Balance-sheet encumbrance varies greatly at Europe’s banks and high encumbrance is not necessarily stress-related, according to new research by Fitch Ratings.
The credit rating agency’s (CRA) study, entitled ‘Major European Banks’ Balance-Sheet Encumbrance and the Creeping Subordination of Senior Bondholders’, shows that encumbrance tends to be higher in parts of the peripheral eurozone, where median secured funding is 28% of funded banking assets compared with 19% outside the region, Scandinavia and specialist property lenders.
Fitch believes there is a growing risk that asset encumbrance, bail-in concerns and possibly even depositor preference will trigger an ever-increasing cycle of asset encumbrance at European banks and that low or even ‘zero recovery’ assumptions for senior bank debt might become the norm, which would reduce the supply of senior unsecured debt in the long term. European bank senior debt issuance fell by around 28% to €182bn in the first seven months of 2012, according to the CRA’s calculations based on Bloomberg data.
“European bank balance sheet encumbrance and the subordination implications for senior unsecured creditors is a high-profile concern for fixed-income investors,” says James Longsdon, co-head of Europe, Middle East and Africa (EMEA) financial institutions at Fitch. “Bank defaults are rare, but as legislators move to make shareholders and creditors bear the losses of a failed bank, rather than taxpayers, they are likely to become more frequent. This gradual erosion of implicit sovereign support for senior debt is in fact a greater threat to senior unsecured debt ratings than subordination risk.”
Balance sheet encumbrance and unsecured bondholders’ potential recoveries relative to secured creditors only matter if a bank defaults. Analysing the banks that Fitch rates, the five-year global cumulative default rate is low, at 0.9%. By comparison, the five-year global cumulative failure rate (i.e. banks that have defaulted or would have defaulted had they not been rescued, usually by governments) is 7.1%.
“While rising subordination risk makes negative actions increasingly possible on senior unsecured debt ratings, on their own they do not represent a ‘cliff risk’,” says Bridget Gandy, co-head of Fitch’s EMEA financial institutions team.
“Vulnerability to default carries much greater weight in Fitch’s ratings than loss-given-default. Bonds are unlikely to be notched down more than twice for loss-given-default.”
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