European financial CDS at the crossroads As bank regulation evolves and bank-debt restructuring precedents occur, European financial CDS adapt to a changing banking world. The introduction of the ISDA 214 Credit Derivatives Definitions is an example of this. The event led to the emergence of a bifurcated market for European bank CDS. Investors considering trading off-the-run itraxx Europe Financial index series might want to thoroughly understand this bifurcated market, both in terms of trade documentation and pricing. European bank regulation also continues to evolve and further changes to the European bank CDS market will have to follow suit. Likely changes include new itraxx Europe index rules and future senior CDS providing protection against credit risk of bail-in-able senior bonds. Contents European financial CDS at the crossroads 1 Financial CDS adapting to a changing world 2 The next itraxx Europe rule change 4 Off-the-run itraxx Europe Financial indices 7 itraxx Financial indices: Series 22 vs. Series 21 9 Single-name CDS that reference European banks 12 23 and 214 Credit Derivatives Definitions 18 The latest example of how the emergence of European bank bail-in regulation shapes European financial CDS is Markit s proposal, published in August, to adjust itraxx Europe index rules. We share our view of the proposal, the rationale behind it and what we think is missing. The most liquidly traded instrument for European financial sector credit risk is the on-the-run itraxx Europe Financial Senior index CDS (the onthe-run Senior ). However, 2 series of the Senior and 2 series of the related Subordinated index (the Sub ) are still quoted and tradable. We provide an overview of these past 2 index series: highlighting what we think investors want to know about the different versions of the ISDA Credit Derivatives Definitions that govern the various index series and listing current index members, from Series 7 to Series 26. We discuss Series 22 5Y roll spreads (vs. Series 21) for the Senior and Sub indices. These indices are still traded and these roll spreads therefore carry market-implied information about the likelihood of governmental intervention and sub-debt restructuring credit events for European banks in general. The market perception of the likelihood of such events has changed in the past two years. Single-name CDS spreads for European banks have been different for 23 and 214 transactions since the bifurcated market emerged on 22 September 214, after the introduction of the ISDA 214 Credit Derivatives Definitions. In the past two years, the (relative) spread differences of 23 and 214 transactions have not only drifted away from initial levels, but they also show single-name idiosyncrasies. We present a few case studies. We also discuss the dependence of bank CDS spreads on subordination schemes of senior debt vs. wholesale and corporate deposits. For our readers convenience we summarize the key differences between the current ISDA 214 Credit Derivatives Definitions (214 CDD) and the updated ISDA 23 Credit Derivatives Definitions. The 214 CDD were finalized in March 214 and first used for trading on 22 September 214. Our summary focusses on the differences that concern European financial sector CDS and change the economic value of related 214 transactions compared to 23 transactions. Author Dr. Tim Brunne, Credit Strategist (UniCredit Bank) +49 89 378-13521 tim.brunne@unicredit.de Bloomberg UCCR15 (Credit Derivatives Strategy) HVIT (itraxx Europe Trading) Internet www.research.unicredit.eu UniCredit Research page 1 See last pages for disclaimer.
Tsunami of bank regulation Capital structure of banks and the no-bail-out dictum The CDS market adapted Financial CDS adapting to a changing world Banking regulation in developed markets has been a major topic of discussion, action and evolution in the past eight years. Arguably, a pivotal event, for the emergence of a tsunami of new regulation that has, since then, hit not only banks but the global financial system in general, was the G2 meeting in Pittsburgh in September 29. G2 leaders agreed to make sure our regulatory system for banks and other financial firms reins in the excesses that led to the crisis and committed to act together to raise capital standards [ ] and to create more powerful tools to hold large global firms to account for the risks they take. Standards for large global financial firms should be commensurate with the cost of their failure (from the preamble of the meeting statement [link]). Since then, important milestones of post-crisis banking regulation have been the 21 Dodd Frank Act in the US, the 211 Basel III Accord and its 213 amendment, the 213 Capital Requirements Directive in the EU, the EU 214 Bank Recovery and Resolution Directive (BRRD), the EU 213 Single Supervisory Mechanism (SSM) and the EU 214 Single Resolution Mechanism. Still, the regulatory framework for banks is not yet complete. A very recent example of new bank capital regulation is the May 216 adoption of a revised bank capital adequacy ordinance by the Swiss Federal Council, which became effective in July. While Switzerland already had high capital requirements for systemically relevant banks, the new law strengthened existing requirements and established new ones. For credit investors, an important implication of bank regulation is the impact that it has had on the capital structures of banks, creating new types of debt and gradually making pre-crisis categories obsolete. Today, we are talking about capital-contingent convertible bank debt, bail-in capital, going and gone-concern capital, non-preferred senior bonds, etc., while for example pre-crisis types of subordinated debt (Tier-1, Upper Tier-2, Lower Tier-2) gradually disappear. As bank-bail-outs were a hot topic of public discussion and policy making in the course of and after the financial crisis, investors today will be aware that a paradigm shift has occurred in relation to implicit state-support for banks. The credit risk associated with bank funding and capital has changed in the post-crisis world. The market for CDS referencing financial entities has already adapted to this changing world to some extent. However, there is also the need for further change. Various credit events caused by bank debt being restructured between 29 and 214 partly precipitated a complete overhaul of the ISDA Credit Derivatives Definitions. The market has adopted an entirely rewritten version of the definitions in September 214, replacing the version of 23 that was amended in 29 by supplements. The related documentation changes were particularly relevant for European financial CDS and we summarize the economically most important aspects of this change as it relates to these CDS in our last section 23 and 214 Credit Derivatives Definitions. The motivation for this refresher on the definitions is that a bifurcated market for European bank CDS emerged in September 214 that still exists today. 23 and 214 transactions are priced differently as the governmental intervention credit event, asset package settlement and a more explicit distinction between senior and sub CDS were added to the definitions in 214. In the sections itraxx Financial indices: Series 22 vs. Series 21 and Single-name CDS that reference European banks we show how pricing differences have evolved over the past two years and provide our interpretation of the market-implied information on European bank credit risk. The section Off-the-run itraxx Europe Financial indices provides the necessary explanation as to why the understanding of the differences between the ISDA 214 and updated ISDA 213 Credit Derivatives Definitions matters for trading off-the-run itraxx European indices. UniCredit Research page 2
and is expected to further adapt We think that the CDS market will have to further adapt to the still-changing capital structure of European banks. The advent of TLAC (total loss absorbing capital) and MREL (minimum requirement for own funds and eligible liabilities), the requirement that related gone-concern bail-in capital must be subordinate to wholesale and corporate deposits and the likely regulation-driven disappearance of Tier-2 debt in some jurisdictions has consequences for European bank CDS. Market participants will have to decide which entities they want to trade in single-name CDS, if there is a decision to be made between bank holding and bank operating companies. For banks that issue different types of senior bonds in the future, a decision in relation to the market standard for proper reference obligations for senior CDS must be made. Regarding itraxx Europe indices, the index rules will have to be amended. In our view, a rule-based selection of the index members and reference obligations should ensure that similar credit risks are traded with future series of the Senior indices. In the current on-the-run Senior index, a dissimilarity of senior debt seniorities prevails among the index constituents that are banks. As regards the Sub index, the gradual disappearance of Tier-2 debt for some of the current index members poses the question of whether an even more comprehensive overhaul of the concept behind the index is required. We discuss index rules in the following section The next itraxx Europe rule change and touch upon the single-name CDS issues in the above-mentioned section Single-name CDS that reference European banks. UniCredit Research page 3
The next itraxx Europe rule change A certain heterogeneity of European corporate CDS referencing financial sector names stems partly from market conventions and trade documentation adapting to a changing regulatory environment. In Europe, the emergence of bank bail-in original precedents and bail-in regulation continues to drive these developments. The latest example is Markit s proposal, published in August, to adjust itraxx Europe index rules regarding the selection of index constituents that are banks. In this publication, we share our view on the proposal and on the rationale behind it. Prior consequences of European bank regulation on CDS August 216 announcement of index administrator IHS Markit Index rules should be amended In September 214, the contractual basis for CDS trading underwent a major overhaul, when the ISDA 214 Credit Derivatives Definitions (214 CDD) replaced the ISDA 23 Credit Derivatives Definitions and the 29 Supplements (the updated 23 CDD). This overhaul addressed several shortcomings that still existed in the updated 23 CDD, in particular regarding sovereign CDS and CDS referencing European banks, against the background of upcoming and already existing bank resolution and recovery laws in EU countries. The implications of this overhaul can still be seen today and will be discussed in the sections below. However, before we look at these implications, we focus on the next potential consequence of changing bank regulation for European financial-sector CDS. On 8 and 9 August, IHS Markit announced that it is considering reviewing itraxx Europe index rules (link): in the next 12 months, a decision will be taken on whether the inclusion of bank entities in the itraxx Europe Financial indices should be at the holdco level, Markit said. We understand that Markit s potential itraxx Europe rule amendment aims to incorporate recent regulatory changes related to banks (future) total-loss-absorbing-capital requirements (TLAC) or the related MREL regulation (minimum requirement for own funds and eligible liabilities) (see our Sector Flash RAS from 12 July). As a consequence of such financial regulation, Markit expects many European banks to increasingly issue senior and Tier-2 debt via their respective bank holding companies. Markit s intention is that CDS included in the financial index should follow the more active bond market. For previous index rolls, a positive feedback loop was behind few itraxx Europe index constituent changes being caused by variations in single-name market activity. For several years, our perception has been that reference entities that are already index constituents attract most of the single-name CDS market activity. To some extent, this is probably caused by index arbitrage. Current itraxx Europe index rules state that single-name CDS market activity data is a principle input for the determination of index membership (see Markit itraxx Europe Index Rules, published by on 1 September). Such a direct link of name selection to observed market activity has prevailed for the past twelve index roll events, since the itraxx European indices rolled into Series 15 in March 211. Consequently, in each of the past eleven index rolls, previous itraxx Europe index members have usually become index members of the new index series again. Name changes have been very rare for the Senior and Sub Financial indices (see section Off-the-run itraxx Europe Financial indices below) and have almost exclusively been triggered by rating changes in the banking sector. Even if in the future bank holding companies (instead of their bank operating companies) become very active issuers of (bail-in-able) senior and subordinated debt, due to the index rule mechanics described above, these holding companies might not become constituents of the Senior and the Sub indices. Indeed, this observation argues for the creation of a new rule for itraxx Europe Financial indices that designates the holding company as a reference entity if it has an increasingly dominant role regarding debt issuance. For most of the banking organizations that have a holdco-opco structure, in the existing index series, the operating companies (opco) are the index member (see table above). UniCredit Research page 4
BANKS THAT ARE CURRENTLY FINANCIAL INDEX CONSTITUENTS AND THEIR RELATED ENTITIES Debt ticker itraxx Europe Senior Financial constituent (Series 24-26) Country Related bank holding company* Related bank operating company** CS Credit Suisse Group AG CH - Credit Suisse AG UBS UBS AG CH UBS Group AG BACR BARCLAYS BANK PLC GB Barclays PLC HSBC HSBC BANK PLC GB HSBC HOLDINGS plc LLOYDS LLOYDS BANK PLC GB LLOYDS BANKING GROUP PLC RBS The Royal Bank of Scotland public limited company GB The Royal Bank Of Scotland Group public limited company STANLN STANDARD CHARTERED BANK GB STANDARD CHARTERED PLC RABOBK Cooeperatieve Rabobank U.A. NL - INTNED ING Bank N.V. NL ING Groep N.V. BBVASM BANCO BILBAO VIZCAYA ARGENTARIA, SOCIEDAD ANONIMA ES - SANTAN BANCO SANTANDER, S.A. ES - BNP BNP PARIBAS FR - SOCGEN SOCIETE GENERALE FR - ACAFP CREDIT AGRICOLE SA FR Credit Agricole Groupe BYLAN Bayerische Landesbank DE - CMZB COMMERZBANK Aktiengesellschaft DE - DB DEUTSCHE BANK AKTIENGESELLSCHAFT DE - ISPIM INTESA SANPAOLO SPA IT - BACRED MEDIOBANCA BANCA DI CREDITO FINANZIARIO SpA IT - UCGIM UNICREDIT, SOCIETA PER AZIONI IT - DANBNK DANSKE BANK A/S DK - *In this column a dash indicates that there is no dedicated bank holding company for the respective index constituent. **The column gives the principle bank operating company if the index constituent is a bank holding company. Source: IHS Markit, Bloomberg, UniCredit Research Given the multiple approaches to achieve subordination a differentiation between holdco and opco is too narrow a focus. However, the holdco-vs.-opco structure used by banks to implement the loss-absorbing capacity of senior debt according to MREL ( structural subordination ) does not prevail in the majority of European jurisdictions. As the table above shows, it is mostly UK and Swiss legislation that has adopted this model. The Benelux countries are likely to follow suit. In contrast, the establishment of bank holding companies will probably not be the capital structure of choice for French, German, Italian and Spanish banks. Instead, French regulation has introduced non-preferred senior bonds, which include a contractual reference to subordination in relation to the preferred (i.e. traditional ) senior bonds. Spanish regulation has introduced Tier-3 bonds, which are subordinate to traditional senior bonds by means of an explicit contractual subordination included in the related bond documentation. In these two jurisdictions (FR, SP), the issuance of traditional senior bonds remains an option and the bond documentation of seniors that are intended to be bail-in-able must include a reference indicating their subordination to traditional senior bonds: we have referred to it as contractual reference to subordination in this publication. In contrast to structural subordination and contractual reference to subordination, legal subordination of senior debt vs. wholesale and corporate deposits is a third option. Legal subordination was implemented in Germany through a modification of the insolvency law (effective 217) and is the method of choice in Italy, while the Italian government refrained from making the existing insolvency law more complicated and selected a different means to implement legal subordination (effective for Italian banks from 219). For itraxx Europe Senior constituents that are banks from jurisdictions with contractual reference to subordination, the current senior CDS reference obligations are senior to the upcoming non-preferred senior bonds (FR) and Tier-3 bonds (SP), respectively. This is similar to the index names that are banks from jurisdictions with structural subordination for the following reason: such index names are currently the bank operating companies (the only exception being Credit Suisse Group), so the index CDS reference obligations are therefore structurally senior to the bail-in-able senior bonds issued by the bank holding companies. UniCredit Research page 5
In contrast, for the jurisdictions with legal subordination (DE, IT), Senior index names that are banks are already offering credit protection for senior debt that is bail-in-able. In the current on-the-run and prior series of the Senior, a dissimilarity of senior debt seniorities therefore prevails among the index constituents that are banks. As we further discuss in the section Single-name CDS that reference European banks below, this dissimilarity among European bank CDS partly explains the dispersion among single-name spreads. The more general question should be whether the Senior index ought to be a proper hedge for bail-in-able bank senior debt. What could happen to sub CDS and the Sub index? We therefore think that the more general question for Markit to answer in the next twelve months is whether financial senior CDS that are included in future itraxx Financial Senior indices (and hence also in the itraxx Europe benchmark index), should always reference bail-in-able senior debt that is (either structurally, by contractual reference or legally) subordinate to the bank s wholesale and corporate deposits. This would imply that bank holding companies will be the preferred index members for jurisdictions with structural subordination, that non-preferred senior or Tier-3 bonds will be the reference obligations for banks from jurisdictions with contractual subordination, and that nothing will change for banks from jurisdictions with legal subordination. The emphasis of MREL-regulation on senior bank debt that is eligible as gone-concern capital has implications for subordinated debt. In July, Swiss bank regulation entered into force that makes bank Tier-2 bonds practically obsolete in the future (see e.g. FINMA website). Some of the future capital requirements will have to be satisfied with high-trigger CoCo bonds. At the same time senior bonds issued by bank holding companies are eligible as bail-in capital. In contrast to earlier post-crisis Swiss bank capital requirements, (low-trigger) Tier-2 bonds have no role to play in the revised Swiss bank capital adequacy ordinance, making them an expensive variant of senior bond funding. As outstanding Tier-2 bonds of systemically relevant Swiss banks mature or are called, these bonds are expected to gradually disappear from the market. How the role of Tier-2 bonds in other European jurisdictions will evolve is not yet certain, but it seems that they will also become exotic instruments elsewhere. There is the risk that Tier-2 debt will gradually die off. This might make current sub CDS obsolete in the future. If this happens, it is clear that the Sub index will not be able to survive in its present form. We are not aware that this problem has yet been addressed by Markit. We can imagine two alternative approaches to save the Sub. One solution would be for the constituents of the Senior and the Sub to cease to be identical: a bank s membership in future series of the Sub index might have to depend mainly on the existence of a sub CDS and related Tier-2 bonds. Alternatively, a more radical approach would be to establish CDS on AT1 debt and re-invent the Sub as an index that protects against losses incurred by such bank capital instruments. UniCredit Research page 6
Off-the-run itraxx Europe Financial indices The most liquidly traded instrument for European financial sector credit risk is the onthe-run itraxx Europe Financial Senior index CDS. However, 2 series of the Senior and 2 series of the related Subordinated index are still quoted and tradable. We provide an overview of these past 2 index series: highlighting what we think investors want to know about the different versions of the ISDA Credit Derivatives Definitions that govern the various index series and listing current index members. 214 CDD vs. updated 23 CDD itraxx European indices governed by the 214 CDD only as of Series 22 The 214 ISDA protocol explicitly excluded legacy European bank CDS from the transition What the ISDA protocol did to the itraxx Europe Financial index transactions A blend of 23 and 214 transactions Until 2 September 214, single-name and index CDS were almost exclusively traded on the basis of the ISDA 23 Credit Derivatives Definitions and related 29 Supplements (updated 23 CDD). Between 22 September and 3 October 214, the ISDA 214 Credit Derivatives Definitions (214 CDD) were first used for trading CDS and became the global market standard for single-name and index CDS after that two-week period. In the last section of this publication, we provide an overview of the differences between the two versions of the definitions with a focus on financial sector CDS. There are some particularly important differences between the updated 23 and 214 CDD, which lead to pricing differences for itraxx Europe Financial indices, until and after Series 21. These economic differences were intended by the documentation overhaul and are motivated particularly by post-crisis changes to bank regulation (see last section of this publication). When itraxx European indices were rolled from Series 21 to Series 22 (two weeks after the introduction of the 214 CDD) in October 214, the Series 22 index instruments were the first to fully reference the 214 CDD. Until October 214, the market standard for trading itraxx European indices was the updated 23 CDD. The ISDA 214 Credit Derivatives Definitions Protocol (link), effective 6 October 214, was created to transform many of the legacy index and single-name CDS trades (23 transactions) into trades referencing the new 214 CDD (214 transactions). However, the protocol excluded certain transactions from this transition, as the economic value of the excluded transactions would have otherwise been changed considerably by the migration to new legal trade documentation. These excluded transactions were therefore stuck in the old regime of CDS trading that had prevailed until late-september 214. Transactions referencing so-called protocol excluded reference entities were excluded transactions for the purpose of the protocol. Among the excluded reference entities on ISDA s Excluded Reference Entity List (link) there were 94 European banks, in particular all the banks that were itraxx index members. By intentionally excluding legacy trades referencing European banks from the protocol and therefore from the transition to the new 214 trading standard, as of 22 September, a bifurcated CDS market emerged: two different flavours of European bank CDS started to co-exist. These two different flavours still exist, both for senior and subordinated transactions referencing European banks. Senior and Sub indices comprise CDS referencing banks and insurance companies. Senior and Sub index transactions, up to Series 21, were affected by the application of the ISDA 214 protocol only in relation to the index constituents that were insurance companies. These index trades were therefore referencing both the updated 23 and the 214 CDD after the application of the ISDA 214 protocol. When counterparties trade Series 21 and earlier series of the Senior and Sub today, they still make transactions that are governed by both versions of the Credit Derivatives Definitions. Hence, the bifurcated market for European bank CDS, which emerged in late September 214, continues to exist in index trading. As the Senior is a sub-index of the itraxx Europe benchmark index, also Series 21 and earlier series of the Europe continue to be partly governed by the updated 23 CDD. The table below lists the (current) index constituents of the past 2 series of the Senior and Sub indices. Some 1Y-tenor trades referencing Series 7 are still outstanding and will mature on 2 June 217. All constituents of the Series 22 26 Senior and Sub transactions are UniCredit Research page 7
governed by the ISDA 214 CDD, as mentioned above. Corresponding transactions referencing earlier indices will be governed by a mix of definitions (unless the two trade counterparties did not both adhere to the ISDA 214 protocol and the trade was done before 6 October 214, or, the particular transaction explicitly excluded from the protocol in bilateral manner). A mix means that the 214 CDD are applicable for constituents that are insurance companies and the updated 23 CDD for constituents that are banks. Such index trades are effectively a blend of 23 and 214 transactions. A few outstanding index trades still exist in the market that reference Series 7 to 21 and are pure 23 transactions. THE LAST 2 SERIES OF ITRAXX FINANCIAL INDICES: CURRENT INDEX CONSTITUENTS AND INDEX WEIGHTS* Index constituent ISO Ticker Numerator of index weight by index series Country 7 8 9 1 11 12 13 14 15 16 17 18 19 2 21 22 23 24 25 26 Credit Suisse Group AG CH CS 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 UBS AG CH UBS 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 COMMERZBANK Aktiengesellschaft DE CMZB 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 DEUTSCHE BANK AKTIENGESELLSCHAFT DE DB 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 BANCO SANTANDER, S.A. ES SANTAN 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 BNP PARIBAS FR BNP 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 CREDIT AGRICOLE SA FR ACAFP 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 SOCIETE GENERALE FR SOCGEN 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 BARCLAYS BANK PLC GB BACR 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 The Royal Bank of Scotland public limited company GB RBS 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 INTESA SANPAOLO SPA IT ISPIM 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 UNICREDIT, SOCIETA PER AZIONI IT UCGIM 1 2 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 LLOYDS BANK PLC GB LLOYDS 1 1 1 1 1 1 1 1 1 1 1 1 HSBC BANK PLC GB HSBC 1 1 1 1 1 1 1 1 1 1 STANDARD CHARTERED BANK GB STANLN 1 1 1 1 1 1 1 1 1 BANCO BILBAO VIZCAYA ARGENTARIA, SOCIEDAD ANONIMA ES BBVASM 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 ING Bank N.V. NL INTNED 1 1 1 1 1 1 1 1 DANSKE BANK A/S DK DANBNK 1 1 1 1 MEDIOBANCA BANCA DI CREDITO FINANZIARIO SOCIETA PER AZIONI IT BACRED 1 1 1 1 Cooeperatieve Rabobank U.A. NL RABOBK 1 1 1 1 Bayerische Landesbank DE BYLAN 1 1 1 Svenska Handelsbanken AB SE SHBASS 1 BANCA MONTE DEI PASCHI DI SIENA S.P.A. IT MONTE 1 1 1 1 1 1 1 1 1 1 1 BANCO POPOLARE SOCIETA COOPERATIVA IT BPIM 1 1 1 Bank of Scotland plc GB LLOYDS 1 1 1 1 1 1 NOVO BANCO, S.A. PT NOVBNC 1 1 1 1 1 1 1 1 The Royal Bank of Scotland N.V. NL RBS 1 1 Banco Comercial Portugues, S.A. PT BCPPL 1 Zurich Insurance Company Ltd CH ZURNVX 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 Allianz SE DE ALVGR 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 Hannover Rueck SE DE HANRUE 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 Muenchener Rueckversicherungs-Gesellschaft Aktiengesellschaft in Muenchen DE MUNRE 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 AXA FR AXASA 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 AVIVA PLC GB AVLN 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 ASSICURAZIONI GENERALI - SOCIETA PER AZIONI IT ASSGEN 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 Aegon N.V. NL AEGON 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 Swiss Reinsurance Company Ltd CH SRENVX 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 ROYAL & SUN ALLIANCE INSURANCE PLC GB RSALN 1 Index weight denominator 25 25 25 25 25 25 25 25 25 25 25 25 25 25 25 25 3 3 3 3 *Series 7 started in March 27 and Series 26 in September 216; Series 22 and beyond use the 214 ISDA Credit Derivatives Definitions. Series 7 includes a ceased name. The index weight of a name is (approximately) equal to the fraction defined by the respective numerator and denominator provided in the table. As of Series 15 (March 211), name selection was no longer determined by a dealer poll, but instead by market activity data ( roll report ) of the DTCC. As of Series 22 (October 214), the ISDA 214 Credit Derivatives Definitions were applicable to the bank names in the index as well. Source: IHS Markit, UniCredit Research Assessing the likelihood of governmental intervention in bank debt restructurings The principle economic difference between European bank CDS governed by the updated 23 and 214 CDD stems from the governmental intervention credit event, the asset package settlement option and the separation of senior and subordinated debt-restructuring credit events (see last section for details). Recent index series include these new features of the 214 CDD in relation to constituents that are banks, while index series until and including Series 21 do not. Many off-the-run series of the Senior and Sub are still quoted and tradable. Related index spreads reveal market-implied information about the perceived importance of governmental intervention in bank debt restructuring. UniCredit Research page 8
itraxx Financial indices: Series 22 vs. Series 21 We discuss Series 22 5Y roll spreads (vs. Series 21) for the Senior and Sub indices. These indices are still traded and these roll spreads therefore carry market-implied information about the likelihood of governmental intervention and sub-debt restructuring credit events for European banks in general. The market perception of the likelihood such events has changed in the past two years. Why we pick the Series 22 and 21 for a spread comparison Market-implied vs. modelimplied information The constituents of Series 22 and 21 of the Senior are Sub are almost the same with only a single name being different: in Series 22, ING Bank replaced outgoing name Swiss Reinsurance Company (see table on previous page). As the outgoing name always traded tighter than the new name over the past two years, both in senior and sub transactions, the associated contribution to the Series 22 roll spread has been persistently positive. This name change contributed roughly 1bp to the Series 22 5Y tenor Senior roll spread in the past two years and never more than 2bp. It usually contributed about 2bp to the corresponding Sub roll spread in the past two years and never more than 3bp. Hence, the name change is of minor importance for the Series-22-to-Series-21 (Senior and Sub) spread difference. The main reasons for the spread difference are therefore the changes made to the trade documentation and the trading standards for the European bank reference names and the small time-tomaturity difference between the two index series. The minor importance of the name change renders the two series a suitable pair for an analysis of the impact of the 214 trade documentation overhaul. The next section, entitled Single-name CDS that reference European banks, includes an analysis of the impact of the 214 trade documentation overhaul on single-name CDS. However, in comparison to single-name CDS, the index market offers a distinct advantage: in contrast to 23 single-name transactions, we deem the indices more actively traded. The left chart below shows weekly trading volume data for the Senior indices (all series and index tenors), split into on-the-run and off-the-run index market activity at each date. Market activity is concentrated on the on-the-run index series, but there is a market for off-the-run indices as well. The right chart shows the same weekly market activity data for Series 21 and 22 only. We conclude that spread data for Series 21 and 22 Senior indices are mostly determined by markets rather than models. SENIOR INDEX WEEKLY TRADING ACTIVTIY: ON-THE-RUN AND OFF-THE-RUN SERIES (L), SERIES 21 & 22 SINCE JULY 215 (R) 7 ITRAXX-FINSEN (ON) 26W trailing average (ON+OFF) ITRAXX-FINSEN (OFF) 1.6 Senior S21 Senior S22 Weekly market activity (EUR bn) 6 5 4 3 2 1 Weekly market activtiy (EUR bn) 1.4 1.2 1.8.6.4.2 1-Jan-14 1-Jan-15 1-Jan-16 17-Jul-15 16-Oct-15 15-Jan-16 15-Apr-16 15-Jul-16 14-Oct-16 Source: Bloomberg, DTCC, UniCredit Research Series 22 sub roll spread The left chart below shows the relative roll spread from Series 21 to 22 since the latter series started to be traded in October 214. This is the spread difference between the 5Ytenor spreads for Series 22 and 21 relative to the Series 21 spread. The time-to-maturity UniCredit Research page 9
difference and the name change from 21 to 22 are the less important drivers of the Series 22 Sub roll spread. In October 214, the Series 22 Sub was about 8% wider than the Series 21 Sub index spread. This relative spread difference temporarily declined to 4% already in the course of 215, where it also currently stands. The additional spread premium of Series 22 transactions stems mostly from the fact that the Series 22 index offers protection against governmental intervention credit events and offers the asset package settlement option (for the settlement of governmental intervention and restructuring credit events) for 16 of the 25 index names (i.e. the banks). We refer the reader to the last section of this publication for a discussion of the difference between 23 and 214 European bank CDS. The market makes a clear statement here: the relative market-implied likelihood of a governmental intervention credit event from losses imposed on subordinated bank debt is currently smaller than two or even one year ago. This means that, more than previously, the market attributes a greater share of the spread of European bank sub CDS to other risks, such as the restructuring of subordinated debt without governmental intervention. SERIES 22 ROLL SPREADS (5Y TENOR): SUB (L) AND SENIOR (R) Index spread (bp) 4 35 3 25 2 15 1 5 ITRAXX-FINSUBS21V1-5Y ITRAXX-FINSUBS22V1-5Y Sub spread difference Relative spread difference (RS) 12% 1% 8% 6% 4% 2% -2% -4% 1-Oct-14 1-Apr-15 1-Oct-15 1-Apr-16 1-Oct-16 % Relative spread difference (S22 vs. S21) Index spread (bp) 14 12 1 ITRAXX-FINSENS21V1-5Y 18 ITRAXX-FINSENS22V1-5Y Senior spread difference (RS) 8 6 6 2 4-2 1-Oct-14 1-Apr-15 1-Oct-15 1-Apr-16 1-Oct-16 14 1 Spread difference (roll spread (bp) Source: IHS Markit, UniCredit Research Series 22 senior roll spreads increased in the course of 216 The difference between the 5Y spreads of the Series 22 and 21 Senior indices is shown in the right chart above, from October 214 until October 216: since 1Q16, the roll spread has increased, driven by an increasingly higher premium being charged for the 214 European bank senior transactions than for the corresponding 23 transactions. The interpretation of this observation is not as straightforward for the senior transactions as it is for the subordinated transactions discussed above. Although the relative likelihood of governmental intervention credit events affecting subordinated debt declined between October 214 and October 215 (left chart), one possible interpretation is that exactly the opposite has happened in 216 for governmental intervention affecting senior debt: the relative importance of governmental intervention credit risk has increased for senior debt (right chart). A second possible interpretation is more complicated. It is apparent that the additional spread demanded by the market for 214 European bank transactions compared to 23 transactions is absolutely and also relatively smaller for senior than for subordinated transactions. This stems from two offsetting effects that the 214 CDD have on the value of senior protection compared to the updated 23 CDD (see last section of this publication for more detail). Compared to the 23 senior transactions, the additional protection of 214 European bank senior transactions against governmental intervention risk increases the spread. This increase is offset by such 214 transactions not being triggered by such restructuring and governmental intervention credit events that are solely caused by bank UniCredit Research page 1
subordinated debt. The observable net effect is typically that 214 European bank senior transactions are slightly wider than corresponding 23 transactions. An increasing spread difference between 214 and 23 senior transactions can also be interpreted as a shifting perception of the risk of 23 senior transactions being triggered by sub debt restructuring ( cross default ). If the market perception were that the significance of such an event was declining then this would translate into tighter 23 senior transaction spreads. The significance of that event could decline in two ways: the likelihood of sub debt restructuring might decline or the recovery expectation for 23 senior CDS in the event of sub debt restructuring might increase. The first option does not appear to be in line with the YTD development of 23 sub CDS spreads, which leaves us with the second option. As a second interpretation of the increasing roll spread in the right chart above, we therefore suggest that market participants, in the course of 216, anticipated an increasingly better recovery of 23 senior CDS in the event of sub debt restructuring, leading to tighter 23 senior transaction spreads. Maturity impact on the roll spread For aficionados of roll-spread calculations, we show fair-value credit curves for Series 21 and 22 below. The maturity effect on spreads comes from the upward-sloping shape of the credit curves and the 6M maturity difference between Series 22 and 21 instruments. The important aspects are the approximate linearity of both credit curves for maturities of less than five years and that the slope of both curves is virtually identical for this maturity range. This implies that the term structure of theoretical roll spreads is flat at the short end. This motivates our implicit assumption above that the maturity effect on the roll spread changes over the past two years is only due to steepening and flatting of the Senior curves, as for example in 1H15. FINANCIAL SENIOR INDEX: SERIES 21 (L) AND 22 (R) FAIR-VALUE CREDIT CURVES AND QUOTED INDEX SPREADS 16 16 14 14 12 12 Spread (bp) 1 8 6 ITRAXX-FINSENS21V1 fair value curve (eod 216-1-3) index composite quotes (eod 216-1-3) Spread (bp) 1 8 6 ITRAXX-FINSENS22V1 fair value curve (eod 216-1-3) index composite quotes (eod 216-1-3) 4 2 4 6 8 1 12 14 4 2 4 6 8 1 12 14 Time to maturity (Y) Time to maturity (Y) Source: IHS Markit, UniCredit Research UniCredit Research page 11
Single-name CDS that reference European banks Single-name CDS spreads for European banks have been different for 23 and 214 transactions since the bifurcated market emerged on 22 September 214, after the introduction of the ISDA 214 Credit Derivatives Definitions. In the past two years, the (relative) spread differences of 23 and 214 transactions have not only drifted away from initial levels, but they also show single-name idiosyncrasies. We present a few case studies. We also discuss the dependence of bank CDS spreads on subordination schemes of senior debt vs. wholesale and corporate deposits (structural subordination, contractual reference to subordination and legal subordination). Single-name CDS spreads for 23 and 214 CDD available As legacy trades of Senior and Sub indices from Series 6 to 21 exist, dealers quote singlename CDS referencing the constituents of the these indices particularly the banks for the transaction type and the version of the ISDA Credit Derivatives Definitions (CDD) that prevail for the index. For major European banks, therefore, Markit distributes the following end-of-day composite spreads: single-name spread curves both for the updated 23 CDD and the 214 CDD. We assume that most of the senior and subordinated CDS that are governed by the 23 docs are rarely traded. Hence, the spread data for single-name CDS shown in the chart below, should be taken with a pinch of salt. Nonetheless, the data show where dealers see the 23 senior and sub CDS spreads. The data complement index pricing data and exhibit some notable single-name pricing idiosyncrasies. 5Y CDS SPREADS AND RELATED RELATIVE SPREAD DIFFERENCES FOR 23 MAJOR BANKS* 7 SNR '3 SNR '14 LT2 '3 LT2 '14 SNR (RS) LT2 (RS 214 (RS) 2% 6 15% 5 4 3 2 1% 5% % -5% 1-1% -15% RABOBK INTNED UBS HSBC LLOYDS Single-name CDS avg. spread (bp) Relative spread difference BACR STANLN RBS CS ACAFP SOCGEN BNP BBVASM SANTAN BYLAN CMZB ISPIM UCGIM BACRED DB MONTE DANBNK SHBASS *Average spread in September 216 for all constituents of the last ten series of the itraxx Europe Financial indices (Series 17 26) that are banks. Relative spread differences are between 214 and 23 documentation CDS for the senior (SNR) and sub (LT2) seniorities, respectively. The third relative spread difference is between the sub and the senior CDS for the 214 documentation (214). Source: IHS Markit, UniCredit Research Explanation of the chart above The chart above shows September average spreads for the 23 European banks that are members of at least one itraxx Europe Financial index series between Series 17 and 26. Relative spread differences are plotted for the following spread pairs: senior 214 vs. senior 23 (red), sub 214 vs. sub 23 (black) and sub 214 vs. senior 214 (black-red). The reference names are shown in four groups. Each group represents a set of reference names from jurisdictions that share a similar approach to subordination of senior debt vs. wholesale UniCredit Research page 12
and corporate deposits: structural subordination (CH, UK, Benelux), contractual reference to subordination (FR, SP), and legal subordination (DE, IT) and the remainder (no general subordination scheme). German and Italian banks have the legal subordination of senior bonds in common European bank senior CDS: 214 vs. 23 7% spread premium as an average net effect European bank sub CDS: 214 vs. 23 On average, a 35% spread premium currently prevails, paid solely for governmental intervention risk and the asset package settlement option Are the senior and sub 214-vs.-23 spread premiums related? Banks in jurisdictions with legal subordination of senior debt vs. deposits (third group from the left; subordination effective 217 in DE and 219 in IT) have wider senior and sub spreads than all other names. The first group of names comprises banks from jurisdictions where structural subordination is the principle strategy to separate wholesale deposits (on the balance sheets of bank operating companies) from the risk of senior creditors (creditors to the bank holding companies). As summarized in the table on page 5, itraxx constituents in the first group of names represent the bank operating companies, with Credit Suisse Group (CS) being the only exception. Corresponding senior CDS (except CS) therefore protect against senior-bond credit-risk that is pari passu with corporate and wholesale money deposited at bank operating companies. Consequently, average senior spreads in the first group of names are tighter than those of the third group, as senior bonds share the same high level of loss protection as wholesale deposits (apart from potential additional deposit insurance). As senior CDS from the second group of names in the chart above are currently referencing senior bonds that are also pari passu with such bank deposits (and do not reference Tier-3 bonds or non-preferred senior bonds), the same rationale applies for the explanation between average senior spreads in the second and third groups. It is no coincidence that the only bank holding company (CS) in the first group has the widest senior spread. A second focus of the chart above is on the current pricing of 23 vs. 214 senior and subordinated transactions (average conventional spread levels in September 216). Senior single-name European bank CDS are around 7% wider for the 214 compared to the 23 transactions (excluding MONTE). MONTE is an exception, as the 23 senior CDS is wider than the corresponding 214 transaction (see discussion below). However, for the majority of senior CDS shown in the chart above, 214 CDS are more expensive, which is driven by the additional protection against governmental intervention credit events and the asset package settlement option. This additional risk premium is not completely offset by the lower credit event probability of 214 senior transactions compared to 23 transactions. The pricing difference looks small. There is a small dispersion of the governmental-intervention premium and weak increasing trend over the past two years. We believe that 23 single-name CDS currently represent a relatively inactive niche market. Hence, most 23 spread data should be the result of dealers mark-to-model exercises, combined by Markit, to create EOD composite spreads. Single-name spread differences between 23 and 214 transactions must be taken with a pinch of salt. While we believe that the market-activity situation is basically the same for the subordinated CDS, with 23 sub spreads not always representing the pricing of executed transactions, dealer quotes do at least give an indication of the relative pricing of 23 and 214 subordinated European bank CDS. On average, and as shown in the chart above, 214 transactions are currently 35% wider than 23 transactions (relative spread difference of 5Y tenor spreads; excluding MONTE). In contrast to senior bank CDS, for sub CDS this spread difference is a pure premium for protection against governmental-intervention credit events and for the possibility of asset package settlement, as there is no offsetting effect from the 214 CDD. We present two hypotheses: First, if, for some particular bank, the 214-vs.-23 sub-spread relative difference is comparatively large in comparison to the average European bank then this means that the market attributes a greater importance to governmental-intervention risk than to other credit risks. Such a case would imply a lower (market-implied) probability of a related 214 senior CDS being hit by a credit event that is triggered by sub debt only (as such senior CDS are not triggered by sub-debt governmental intervention). That logic would mean for this bank that the related 214-vs.-23 senior-spread relative difference is smaller than UniCredit Research page 13
for the average European bank, leading to an inverse relationship between the senior and sub 214-vs.-23 spread differences. Second, while governmental-intervention probabilities fundamental or market-implied should be expected to be different for senior and sub CDS, if a sub CDS governmental-intervention probability is higher for a given bank than for the average European bank then one would expect that the corresponding senior CDS governmental-intervention probability is usually also larger than for the average European bank. This leads to the hypothesis that there is a positive correlation between the senior and sub 214-vs.-23 spread differences. For the sample of banks shown in the chart above (excluding MONTE), neither of the two hypotheses can be strictly excluded. A Pearson correlation coefficient of 3% for the data shown in the left chart below suggests that the evidence lends more credence to the second hypothesis. This conclusion is in accordance with the observation that the relative spread difference for senior CDS (7% on average) is usually much smaller than for sub CDS (35% on average) while both are positive. 214-VS.-23-RELATIVE-SPREAD-DIFFERENCES * BANCA MONTE DEI PASCI CDS SPREADS** Senior CDS relative spread difference ('14 vs. '3) 12% 1% 8% 6% 4% 2% 1% 2% 3% 4% 5% 6% 7% Sub CDS relative spread difference ('14 vs. '3) 5Y CDS conventional spread (bp) 2 16 12 8 4 SNRFOR-MM SNRFOR-MM14 SUBLT2-MM SUBLT2-MM14 BANCA MONTE DEI PASCHI DI SIENA S.P.A. SNR (RS) SUB (RS) 16% 12% 8% 4% -4% 2-Sep-14 2-Mar-15 2-Sep-15 2-Mar-16 2-Sep-16 % Relative spread difference ('14 vs. '3) *The same relative spread differences are shown in this chart as in the chart on page 12. Average end-of-day composite spreads (in September 216) for 214 and 23, senior and sub CDS were used to determine the relative spread differences presented in the chart. The data point for MONTE is not shown here. **In the chart legend, MM denotes 23 CDS and MM14 214 CDS. Source: IHS Markit, UniCredit Research An exception to the rule: MONTE The exception to the rule is MONTE (which has not been a constituent of the on-the-run itraxx Europe indices since September 212). The 214 senior CDS on the name has been quoted tighter than the 23 senior CDS since early July: on 4 July, the bank confirmed that it had received a request from the ECB to reduce its non-performing loans. This was the day when the difference between 214 and 23 senior CDS spreads turned negative (see right chart above). Since early July, the 214 sub CDS has also notably underperformed the 23 sub CDS, leading to an increasing relative spread difference from around 5% to around 1% recently. Since early September, the market has again been discounting an increasing probability of a governmental intervention credit event for 214 sub CDS. Nonetheless, the market-implied probability of such a credit event occurring for the 214 senior CDS has apparently not increased: in fact, in comparison to early July, the market-implied probability is actually smaller now. Instead, the risk that the 23 senior CDS would be triggered by a traditional sub-debt restructuring (without governmental intervention) has led to the clear underperformance of 23 senior CDS vs. their 214 counterparts since July. Importantly, we suggest that this underperformance did not come from a higher probability of a credit event occurring without government intervention, since 23 sub CDS spreads remained fairly constant since February. Instead the market development suggests that investors anticipate that a sub-debt restructuring credit event would leave the bank s senior bonds even more exposed to losses than before such a hypothetical restructuring, leading to senior bonds UniCredit Research page 14