AXA IM says Cyprus deal marks a significant shift from ‘too big to fail’.

26th March 2013

The Cyprus deal marks a further move by Europe’s politicians to move from “too big to fail” to “safe to fail” according to Axa Investment Management’s head of research Eric Chaney.

Chaney says that the recent nationalisation of SNS in the Netherlands, new legislation from the European Commission and the Cyprus deal show EU countries are accelerating moves towards bail-ins rather than bail-outs. Effectively some bond holders, shareholders, and as in the case of Laiki, big depositors will pay the price of a rescue and restructuring rather than the taxpayer with many classes of bondholder at risk of receiving nothing.

Chaney says these moves may have implications for the rating of different types of bank debt, i.e. some is being re-rated, given the lack of implied government support and therefore becomes riskier. But this may result in opportunities for investors to buy higher yielding debt, providing they are selective about the institutions they invest in.

Chaney, who is also chief economist AXA Group, says: “The 11th hour agreement opening the way to a bailout of Cyprus includes a large bail-in dimension, with large contributions from bank debt holders, including unsecured senior lenders and wealthy depositors. This should not come as a surprise: the European Commission’s June 2012 proposal for a Recovery and Resolution Directive was a landmark  attempt to limit, if not eliminate, the moral hazard risk that a financial institution is ‘too big to fail’ by defining a resolution framework where all systematically important financial institutions become ‘safe to fail’.  The Directive will include a debt write-down tool by which resolution authorities will be given statutory powers to restructure the liabilities of a distressed financial institution when it becomes dangerously close to insolvency.”

Chaney says the recent example of the Dutch bail-in may be a case in point with the strictest terms of any bail-in since Northern Rock and, of course, Cyprus.

He writes: “In February, the Dutch government announced the full nationalisation of the SNS Bank NV, and a bail-in of its equity holders and junior stakeholders up to Tier 2 bondholders. The bail-in took the form of zero recoveries. Yet the decree nationalising the bank made clear that senior creditors would not suffer losses, while the claims of subordinated creditors and equity holders have been fully wiped out. Aside from the UK’s Northern Rock episode, where some preference shares were nationalised and completely wiped out, the SNS announcement was the strictest treatment of any bail-in, until the Cyprus agreement.”

Chaney says that bail-ins have become the rule for subordinated debt thus increasing their risk. (Chaney’s note gets quite complicated in describing some of the issues affecting different tiers of bank capital the bond market. However, for those readers interesting in the technical detail, the note continues:

“The fact that bail-in has become the rule for subordinated debt is illustrated by rating agencies having withdrawn sovereign support from related ratings. The potential for bail in suggests that the implicit ratings support enjoyed by senior financial debt holders on account of the sovereigns’ own long-term debt ratings, is lost. When senior debt for highly systemically important EU banks can include up to three notches of ratings uplift for possible government support, this is by no means a trivial matter.”

“In what will surely change the constitution of the capital structure of banks over time, the EC has suggested the use of subordinated debt instruments as bail-in eligible liabilities above and beyond those that will qualify as regulatory capital under Basel III. AXA IM Research teams therefore expect an increase in subordinated issuance, particularly subordinated Tier 2 capital. For banks, Tier 2 is the cheapest capital structure to use to build a bail-in buffer. Like Lower Tier 2, non-called Tier 1 debt is also valuable in building the bail-in buffer, even if it is not Basel III compliant. Nonetheless, as more Tier 2 debt is issued, less Tier 1 capital is required and we believe this is likely to be the point of greatest impact for a change in the structure of the existing Western European bank capital.”

“Although many unknowns remain, the market has come a long way in terms of its capacity to absorb shocks. With this in mind, and with senior bonds potentially offering minimum additional recovery in case of bail-in compared to subordinated instruments, investors might be well advised to move down the capital structure in an effort to capture the significant premium that this asset class is offering. Given expectations for an increase in Tier 2 supply in the lead up to bail-in implementation, opportunities to shift down the capital and hence ratings structure, whilst maintaining access to Basel compliant assets, should also increase. Although this is clearly a riskier level of the capital structure, we feel the European banking system has stabilised broadly, offering potentially safer entry points on account of a ‘lower probability of distress’. In that context, picking the right names in which to move into further down the structure remains a must, especially in light of the recent bail-in witnessed in the Netherlands.”

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