BANK DEBT - CONTINGENT CAPITAL AND BAIL-IN

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1 BANK DEBT - CONTINGENT CAPITAL AND BAIL-IN Summary ABI members support the principle that banks regulatory capital should be loss absorbing. However, there are significant risks that need to be taken fully into account in designing a loss absorbent capital structure for banks. Debt instruments that meet this need are of necessity innovative and complex. In comparison, there are many advantages to the well understood and simple characteristics of equity. Fixed income investors have limited appetite for contingent capital or bail-in bonds. There is a risk that these measures will therefore restrict banks access to finance, with consequential reductions in banks capacity to finance the economic recovery The key principles for regulators to bear in mind are respect for the sanctity of existing contracts, maintaining the hierarchy of the capital structure, and ensuring that future bank debt is appropriate for the investor base. In the absence of default, existing debt instruments should be allowed to run to term without altering their terms. A bail-in regime should apply only to new instruments. A bail-in regime should be applied only at the point of non-viability. The triggers and their consequences must be fully transparent, with minimum discretion for regulators. If senior unsecured debt is included in a bail-in regime, there are potentially severe consequences for the secondary debt market, and for banks access to finance. Equally, investors recognise the key importance, for the stability of sovereign debt, of breaking the link between banks and their sovereigns. Introduction 1 The ABI is the voice of insurance, representing the general insurance, investment and long-term savings industry. It was formed in 1985 to represent the whole of the industry and today has over 300 members, accounting for some 90% of premiums in the UK. The ABI s role is to: - Be the voice of the UK insurance industry, leading debate and speaking up for insurers. - Represent the UK insurance industry to government, regulators and policy makers in the UK, EU and internationally, driving effective public policy and regulation.. - Advocate high standards of customer service within the industry and provide useful information to the public about insurance. - Promote the benefits of insurance to the government, regulators, policy makers and the public.

2 2 This note considers the potential for bondholders contributions in the case of a distressed bank. As responsible long-term investors in banks, both as bondholders and as equity investors, ABI members are deeply concerned that proposals made in this area should be thoroughly thought through, taking full account of the wider consequences to bank funding, the financial markets and the wider economy. The note is written from the perspective of institutional investors, and is intended to broaden understanding of this perspective among banks, regulators and other interested stakeholders. It is written in the hope that an orderly transition can be achieved to a revised capital structure for banks over the relatively long timescale contemplated in Basel III. However, recent events in Ireland demonstrate that it is difficult at present to distinguish a banking crisis from a sovereign crisis. There is a significant risk that more immediate pressures on banks and sovereigns will lead to a sub-optimal outcome in a shorter timescale. The considerations in this note are in many cases relevant for the institutions dealing with those immediate pressures. Loss absorbability of bank capital 3 An important feature of the bank recovery and resolution regimes under consideration at national, EU and international level is regulators concern to ensure that bank regulatory capital and specifically debt capital should effectively absorb losses. The suggestion has been made that this can be done by imposing haircuts on bondholders, or by converting bonds to equity, in reaction to a given event - or trigger. Several kinds of trigger have been contemplated: levels of regulatory capital, regulatory discretion, or simply running out of cash. 4 ABI members support the principle that banks regulatory capital should be loss absorbing. What are the risks? 5 In designing a debt instrument capable of absorbing losses, there are significant risks to investors, to the banks, and to financial stability if this is not approached in the right manner, working with the grain of the financial markets. Extreme haircuts on bondholders will impose heavy losses on Europe s pensioners and savers, who stand behind the bondholders; Europe s banks face a heavy re-financing programme over Success is essential to ensure the flow of credit to the economic recovery. Issues of bank debt that fail, for example, because they over-estimate investors appetite for contingent capital, could cast doubt on an institution s re-financing programme; Regulatory proposals that blur the hierarchy of the capital structure may restrict future financing programmes by closing down funding avenues, in particular senior unsecured debt; Proposals or statements that destabilise the existing stock of bank debt could have unexpected impacts on the secondary markets, and in extremis on the financial stability of insurers holding corporate bonds as regulatory capital ; The secondary market in any future stock of contingent bank capital may behave under stress in an unpredictable and pro-cyclical manner, exacerbating systemic risks.

3 6 The key principles for regulators to bear in mind from investors perspective are respect for the sanctity of existing contracts, maintaining the hierarchy of the capital structure, and ensuring that future bank debt is appropriate for the investor base. Investors concerns 7 There is a perception among some commentators that imposing haircuts on bondholders is a relatively painless political route, particularly if contrasted with the need for taxpayers to step in. However, it is important to remember that bond investors represent millions of ordinary European savers, and in particular pensioners. 8 ABI members are concerned that regulators desire for contingent capital or bail-in bonds to form a significant part of banks capital structure could lead to a misallocation of resources, and artificially restrict banks access to finance. These instruments are by their nature a hybrid between debt and equity. They have none of the potential for growth of equity, and little of the defensive qualities of traditional bonds. As a result, they are not suitable for traditional fixed income mandates. Attempts by regulators or others to force them into those mandates would compromise the interests of the savers and pensioners who depend on the mandates. There are also regulatory restrictions on insurers investment in bonds. For example, regulators have to satisfy themselves that bonds are suitable to be matched against long-term products such as annuities. In conclusion, only high yield investors are likely to be interested in the risk/reward profile of contingent capital or bail-in bonds. This is a relatively limited section of the fixed income market, indicating a limited capacity for these instruments to provide funding for banks. 9 Contingent capital and bail-in introduce additional risks by comparison with traditional bonds. These are new risks, different from default risk, and difficult to price. In purchasing these instruments, investors will require a discount to traditional bonds. Capital raising by these means will therefore be more expensive for the issuing institution. The extent of the discount, and the additional cost, will depend on the perceived soundness of the financial institution in question, and the terms of the regime. Smaller or weaker institutions may struggle to raise contingent capital cost efficiently, which could lead to concerns about their ability to raise capital and fund growth. This could lead to a forced deleveraqing, and increase the concentration of the banking system already seen as a result of the banking crisis. 10 Some commentators have suggested that bondholders continue to rely on the implicit Government guarantee for banks, and that bail-in or contingent capital is necessary if bondholders are to impose market discipline. It is true that, historically speaking, banks bonds have suffered a relatively low level of default. However, decision-makers should bear in mind that debt conditions are only one factor affecting market confidence. In addition, bondholders capacity to impose market discipline is limited, mainly to investments in those institutions with a regular programme for accessing the debt markets. 11 In all cases, investors assume that the treatment of existing debt instruments has to be handled separately from any instruments issued under a future regime. These regimes can only with fairness be applied to future contracts. Working on the optimistic basis that

4 confidence in banking institutions is maintained, the stock of existing bank debt should be allowed to run off in the normal way. Contingent capital or bail-in 12 Two principal methods have been floated of making banks regulatory debt loss absorbing: (i) (ii) The contractual approach, for example the proposals for contingent capital. The regulatory approach, known as bail-in. 13 The contract-based approach is of course a matter for negotiation between private parties, and is the preferred course of action for ABI members. Maintaining the contractual approach will ensure that existing contracts are honoured. Under the contractual approach, investors can invest in bank debt with certainty over their treatment and position within the capital structure, and with some degree of certainty as to if and when loss absorbency may occur. The main question is whether the banks can find a market for contingent capital in the volumes they require. 14 The regulatory approach imposes a similar outcome by regulatory means. This approach may include a greater or lesser degree of discretion for the regulator in exercising the trigger. Depending on its definition and design, a bail-in regime has the potential to alter materially the nature of a bond investment, and the implications need to be considered carefully. It is difficult to predict changes in circumstances over the lifetime of a bond, and the very flexibility of a regulatory solution and uncertainty of outcomes for bondholders will diminish investors interest. However, ABI members would not wish to rule out a bail-in regime at the point of non-viability, which may produce better results than winding up. 15 The contractual and the regulatory approach share many common features, but analysis suggests that they would in practice be used in different circumstances. Contingent capital works best with an early trigger; bail-in with a late trigger. The rest of this note considers in more detail some of the implications of bail-in. Going concern or gone concern. 16 The timing of the trigger to activate haircuts or conversion to equity greatly changes the nature of the regime from the perspective of institutional investors. An early trigger makes the regime a contributor to a bank s recovery ( going concern ). A late trigger makes the regime a factor in a resolution regime for a failed bank ( gone concern ). In principle, both bail-in and contingent capital regimes can be applied on a going concern or a gone concern basis. In practice, contingent capital is usually treated as going concern and bailin as gone concern. It is of course possible to set the trigger somewhere in between, in which case the instrument will share some of the features of both instruments and be very difficult to price. 17 Most proposals for bail-in regimes build in a substantial degree of discretion for regulators surrounding the decision to exercise the trigger. This is understandable, but will greatly increase the discount required by investors, as the timing of a loss, or conversion to equity, will not be clear to them. The risk is that regulators and management will have many incentives to exercise the trigger early, thus depriving investors of value.

5 Liquidity issues 18 ABI members see advantage in a bail-in regime at the point of non-viability. An earlier trigger, or discretionary intervention by regulators at an earlier stage, risks dispossessing existing equity investors and bondholders. However, considerable caution is required in assessing an untested regime that will inevitably be applied under stress conditions. The liquidity of the bank in question is an important factor in the equation. Experience with failing institutions during the crisis demonstrates that, if the bank is unable to fund itself, no additional amount of capital will help, and cash is needed. In this case, haircutting the bondholders or conversion to equity is just a part of settling priorities in a winding up. 19 It is difficult to think forward to the dynamics of a fully introduced Basel III regime, with higher regulatory capital levels and substantially increased levels of liquidity. However, it still looks likely that bail-in will work only in the context of an additional injection of liquidity, whether from a sale to another banking institution, the establishment of a bridge bank, or a call on a pre-funded resolution fund. Moreover, the higher chance of losses on bail-in if senior debt were included would lead to a reduction in funding provided to a bank as its credit quality deteriorated, exacerbating the liquidity issues. Which debt instruments should be included in a bail-in regime 20 The inclusion of senior debt in a bail-in regime would have significant consequences, which need to be thought through carefully. If future senior unsecured debt could bear losses, this would affect both its cost and its availability. Europe s banks have raised significant sums in senior unsecured debt in Closing or restricting this avenue of finance would therefore have severe consequences for banks re-financing plans. 21 On the other hand, senior unsecured debt forms a much greater part of bank debt than subordinated debt. On the assumption that this continues to be the case, then - seen from the regulatory objective of ensuring that the capital structure of banks is genuinely robust enough to exclude future interventions by the taxpayer senior debt may need to be included in order to ensure that the new regime has the firepower to resolve the problems faced by an failing institution. 22 Investors also recognise the pressing immediate problem caused by the linkage between bank debt and sovereign debt. ABI members are significant investors in sovereign debt as well as bank debt. Events in Ireland have shown that attempts by a Government to protect senior unsecured bank debt can bring down the sovereign, and lead to extreme policy measures. There is a clear need to break the link between bank and sovereign debt. This will need to be done with considerable care, to avoid unintended consequences in the bond market. 23 In any event, secured debt such as asset-backed securities and covered bonds should have clearly articulated protection in a bail-in regime. Holders of senior debt should also not be haircut while full payments are made to other senior creditors. othercreditors.. Alternative solutions

6 24 If loss absorbability is required in the banks capital structure, what is wrong with equity? As this paper demonstrates, both contingent capital and bail-in raise complex considerations, leaving scope for uncertainty and ambiguity at later stages. The advantage of equity is that all parties know how it works. 25 It may be worth considering the motives for Governments implicit guarantee for their banks, and addressing those directly, rather than by a roundabout means through the capital structure. Major factors in Governments decisions to rescue the banks were the desire to protect the real economy, in particular depositors, and the money transmission systems. One possible solution might be to ring fence those operations from the riskier aspects of banking business. Much work has already been done on Deposit Guarantee Schemes, or the issues can be addressed through bank structure (so-called narrow banks ), an approach under consideration by the Independent Commission on Banking in the UK. Factors for a successful bail-in regime 26 In summary, if the decision is taken to go down the regulatory bail-in route, ABI members wish to see arrangements that meet the needs of bank regulators, and allow investors to meet the banks re-financing needs on terms that are consistent with our own regulatory requirements, and with our fiduciary duty as fund managers. We therefore offer the following suggestions: Bail-in should not be used to void or negate existing contracts. All creditors and equity holders should be treated in accordance with their position within the capital structure The recovery and resolution process should be articulated in stages, with a progressive ladder of management and regulatory intervention building out of the recovery stage, before bondholders are haircut; Bail-in should be fully transparent, with the triggers and their consequences fully visible to all in the market. Regulatory discretion should be kept to a minimum; Politicians need to take greater care in explaining their propositions to the financial markets. ABI December 2010