Are investors adequately compensated for not only “bail in” but also regulatory risk on bank senior bonds?

Spreads have recently been close to historic lows, as discussed in the Bank of England’s December 2015 Financial Stability Report.

This graph shows decline in credit spreads over the past 4 years for British banks.

For some banks, however, the story is not quite so bright. The graph below shows the collapse in price of some of Portugal’s Novo Banco’s long dated senior bonds to trade at c. 65 cents. Novo Banco 2043 3.5% bonds


The drop in price for Novo Banco (formerly Banco Espirito Santo) bonds to distressed levels reflects both bail-in and regulatory risk. The investors in these bonds must have breathed a sigh of relief in August 2014 when Banco Espirito Santos’ resolution was set in motion and the bank’s senior creditors were moved to Novo Banco with no loss.

Just 15 months later, some institutional investors in Novo Banco senior debt face almost complete write down in order to both recapitalise the bank and avoid imposing losses on retail investors. Other investors fear a similar fate, as the pricing on the above bonds demonstrates.

Here is the back story: Analysts were always sceptical that the Banco Espirito Santo resolution in August 2014 would be sufficient to solve the problems. The split into a good bank (Novo Banco) and bad bank followed a proven template, with equity and subordinated debt investors placed in the bad bank and likely to face almost total loss.

So far so good!

However, with typical European optimism, it was hoped that new investors would be willing to take Novo Banco off the hands of the regulators and avoid all losses for senior creditors. The South Africans were more realistic when they resolved African Bank and imposed an immediate write down of 10% on senior debt.

The ECB brought the issue to the fore requiring Novo Banco to find €1.4 billion of new capital as a result of a recent stress test. Unfortunately, interested investors from both China and the US were unwilling either to reimburse Portuguese taxpayers for the full cost of their bail-out or to cover stress and future capital needs. Following the debacle with Spain’s Bankia recapitalisation, the Portuguese were understandably reluctant to try to foist new capital onto unsuspecting retail investors.

With no new capital to be found, existing debt capital needed to be haircut. With €12 billion of senior debt (52 separate issues), the logical solution would be a 12% – 15% haircut across the board to cover the €1.4 billion and provide some cushion. However, many of the bonds were held by retail investors and Portugal feared the backlash that happened in Italy when retail investors in the subordinated debt of four smaller banks were bailed in. One investor who lost all his savings committed suicide.

So regulators chose to impose all the losses on just €2 billion of the debt, largely issues sold to institutional investors like Blackrock and Pimco. Their bonds will be transferred to the bad bank where losses will be much higher than the 12% – 15%. Although the Banking Recovery and Resolution Directive gives due respect to creditor priority and “no creditor worse off” principles, a loophole permits regulators to discriminate where it is “in the public interest”.

In the past, bank creditors relied too heavily on the supposition that all creditors will be “bailed out”, “in the public interest”. Nowadays, that public interest question is much more challenging. As if assessing exposure to a bank was not challenging enough, now large creditors have to wonder “what about me?”