Greater use of secured funding, depositor preference and bail-in regimes mean that bank failures and defaults on unsecured bank debt are likely to converge, while recoveries fall.

Since the financial crisis in 2008, a growing proportion of bank wholesale funding, especially in the EU, has been in secured formats such as covered bonds and collateralised repo transactions. In the first seven months of 2012, European bank debt issuance fell 10% to €421bn compared with the same period in 2011. This was entirely due to senior unsecured issuance, hitherto the backbone of bank finance, dropping by 28% to €182bn.

At this level, senior unsecured issuance accounted for just 43% of total new debt issued – the first time it has fallen to less than 50%. Conversely, covered bond issuance was up 4% at €209bn. Interestingly, at the other end of the spectrum, subordinated debt almost doubled to €30bn.

Fixed-income investors have become increasingly concerned about the rising encumbrance of EU banks’ balance sheets – the proportion and quality of bank assets that are tied to secured funding transactions. This has subordination implications for senior unsecured creditors.

On the positive side, EU banks’ ability to raise secured funding has unquestionably helped alleviate refinancing risks and limit the extent of bank failures and ratings downgrades. Pools of assets that can be easily packaged and used as collateral, such as mortgage loans, provide a bank with flexibility to access different investors depending on market conditions. Even in a worst-case scenario, they are at least eligible as central bank collateral. Unless banks rely too much upon access to secured financing, or encumbrance reflects a structural funding problem or diminished ability to cope with a future funding shock, secured funding is often no worse than ratings neutral.

Fitch Ratings has looked in detail at levels of balance sheet encumbrance at more than 60 banks across Europe. There is a huge variation in encumbrance levels, and high encumbrance is not necessarily stress related. Encumbrance is highest in parts of the peripheral eurozone, but also among the less stressed financial sectors of Scandinavia, and at specialist property lenders. We estimate median encumbrance in the sample to be about 28% of funded banking assets.

Sovereign support fades

An unsecured bondholder’s potential recoveries relative to secured creditors only matter if a bank defaults, and five-year global default rates for banks have been very low to date, at about 0.9%. However, the failure rate, which includes those banks that would have defaulted had they not been rescued, is 7.1%. In the future, failure risk and default risk are likely to converge.

This will make creditor hierarchy increasingly relevant to unsecured debt, and concerns about encumbrance are exacerbated by the growing possibility of the introduction of depositor preference of some sort. Subordination risk due to depositor preference has the scope to be a more material, as well as a more universal, influence on subordination than balance sheet encumbrance.

For senior unsecured debt ratings, this rising subordination risk is less important than the potential erosion of implicit sovereign support under the evolving resolution and bail-in agenda. More than one-third of Fitch’s western European bank issuer default ratings benefit from uplift, often of multiple notches, for the likelihood of sovereign support if needed.

Fitch believes that the implementation of the EU’s June 2012 proposals on bank recovery and resolution represents a huge challenge, especially for the large, systemically important financial institutions, and will likely take a few years to implement. However, the proposals will ultimately result in Fitch factoring less support into EU bank ratings. For those banks with two or more notches between their issuer default rating and their viability rating (a bank’s rating absent extraordinary support potential), the bank resolution agenda represents a far greater potential ratings cliff over the long term than subordination, unless they are able to sufficiently improve their standalone profiles.

Vicious cycle

While rising subordination risk makes negative actions increasingly possible on senior unsecured debt ratings, it does not on its own represent a 'cliff risk'. Vulnerability to default carries much greater weight in Fitch's ratings than the loss given default. Bonds are unlikely to be notched down more than twice for loss given default.

However, there is a growing risk that encumbrance, depositor preference and bail-in concerns will trigger an ever-increasing cycle of asset encumbrance and that low or even 'zero recovery' assumptions might become the norm, which would have an adverse effect on the supply of senior unsecured debt.

The eurozone authorities’ focus appears to be moving away from minimising systemic bank risk and towards trying to break the sovereign/bank risk nexus. This strikes at the heart of sovereign support assumptions made to date and could drive a convergence between the failure of banks and defaults on their senior unsecured debt.

James Longsdon and Bridget Gandy are co-heads of Fitch Ratings’ Europe, Middle East and Africa bank rating team.

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