust issue as much as anything else.
@ B_E_B
Okay, I think I understand your reasoning
Eoin
“I can’t think of a situation whereby a distressed entity has looked for fresh capital to come in junior. If anyone has any examples, i’d be grateful to hear them.”
Governments buying prefs and equity in actually bust banks. Nobody else would be that stupid or reckless.
There was Morgan Stanley and the Squid – paying big coupons or warrants, Barclays etc, but there is generally a kicker for risk.
Instead of creating a new category of senior debt why don’t the commission just make explicit what is already implicit and suggest that states guarantee existing senior debt and say that future senior debt won’t be guaranteed and provide for an easy to implement resolution regime that allows losses to be imposed on seniors over a weekend. Are they trying to make this new category of debt junior to deposits?
@ christy
“Are they trying to make this new category of debt junior to deposits?”
Yes, absolutely. Bondholders argued, “we’re equal in law to depositors, governments will be very loathe to torch depositors, and for other reasons will go to extreme ends to prevent the formal insolvency of a systemic bank ergo our security is almost as good as that of the State”. What the Resolution regime is attempting to do is to say “bondholders security is as good as the bank being solvent in substance but if it is being kept solvent for the greater good of society they will not benefit from the societal intervention”.
Of course, one of the problems with new or existing bonds is that they are all subordinate to derivative collateral. With trading derivatives unregulated (in notional amount the banks can trade, the risks they can take, the directionality of their trade (buy or sell, there’s no requirement to be balanced)), a bank that funds itself by repo can leave itself in the position that there is nothing left in a liquidation.
As Eoin said above (or on another thread), the problem with the increased asset-backing of lending to banks is that the assets of the banks are hollowed out. Derivatives add further to this hollowing effect. The ability to keep collateral on losing positions as cash within the bank gooses the funding position of the bank, even if there is little likelihood of the position coming good.
Add to this the increased collateral that can be required even on a not currently losing position with rating downgrades and you have a toxic mix. Not only would there be nothing left for the new junior debtholders, there would be little enough left for any depositors foolish enough to remain in a bank that shows signs of going bad.
A badly run bank is a badly run bank. It will eventually go bust. I note with interest that the FDIC is to pursue 119 former directors of failed banks in the US for 2.5 bn dollars, an average of 21 million dollars each. It is, apparently, only the first tranche of cases. Looters beware… or move to Ireland…
@ Hog
Glad you didn’t mention Quadrillion for he is often found to be not far away when that Derivatives chap comes up for mention. A couple of weeks back Pat Rabbitte shocked the RTE panel when he said he had a sniff of a Derivatives problem that would make everything else up to now pale into insignificance. Talk of Derivatives can have that effect on the populace. It transpires that Pat had been sold a pup.
I think your collateral point is also a red herring. If banks lose money on derivative trades, of course that weakens other stakeholders’ position just as losing on lending projects would have a similar effect. Derivatives are collateralised so that in effect any losses are instantly crystallised. It is no different from continually rolling them over on a mark to market basis.
Off topic but I can’t start topics of my own. David McWilliams has a 10 point plan in today’s Indo to solve the crisis. I won’t repeat all the points but the essential features are as follows:
1) Convert bank senior debt to equity
2) Convert the ECB 97bn support of the banking system to equity
3) Convince US MNCs to invest 80bn in Ireland
4) Allow mortgage holders to walk away from negative equity
5) Put it all to a Referendum which would then lend it legitimacy in international circles, a Referendum which he says would pass handsomely.
He also lambasts the blanket nature of the 2008 government guarantee and his Pauline conversion has actually swung so far as to recommend the withdrawal of any guarantee.
@BWII
“If banks lose money on derivative trades, of course that weakens other stakeholders’ position just as losing on lending projects would have a similar effect. Derivatives are collateralised so that in effect any losses are instantly crystallised. It is no different from continually rolling them over on a mark to market basis.”
My point is that it the collateral gives the impression that the bank has more funding than it has. I think separate items should be held for “holding collateral for derivative positions” and “in the money collateral for derivative positions at other banks”, rather than “other bank deposits” and “deposits in other banks” which are rather opaque lumpen items.
That would make clear how much a bank has to pay out in a liquidation. Note well that it will receive nothing back from its currently profitable positions – the counterparty who owes “the bank” (okay, let’s call it Anglo) neither has to close off the contract and pay over the current position, nor continue paying on the contract ( http://ftalphaville.ft.com/blog/2011/01/05/449016/when-derivatives-counterparties-collapse/ ). This argues that both liquidating Anglo or indeed letting it collapse were near impossibilities. With a large derivative book, even if it is in profit, a collapse would mean that only costs have to be borne. No?
@ Hog
As I have stated before, I am not an economist and I am most certainly not a lawyer. I would have thought though that the whole point of collateral is that where party B cannot meet its obligations or indeed is entitled not to meet its obligations because party A is bankrupt, party A has the collateral to cover such a situation. I find it hard to believe that party B would be entitled not to make its obligations and also to have its collateral returned, i.e. have its cake and eat it.
BW2
Though its not that collateral has to be returned by defaulting counterparty, but that further margin or close out payments do not have to be made. Don’t see contradiction to that in hog’s v useful link.
Hog
“This argues that both liquidating Anglo or indeed letting it collapse were near impossibilities. With a large derivative book, even if it is in profit, a collapse would mean that only costs have to be borne. No?”
This is where competent management is relevant – you would ask the head of risk to run off the positions each way and work out what the in the money swaps amounted to. Would you be surprisedif it was not much? 😉
@ grumpy
Not a lawyer but I kinda get the thrust of Hog’s link, which was interesting I agree. Clearly it would be ridiculous to require party B to continue to meet its obligations whilst party A has declared that it will not be able to meet its side of the bargain. If the situation has not been collateralised and party B has a net liability then one can see that party B effectively is a windfall beneficiary of party A’s bankruptcy.
But if collateral has been posted more or less to fair value then party A would appear to be covered irrespective of whether party B elects to close out or opts to keep the swap open but not meet its obligations.
I agree that party A will not enjoy any further upside on its position but that’s the same as party B electing to close out the position, I don’t see any asymmetry here, but I could well be indulging a deposit selling moment.
@grumpy
“This is where competent management is relevant – you would ask the head of risk to run off the positions each way and work out what the in the money swaps amounted to.”
But the point of the case FTAlphaville report on is that under the ISDA agreement, you have no automatic recourse to the money of any of your swaps that are in the money, nor can you expect to receive payments.
“Would you be surprisedif it was not much? ;-)”
😀 No, not really/not at all/no way Jose/hey, I ordered a gin!
@BWII
Collateral is largely not exchanged until the close of the contract. It is kept in the underwater bank as “deposits from other banks”. The reason being that positions can change quite quickly so it avoids the costs of transferring large sums daily.
This is if the underwater bank is the custodian of the collateral. You can read all about it here: http://www.isda.org/press/pdf/colguide.pdf
I wonder what effect Anglo no longer operating a custodian service will have? Who will become the custodian for its collateral? Nice way to pump some of the other bank deposit ratios?
Hog I was suggesting that if there were few swaps in profit then it might not make much difference.
@grumpy
Well, that would mean that the accounts are misrepresenting the positions… or that the standard valuation method (replacement value) is, eh, that rude word for men’s bits.
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