EU group throws weight behind new sub debt asset-class

By Helene Durand

LONDON, Oct 4 (IFR) - An EU expert group on bank structural reform this week threw its weight behind the idea of introducing a separate layer of bail-inable bank debt as policymakers try to address the problem of "too big to fail".

The group, led by Finnish central bank governor Erkki Liikanen, thinks this discrete layer of debt would be more efficient for banks' funding than capturing all debt issued by banks as proposed in the European Commision draft of the Crisis Management Directive (CMD).

Their report adds weight to one of the proposals in the EC June draft, which already left room for banks to also issue specific subordinated debt instruments that would absorb losses after regulatory capital but before any senior debt. This debt would be different from Tier 2 and Additional Tier 1 under CRD4. .

The expert group went even further, saying the bail-in requirement ought to be applied explicitly to a certain category of debt instruments and phased in over time. This would help market and price the new securities, the group said.

"From an issuer's point of view, it would be cheaper than issuing Tier 2 as it could be shorter-dated and would not have to include the same features as regulatory capital," said Selim Toker, head of global finance solutions at Nomura.

"Meanwhile, some investors who can't buy Tier 2 because of their mandates would potentially be able to buy this."

Emil Petrov, head of capital solutions at Nomura, also said that adding this layer of subordinated debt to protect senior holders should, in theory, benefit the pricing of a bank's senior funding.

Capital solutions experts are uncertain how much value banks would obtain by adding layers of debt to potentially protect senior investors, unless regulators impose it.

"If you improve the potential recovery rate by 5%, in an ideal world, there should be a day 1 pricing benefit," Petrov said.

"However, whether that's the case in the real world is a different question. And investors would typically want to see a meaningful buffer beneath them in order to start reflecting the improved recovery assumption in their pricing of senior unsecured debt. It will also depends on the structure of each bank's balance sheet."

Simon McGeary, head of new products group at Citi agreed, saying that for issuers with a significant reliance on wholesale funding, having a bigger layer of debt sitting underneath senior would have a quantifiable benefit on senior pricing.


However, not all agree. "It all comes down on the premium banks would have to pay to issue this type of debt and how much of a benefit issuers get on senior by doing it," said a hybrid solutions specialist.

"As an issuer, you have to ask yourself: what is the purpose of this? And is there something else you can issue that can do the job better? Tier 2 has the same purpose and gives you regulatory capital benefit, so why not do that?"

Others question whether there would be a sufficiently liquid market, and what the benefit would be for banks to issue what is essentially short-dated debt.

If the Liikanen group's recommendations are approved, the amount banks need to issue could be large.


Click for a view of estimated shortfall


Nomura estimates that, without relying on senior debt, banks would have a EUR530bn shortfall to cover if they are to hit the target, revealed in an earlier EC draft, of having bail-inable liabilities account for 10% of total liabilities.

But whether banks will be able to find enough investors to cover it remains to be seen, as the report also said that bail-in instruments should not be held within the banking sector, potentially taking out a big chunk of demand .

It said banks should be allowed to satisfy another requirement to issue bail-inable debt instruments with common equity should they prefer to do so.

(Reporting by Helene Durand, Editing by Alex Chambers, Marc Carnegie)

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