Do Markets Believe In Bail-in of European Banks?

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1 OCTOBER 17, 214 CREDIT POLICY SPECIAL COMMENT Do Markets Believe In Bail-in of European Banks? Table of Contents: SUMMARY 1 BACKGROUND ON THE EUROPEAN BAIL-IN REGIME 1 THE IMPACT OF BAIL-INS ON BOND PRICES: AN ANALYTICAL APPROACH 2 THE CREDIBILITY OF BAIL-IN: EVIDENCE FROM FINANCIAL MARKETS 3 CHANGING LIABILITY STRUCTURES HAVE ALSO PLAYED A ROLE 4 MOODY S RELATED RESEARCH 9 Analyst Contacts: LONDON Antonio Garre Analyst antonio.garre@moodys.com Colin Ellis Managing Director - CCO EMEA colin.ellis@moodys.com Marie Diron Senior Vice President marie.diron@moodys.com NEW YORK Richard Cantor Managing Director Chief Credit Officer, EMEA richard.cantor@moodys.com Summary With new rules now coming into place to potentially bail-in senior bondholders before public funds can be used to support banks, financial market prices have reacted accordingly, suggesting that resolution and bail-in procedures are viewed as a credible mechanism for predistributing bank losses in the euro area. One key aim of the new Bank Recovery and Resolution Directive (BRRD) framework is to transfer potential costs of bank failures from taxpayers to senior unsecured bondholders, while also providing a clear ranking of debt instruments when banks need to be resolved. 1 In principle, these changes in the distribution of bank failure costs should already be evident in bond prices, given the forward-looking nature of financial markets. Examining the different ranking of instruments, we find evidence that senior bond spreads have risen relative to covered bonds, which are exempt from BRRD, consistent with greater expectation of bail-in. In addition, spreads between different types of subordinated debt have converged, consistent with all these lower tranches being bailed-in prior to any impact on senior bondholders. Background On The European Bail-In Regime On 15 April 214, the European Parliament adopted the BRRD, establishing a new framework for managing troubled banks in the European Union (EU). 2 It has also adopted the Single Resolution Mechanism (SRM) regulation, which empowers a Single Resolution Board to manage bank resolution in the euro area (and for other states that choose to opt in). 3 The BRRD includes rules aimed at preventing bank failure and enabling early intervention when an institution is under stress but not at the point of failure. The resolution rules that form the core of BRRD aim at transferring the cost of resolution from taxpayers to shareholders and unsecured creditors. Resolution can happen by selling the bank or parts of the bank, setting up a bridge institution, separating good assets from bad ones as well as by bailing in preferred shares, debt instruments and potentially even certain deposits. Before any public money (or other resolution funds) can be used to bail-out a bank, the BRRD specifies that at least 8% of the bank s liabilities (or, alternatively, 2% of risk weighted assets in specific situations) would need to be bailed-in first. After this, a resolution fund and/or extraordinary public financial support can be tapped to absorb losses of up to 5% of total liabilities, or more in a systemic crisis. 1 See EU Banks: Agreed Resolution Framework Confirms Credit Negative Implications for Senior Unsecured Creditors,16 April The BRRD should be transposed into national laws by all EU member states by 31 December All countries participating in the Single Supervision Mechanism will be subject to the SRM regulation, namely all euro area members and potential opt-ins

2 After transposition into national law, the BRRD will be applicable in all 28 EU member states. This finalises two years of negotiations about the nature and implementation of bail-ins for banks, which in turn followed the first package of financial aid for Greece. Exhibit 1 sets out key dates in the process. Bail-ins provisions will enter into force by the beginning of 216 at the latest, with some states implementing it alongside the other BRRD provisions in We are separately assessing the implications of the BRRD and new Single Resolution Mechanism (SRM) for systemic support in bank ratings. 5 EXHIBIT 1 Significant milestones in negotiations on the BRRD Apr-1 Greece officially asks for first aid package Jan-11 Feb-11 Jun-12 Jul-12 Jul-12 Sep-12 Oct-12 Dec-12 Mar-13 Jun-13 Jul-13 Apr-14 Jul-15 Publication of EC working paper on bank resolution regime Amagerbanken First Senior Debt and Deposit Losses in Europe Euro-area leaders affirm that it is imperative to break the vicious link between banks and sovereigns and call for a BRRD Rescue program for Spanish banks; Junior Debt took losses when support was provided. Spanish and Italian bond yields reach euro-era record highs ECB President pledges the ECB will do whatever it takes to save the euro ECB announces Outright Monetary Transactions (OMT) The EC launches a consultation on a possible framework for the BRRD EU finance ministers reach common position on Single Supervisory Mechanism (SSM) Euro area announces Cyprus bailout plan EU finance ministers reach deal on BRRD EC releases proposal for a euro area SRM, including 55 billion common fund European Parliament adopts the BRRD EBA publishes the technical standards and guidelines of the BRRD 215/216 Contributions to common resolution fund 216 Bail-in provisions of BRRD come into effect 218/219 Full Basel III implementation Source: Moody s Investor Services The Impact Of Bail-Ins On Bond Prices: An Analytical Approach This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page on for the most updated credit rating action information and rating history. The introduction of a formal bail-in regime, relative to a previous regime in which taxpayer-funded bail-outs were more prevalent (sometimes accompanied by ad hoc burden sharing of junior bank instruments), has particular implications for senior unsecured and junior security holders. These implications should be visible in financial market prices, if the regime is credible. Given the forwardlooking nature of financial markets, one implication of such a credible shift is that the price of debt that can be bailed in should fall relative to the price of debt that cannot be bailed in, reflecting the greater risks associated with bail in. There are two instances where market prices may have adjusted in this type of manner. First, senior unsecured debt will be eligible for bail-in under BRRD; but senior secured debt, such as covered bonds, will not. As such, the new bail-in regime should have driven a wedge between covered bond yields and senior unsecured bond yields. 4 See Early Introduction of European Union Bail-In Regime Is Credit Negative for Banks Unsecured Bondholders, 16 December See Reassessing Systemic Support for EU Banks, 29 May OCTOBER 17, 214 SPECIAL COMMENT: DO MARKETS BELIEVE IN BAIL-IN OF EUROPEAN BANKS?

3 Second, market perceptions of how loss-absorbing junior and subordinated securities would be may also have changed. It is possible that so-called Tier 1 instruments securities that, under the Basel II framework, are typically preferred securities and relatively close to common equity may have been thought of as more likely to suffer losses in the event of bank failure than more senior Tier 2 instruments. This was reflected in the wide pre-crisis spread between yields on Tier 1 and Tier 2 instruments, as the perceived risk profiles were different. However, current European Commission state aid rules require that all junior debt should be bailed-in prior to any taxpayer-funded recapitalisation. 6 If these rules are seen as credible, then the gap between the prices of Tier 1 and Tier 2 securities should have narrowed. It is more difficult to analyse what should happen to the spread between senior unsecured bond yields and yields on Tier 2 instruments. In principle, senior bonds would only be bailed in once all junior instruments had already been bailed in; and, in those instances, the total losses suffered by senior bondholders would likely be less than the losses for junior security holders. In other words, under bailin the loss on senior debt should be proportionally less than the loss on junior debt. That could potentially result in the spread between yields on the two instruments widening; however, the spread would also depend on investors views of the total loss incurred on banks assets in the event of nonviability and on the size of the subordinated debt cushion. It is also important to note that the above analysis focuses on pervasive effects of the new bail-in regime across European banks as a whole. Beside these general considerations, the new bail-in procedures will also likely have different implications for individual banks, reflecting actual or perceived differences in credit quality, capital and liability structures, and other idiosyncratic factors. The Credibility Of Bail-In: Evidence From Financial Markets We can test the hypotheses stated above using data from financial markets. We focus on bonds rather than credit default swaps (CDS), as until March 214 CDS contracts did not protect buyers against bail-ins. 7 Exhibit 2 presents senior unsecured bond spreads and covered bond spreads. 8 While the data are volatile, and subject to normal uncertainties around index composition and market liquidity, they show a clear widening between senior unsecured and covered bond yields since 213, consistent with bail-in being credible. Exhibit 3 presents spreads for subordinated securities: together with the aggregate index for subordinated securities, we present the index for lower Tier 2 instruments, and an estimated index for upper Tier 2 9 and Tier 1 securities. In the event of bank failure, lower Tier 2 instruments sit higher in the liability structure than Tier 1 instruments, and may have always been viewed as less likely to be bailed in. While the overall level of spread has been volatile, the gap between lower Tier 2 paper and other junior securities has narrowed, consistent with the bail-in regime being credible. Boxes 1 and 2 look at two specific case studies where bondholders were bailed in, in Denmark and Portugal. 6 For further detail on subordinated defaults since the financial crisis, see Selective Subordinated Debt Defaults Among European Banks, 9 August The 214 ISDA Credit Derivatives Definitions introduced a new contract featuring an additional bail-in trigger and an expansion of deliverable obligations. In February 213 the Dutch bank SNS Reaal was nationalised and its subordinated debt expropriated by the government. Subordinated bondholder suffered a loss (1% principal), but it was not clear that the expropriation constituted a credit event in CDS under the existing definition. 8 These spreads are calculated by Markit, the data provider, as the bond yield index less the interest rate swap. However, as the swap rate is common to all indices, differences in the spread data reflect differences in bond yield indices. 9 Upper Tier 2 securities are cumulative junior subordinated debt instruments. 3 OCTOBER 17, 214 SPECIAL COMMENT: DO MARKETS BELIEVE IN BAIL-IN OF EUROPEAN BANKS?

4 EXHIBIT 2 Bail-in effects visible in senior unsecured and covered bond yields Basic point spreads over interest rate swaps 3 iboxx Covered Bonds iboxx Banks Senior Sources: Markit and Moody s Investors Service. Vertical lines correspond to key events in the negotiation on the BRRD (see Exhibit 1) EXHIBIT 3 Convergence between junior debt securities Basic point spreads over interest rate swaps iboxx Banks Subordinated iboxx EUR Banks Subordinated LT2 EUR Banks Subordinated T1 & UT Sources: Markit and Moody s Investors Service. Vertical lines show the main events in the negotiation on the BRRD (see Exhibit 1) EUR Banks Subordinated T1 &UT2 has been estimated using the iboxx Bank Subordinated and iboxx EUR Banks Subordinated LT2 indices, under the assumption that the weight of the estimated index over total subordinated debt is 1% (base d on the average historical weight of Subordinated T1 &UT2in the iboxx Subordinated index). Changing Liability Structures Have Also Played A Role Evidence from spreads on different bond yields suggests that the new European bail-in regimes are credible. However, the absolute size of spreads between senior secured and unsecured debt, or senior and junior debt, are relatively small. In part, this is likely to reflect current market conditions and in particular the general yield compression associated with low benchmark interest rates. But it is also important to acknowledge the impact of other structural changes to banks balance sheets. The degree to which individual bondholders suffer losses will depend both on the thickness of the debt tranche that they inhabit, but also on the amount of debt that is subordinated to them in the event of bank failure and resolution. 1 1 This is a key concept in Moody s proposed rating methodology for banks. For more details, see Proposed Bank Rating Methodology, 9 September OCTOBER 17, 214 SPECIAL COMMENT: DO MARKETS BELIEVE IN BAIL-IN OF EUROPEAN BANKS?

5 Under new European regulations, a bank must hold a minimum amount of debt that can be bailed in equivalent to 8% of its total liabilities including own funds, or 2% of its risk-weighted assets. These buffers must be exhausted before external funding either from bank resolution funds or directly from governments can be received. Across the largest European banking systems, loss-absorbing debt instruments have increased from around 6%-1% of total assets in 29 to around 1%-16% in H1 214 (Exhibit 4). EXHIBIT 4 Debt that can be bailed in % of total assets, 29 and H % 18% 16% 14% 12% 1% 8% 6% 4% 2% % Capital and Reserves Subordinated Senior Unsecured (bail-inable) 9 H114 9 H114 9 H114 9 H114 9 H114 9 H114 France Germany Italy Spain Netherlands United Kingdom Sources: Total assets and capital (ECB), Subordinated and senior debt (Dealogic) In large part, this greater loss-absorbing capacity has been driven by increases in capital. Under the Basel III regulations, 11 banks are required to hold more and better-quality capital. Conditional on the total losses on banks assets in the event of failure, these higher capital buffers should offer greater protection both for junior and senior bondholders. The significant increase in capital cushion consistent with the Basel III requirements (Exhibit 5), which are implemented at the same time as the European bail-in regime, should also have an impact on the relative risk premia of various debt instruments. More and better quality capital under Basel III in particular the requirement for banks to hold more common equity Tier 1 (CET1) capital is positive for bond holders. If capital and subordinated instrument cushion are large enough, senior debt creditors will be protected from bail-ins. 11 See Basel III Implementation in Full Swing: Global Overview and Credit Implications, 4 August OCTOBER 17, 214 SPECIAL COMMENT: DO MARKETS BELIEVE IN BAIL-IN OF EUROPEAN BANKS?

6 EXHIBIT 5 Basel III requires more high-quality CET1 capital; new buffers must also be met with CET1 18% 16% 14% D-SIB / G-SIB Capital Surcharges (CET1) 16.5% 12% 1% 8% 6% 4% 2% % 8.% 6.% 4.% 3.1% 2.% Lower Tier 2 Upper Tier 2 Innovative Tier 1 Non-Innovative Tier 1 Common Equity Countercyclical Capital Buffer (CET1) Capital Conservation Buffer (CET1) Tier 2 (T2/AT1/CET1) Additional Tier 1 (AT1/CET1) 13.% 1.5% 8.% 6.% Common Equity Tier 1 (CET1) 4.5% Basel II Basel III Source: Basel Committee on Banking Supervision In addition to issuing more common equity, banks have also acted to boost their issuance of Basel III compliant Additional Tier 1 (AT1) and Tier 2 securities. These are designed to absorb losses either before or at the time of bank failure, and prior to any claim on senior bondholders or taxpayers. By June 214, the ratio of outstanding amounts of subordinated to senior debt had increased to 44%, up from 39% in 212 and 213 (Exhibit 6). This should further support senior bondholders in the event of bank resolution and bail-in. EXHIBIT 6 European senior and subordinated outstanding debt by year EUR bn. 2, 1,8 1,6 1,4 1,2 1, Source. Dealogic senior (lhs) subordinated (lhs) ratio sub/sen (rhs) 39% 39% Jun14 4% 44% 46% 44% 42% 4% 38% 36% ratio 6 OCTOBER 17, 214 SPECIAL COMMENT: DO MARKETS BELIEVE IN BAIL-IN OF EUROPEAN BANKS?

7 Box 1. Case study: market reaction to the implementation of a resolution regime in Denmark Denmark introduced bail-in regulation in October 21 and the regulation was used in the resolution programmes for Amagerbanken in February 211 and of Fjordbank Mors in June 211. This offers a useful case study of financial markets changing perceptions of the relative riskiness of debt instruments during this period. The implementation of a special resolution regime in Denmark resulted in a re-pricing of risk for the Danish banking sector relative to its close European peers. Between November 21 and January 211 after the institution of the new regime but before the two bail-ins the yield on Danske Bank debt, relative to some Nordic peers, jumped by around 4 bps (Exhibit 7). After the two bail-ins of Amagerbanken and Fjordbank Mors, this spread widened further, although it is difficult to know whether this reflected the increased credibility of the regime or the general deterioration in market sentiment associated with the intensification of the euro area crisis during late EXHIBIT 7 Impact of Danish resolution regime Basis points 5Y senior CDS (bp.) Peer group Danske Bank Fjordbank Mors BAIL-IN Amagerbanken BAIL-IN Danish bank resolution scheme Jan/1 Feb/1 Mar/1 Apr/1 May/1 Jun/1 Jul/1 Aug/1 Sep/1 Oct/1 Nov/1 Dec/1 Jan/11 Feb/11 Mar/11 Apr/11 May/11 Jun/11 Jul/11 Aug/11 Sep/11 Oct/11 Nov/11 Source: Bloomberg. Peer group (5y Senior CDS) Nordic Banks: Nordea Bank AB, Svenska Handelsbanken AB, Swedbank AB, DNB BANK Dec/11 12 Following the negative impact of haircuts on Amagerbanken and Fjordbank, Denmark revised its regulatory framework and published its Bank Package IV, including the possibility of the most solvent banks acquiring the weakest banks with government aid, to facilitate private sector solutions (see Moody s, Danish Bank Package 4 Offers Alternative to Write-downs, a Credit Positive, August 29, 211) 7 OCTOBER 17, 214 SPECIAL COMMENT: DO MARKETS BELIEVE IN BAIL-IN OF EUROPEAN BANKS?

8 Box 2. Case study: Only a small probability of a senior bail-in was priced in for Banco Espirito Santo On 3 August 214, Portugal s central bank imposed resolution measures on Banco Espirito Santo S.A. (BES) in the face of the bank s imminent risk of default. 13 This followed a number of weeks during which concerns over the bank s governance and refinancing of its holding companies emerged. The Bank of Portugal (BoP) transferred most of BES assets, liabilities and off-balance-sheet items to a newly created bank called Novo Banco. In addition, Novo Banco received a capital injection from the Portuguese Resolution Fund of 4.9 billion, which became the sole shareholder of the bank. Depositors and senior debt holders were protected by the Portuguese authorities, as they were transferred to Novo Banco. However, shareholders and holders of BES s junior debt instruments were not transferred to the new bank. Ahead of the BoP s intervention, senior spreads over covered bonds widened by 14 bps during the days before the intervention (Exhibit 8), reflecting the increased probability that senior debt would be bailed in. Meanwhile, the spread of Tier 2 debt over covered bonds widened by 9 bps in the same period, reflecting the likelihood that subordinated debt would be bailed-in. In the event, after intervention senior spreads narrowed again, reflecting the lack of bail-in for these bonds, while Tier 2 spreads widened further. However, senior spread over covered bond has widened by around 15bp since early September, as speculation has grown that senior debt (now transferred to Novo Banco) might not be immune to bail-in. Given the lack of any junior debt cushion for Novo Banco and the potential risk of further asset-quality deterioration, senior debtors would likely face losses in the event that further intervention is required. EXHIBIT 8 Pre-resolution variability in BES bond spreads ASW Spreads (Basic points) -- difference between yield bond and the interest rate swap Senior Covered Bonds Subordinated debt (T2) (right axis) bail-out BES /Jun/14 9/Jun/14 16/Jun/14 23/Jun/14 3/Jun/14 7/Jul/14 14/Jul/14 21/Jul/14 28/Jul/14 4/Aug/14 11/Aug/14 18/Aug/14 25/Aug/14 1/Sep/14 8/Sep/14 15/Sep/14 22/Sep/14 29/Sep/14 6/Oct/14 13/Oct/14 Source. Bloomberg. Senior due Jan 219, subordinate due 223, covered bond due See Banking System Outlook: Portugal, 7 October OCTOBER 17, 214 SPECIAL COMMENT: DO MARKETS BELIEVE IN BAIL-IN OF EUROPEAN BANKS?

9 Moody s Related Research Rating Methodology:» Moody s Approach to rating Covered Bonds, March (SF345822) Sector Comments:» Banking System Outlook: Portugal, October 214 (175167)» Adoption of New Bank Resolution Framework Supports Creditworthiness of EU Sovereigns, May 214 (171259)» EU Banking Union: Ecofin Compromise Confirms Momentum Towards Bail-in, January 214 (162189)» Early Introduction of European Union Bail-In Regime Is Credit Negative for Banks Unsecured Bondholders, December 213 (16182)» European Commission s Bail-In Proposals Indicate Lower Support in Future for Senior Bank Debt, January 211 (129951)» Growing Support for Bail-In Rules Is Negative for Creditors of Systemically Important Banks, October 21 (128173) Special Comments:» Basel III Implementation in Full Swing: Global Overview and Credit Implications, August 214 (17763)» Bank Systemic Support Global Update: Resolution Regimes Drive Shifts in Support, July 214 (16611)» Reassessing Systemic Support for EU Banks, May 214 (1746)» EU Banks: Agreed Resolution Framework Confirms Credit Negative Implications for Senior Unsecured Creditors, April 214 (168466)» Moody s Reassesses Systemic Support for Senior Debt of Smaller European Financial Institutions: Spanish Bank Ratings Downgraded as a First Step, March 211 (13192)» Supported Bank Debt Ratings at Risk of Downgrade Due to New Approaches to Bank Resolution, February 211 (13168) To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of this report and that more recent reports may be available. All research may not be available to all clients. 9 OCTOBER 17, 214 SPECIAL COMMENT: DO MARKETS BELIEVE IN BAIL-IN OF EUROPEAN BANKS?

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