Fitch: EU Bank Bail-In Rules May Change Short-Term Investor Behaviour

EU bank short-term (ST) debt is as vulnerable to bail-in as long-term debt in the event of bank resolution, says Fitch Ratings. This could lead to ST investors changing their behaviour, preferring exposure to EU operating banks rather than their holding companies or shifting the legal form of the exposure to reduce bail-in risk.

Bail-in buffer initiatives such as the EU Bank Recovery and Resolution Directive's 'minimum requirement for own funds and eligible liabilities' and the Financial Stability Board's (FSB) proposals for 'total loss absorbing capacity' include a one-year minimum maturity requirement for liabilities to be eligible.

Some investors have interpreted this as meaning that debt with an initial maturity of more than one year is more likely to be bailed in than debt with shorter initial maturities. Fitch believes the purpose of this requirement is to ensure liabilities do not roll off rapidly under stress and not to exempt eligible short-term liabilities from losses. If a resolution event occurs, eligible bank debt maturing in less than one year, such as commercial paper, is as vulnerable to bail-in or 'bad bank' liquidation procedures as debt maturing in more than one year.

Consequently, bail-in buffer proposals could trigger a shift by ST investors to reduce default risk. Under a 'single point of entry' resolution approach via a holding company, ST investors might prefer exposure to the operating company (regulated bank), rather the holding company's ST debt. Under the FSB's plans, holding company senior debt is intended to protect senior creditors of the operating bank and be bailed in first. Protection of the operating company's senior creditors can be achieved by down-streaming the holding company debt into the operating company, in a subordinated manner, for example.

The FSB's proposals, when finalised, will apply to the largest global systemically important banks. In contrast, the EU's requirement applies to all EU banks and is set on a case-by-case basis by the supervisor; the European Banking Authority is due to finalize its draft technical standards by July 2015.

Draft legislation in Germany addresses the technical legal challenges in implementing the EU's Single Resolution Mechanism. It proposes an amendment to the German Banking Act under which, investors in German bank senior unsecured debt (and now also Schuldscheine, according to a recent amendment to the draft law) would be bailed in ahead of other senior unsecured creditors such as institutional depositors in the event of resolution. This action is permitted under EU law because the BRRD reflects the hierarchy of claims in domestic insolvency law.

In Germany, or more widely if other EU countries adopt this approach, this could incentivise ST investors to switch exposure from debt instruments such as commercial paper to deposits or deposit-like instruments like certificates of deposit, provided their seniority is confirmed in final legislation.

Weakening government support for EU banks is exerting pressure on both ST and LT bank ratings. Around 30 EU banks face pressure on their ST ratings.