Last Updated: 22 September 2023
Back in 2000 financial academics were busy naming a new policy concept after a series of debt restructurings in countries like Pakistan, Ukraine and Russia.
‘Bail-ins’ was pleasingly short but deemed too coercive by some. ‘Burden-sharing’, likewise, had a touch of menace to it. The wordy but far less threatening ‘private sector involvement (PSI) in crisis resolution’ was eventually settled upon, but soon forgotten.
A decade later – and after a series of huge and high-profile bank bailouts – the idea of forcing private investors to share in the losses of failed financials is back. In crisis-roiled Europe especially, the cuddly PSI terminology has been whole-heartedly dropped and the sentiment hardened by governments seeking to avoid taxpayer-funded bailouts. In doing so, they have to walk a fine line between portioning out financial losses and spooking already-nervous credit markets.
“The great tragedy of the 2008/9 banking debacle was, despite the presence of more than sufficient capital, that the taxpayer was placed involuntarily into the capital structure, between bondholders and equity holders, to shield the bondholders from losses that they should have suffered,” said Paul Marson, of Lombard Odier private banking. He added: “As it was, taxpayers absorbed all losses and bond holders were made good: in effect, the debt component of bank capital has been rendered entirely risk free.”
What regulators and governments are now seeking to do is to take the public element out of financial crises and make sure that big financial losses take a fair chunk out of private investors – and specifically bondholders. Burden-sharing, as it’s now known now, would entail forcing debt investors to take haircuts on their investment, while bail-ins would enable regulators to compulsorily convert bonds into shares.
To understand the shift taking place, it helps to imagine banks’ current capital order as something like a cake. Shareholders sit at the bottom and are most likely to take losses in a crisis. Junior debt investors sit in the middle, while senior debt investors occupy top position. Senior investors have traditionally been the last to bear losses should the bank fail, usually ranking equal with depositors under law.
Marson estimates that, as of June 2010, Europe’s financial system had some US$13.8 trillion worth of bonds and just US$2 trillion worth of equity. Shifting losses onto the debt, rather than just the equity portion of banks’ capital structure would therefore provide a significant cushion should a bank fail. The same idea is also being applied to some of the European Union’s troubled members, with talk of restructuring Greek or Irish outstanding government debt surfacing in recent weeks.
Corporate bond and credit indices, many of them tracked by ETFs, have reacted nervously to such proposals. For instance, the euro-denominated Markit iBoxx Financials index, which tracks the bonds of investment-grade financial firms, widened 49 basis points in November. The junior-ranking debt of European banks, judged most at risk of burden-sharing, was the worst performer. The Markit iTraxx Sub Financials index, which tracks credit default swaps (“CDS”) written on the subordinated debt of 25 European banks and insurers, surged 70% to 310 bps.
“At least three things have shifted,” said Matt King, Citigroup’s head of credit products strategy. “The Anglo Irish debt exchange was a timely reminder that there are risks in subordinated debt. Second, the widening in sovereigns, especially Spain and Italy, has obvious systemic implications. Third, and most importantly to our minds, market perception of the political stance towards bondholders has shifted” he added.
In October, Ireland opted to force losses on holders of the bailed-out Anglo Irish Bank’s junior debt via a deeply discounted exchange offer in an effort to ease pressure on public coffers. When Ireland failed to convince markets its finances were improving, talk of losses for senior debt investors began to surface.
Between November 21 and November 28, when Ireland’s bailout terms were finally announced, it looked like a panic was underway within the sector.
The Markit iTraxx Europe Senior Financials Index, tracking CDS on the senior debt of 25 European banks and insurers, jumped 30 basis points, over 20%, to 165bps. During the week it nearly overtook its sovereign counterpart, the Markit iTraxx SovX Western Europe, which represents an unweighted average of the credit default swap (CDS) spreads of 15 sovereign issuers.