Bank investors still don’t think bail-in will happen, FSB told

Investors in bank debt still assume governments would bail out a large bank rather than bail in bondholders, a global watchdog has been warned by analysts and former regulators.

“The market thinks you will still blink when it comes to it,” said Paul Tucker, chair of the Systemic Risk Council, which focuses on the US and Europe. He was addressing a virtual workshop on September 4 organised by the Financial Stability Board.

Tucker, a former deputy governor for financial stability at the Bank of England, pointed to an FSB report in June, saying it had found a widening in spreads on the debt issued by global systemically important banks (G-Sibs). But he added: “My instinct is that the magnitude of those spreads is still small.”

The FSB report notes that, in the wake of too-big-to-fail reforms, bail-inable debt now yields more than “otherwise similar debt instruments to which it is subordinated”. “This suggests that investors are at least partially pricing in the risk of G-Sib failure and a potential bail-in,” the document reads.

Tucker warned that the “scale and rapidity” of market interventions by central banks in March this year might strengthen the conviction among investors that officials would ultimately baulk at allowing a G-Sib to fail.

Speaking at the same event, Stuart Graham, co-founder and head of banks strategy at Autonomous Research, said he was struck by end-investors’ relatively limited understanding of total loss-absorbing capacity (TLAC), the new class of senior debt designed by the FSB to be easily bailed in during a bank resolution.

“I would estimate – gut feeling – probably only 25% of them understand TLAC and how it works. Most of them have a very hazy knowledge of it, and very few of them think regulators would actually allow a major financial institution to fail,” Graham said.

That belief had been strengthened by the “contortions” of Italian or German authorities in recent years to save banks that are not even anywhere near the G-Sib category, but are deemed significant to specific regions or sectors, he added. Italy provided aid for the takeover of two banks in the Venetian region in 2017, on the basis that they were regionally systemic, even after the European Union’s Single Resolution Board had ruled that they were not systemic. Germany intervened in 2019 to rescue NordLB – an important player in ship finance but not a G-Sib.

Tucker said his impression was that analysts and investors were not looking into the many nuances of resolution strategies, suggesting they did not think bail-in was a real possibility.  

One versus many

Alberto Gallo, head of macro strategies at Algebris Investments, which manages around €12 billion ($14 billion) in assets, mostly bank capital instruments, said he thought individual banks were now easier to resolve. But he warned that “too-big-to-fail has not gone away”, noting that banking systems across Europe were several times larger than national GDP.

“Banks have more capital, so it looks like you have reduced the risk from a single-institution point of view,” Gallo said.

“But overall, at a top-down level, when looking at the banking system size as a whole, the problem is still there – it is very hard to believe that, in a systemic crisis, you would be able to bail in many banks in the same country,” he continued, implying that imposing losses on a large number of bondholders at the same time would be too damaging to the economy.

But even at the level of individual banks, there are still “very serious problems” with bail-in, said Martin Hellwig, director of the Max Planck Institute for Research on Collective Goods and a former chair of the advisory scientific committee at the European Systemic Risk Board. Specifically, he said, it was still not clear where extra liquidity would come from for a bank in resolution, to keep it operating, once an existing EU emergency pot ran dry – a question that was raised publicly by the Single Resolution Board in 2018.

What’s more, single-institution and systemic crises are not two distinct problems but “circles of hell”, said Tucker of the Systemic Risk Council. If Bear Stearns had been bailed in early in 2008, he said, “the incentives on Lehman to take outside capital during the summer and for some others…to delever their repo and derivatives books would have been greater”, potentially defusing the wider systemic crisis that unfolded in September that year.

Politics versus rules

Hellwig also suggested that the resolution of a G-Sib would encounter political difficulties: “You have political resistance which comes in anytime there are vested interests inside the political system trying to make sure that the bank remains there. What I do not see is any big change in stance on the side of the political authorities – resolution is not just a technical problem, but a political one.”

This view was echoed by Thierry Philipponnat, head of research at public interest lobby group Finance Watch, who warned: “If you want someone to take an unpopular decision – and bail-in is likely to be an unpopular decision – do not ask politicians to do it.”

In Italy in particular, retail investors’ holdings of bank debt have made bail-in a highly controversial topic.

There is a way for regulators to take the politics out of decisions on bank recapitalisations, including through bail-in: by making greater use of stress-testing, argued Stephen Cecchetti, a finance professor at Brandeis International Business School who previously worked at the Bank for International Settlements. Stress tests could be used during a crisis to either reassure markets or show that a bank needs extra equity, he said.

“How can we use private funds to recapitalise an institution in a manner that ensures its ability to serve as a source of credit to healthy non-financial firms? I believe stress tests are an important part of the answer,” he said.

The US Federal Reserve faced criticism earlier this year when its stress test add-on based on coronavirus scenarios was not used to determine whether banks should raise extra capital.

“My hope is that one morning, I am going to open my email alert from the FSB and there’s going to be an announcement of the publication of key attributes of effective stress tests and automatic recapitalisation regimes – then we will know that too-big-to-fail is further in the past,” Cecchetti said.

Editing by Olesya Dmitracova