Bond haircuts in fashion for banks; There is a growing belief that even banks that are relatively rich in deposits should be forced to hold large quantities of bonds that can be “bailed in” if crisis hits.

June 3, 2013 8:10 pm

Inside business: Bond haircuts in fashion for banks

By Patrick Jenkins

Go back a decade and the only reason the Co-operative Bank was in the headlines was because it had raised a chunk more charity money or found a way to make cheque books out of recycled paper.

Today’s news agenda at the UK’s main ethically-minded lender is rather more existential. Over the weekend there was another spate of jitters over the Co-op. A few months after it first emerged that the bank faced a capital hole of up to £1bn, and three weeks on from its dramatic six-notch credit rating downgrade at the hands of Moody’s, there were fresh revelations. First the Financial Times reported that some institutional depositors had begun withdrawing funds. Then it emerged that the umbrella Co-op group, which spans supermarkets and funerals, was weighing some dramatic financial restructuring that would hurt bondholders.The fate of the Co-op – a relatively small, Manchester-based lender – is not the parochial tale it might seem. Its challenges reflect one of the key questions of the global regulatory capital agenda: the extent to which banks should be financed by bonds and to which bondholders should be subject to losses.

A few years ago the fashion among regulators was to push banks to finance themselves with deposits, no more so than in the UK where the deposit-light Northern Rock collapsed amid a freeze in wholesale funding markets in 2007.

Now, though, the thinking has moved on. There is a growing belief that even banks that are relatively rich in deposits, as indeed the Co-op is, should be forced to hold large quantities of bonds that can be “bailed in” if crisis hits.

In part, this helps avoid the politically unpleasant prospect of bailing in depositors’ money above an insured threshold, as happened recently in Cyprus. But bond funding, providing it is long-term in structure, is also recognised as being more stable than customer deposits, the bulk of which may be a flight risk, especially in jittery times.

None of that is very popular with banks that see themselves as having exemplary funding structures backed by surplus deposits, such as HSBC in the UK or Wells Fargo in the US. This week, Wells’ chief executive John Stumpf told the FT he was dismayed at plans by US regulators to force banks to hold higher levels of long-term debt for the purposes of bail-in contingency planning.

Regulators could well point to the woes of the Co-op as proof of the merit of their thinking. What remains unclear is exactly what will happen to the holders of Co-op’s £1.3bn or so of bonds.

Over the past few weeks virtually all the bonds have been trading at a significant discount to their par value, as suspicions grow that investors may not get all their money back. The most extreme discount is evident in a £200m bond, inherited through the Co-op’s purchase of Britannia building society, which is trading at barely half its nominal value. Some in the market are braced for a failure of the bank and a massive haircut on bondholders.

In reality, disaster does not appear to be imminent. Despite various suggestions that a government rescue has been discussed or that regulators would forcibly wind the bank up, neither a state bailout nor a bondholder bail-in is on the cards.

Instead, alongside a range of measures such as Co-op group disposals of insurance and other businesses, there looks likely to be a significant example of what banks these days quaintly term “liability management exercises”.

In a spectrum of problem banks, this puts the Co-op at one end, a long way from the likes of SNS Reaal in the Netherlands which was nationalised early this year, triggering losses for subordinated bondholders, or the more extreme wipeout at Cyprus’s Laiki, where even senior bondholders were forcibly haircut alongside the country’s aid deal.

The Co-op bonds, as instruments of a going concern, would be restructured, nominally at least on a voluntary basis. As has happened at a string of banks around the world in recent years, there would be a tender to buy back certain bonds at a certain price, which may offer a premium to their market value but a discount to par. A buyback at an average 65 per cent of par of only two junior bonds could give the Co-op a capital gain of more than £100m. The bank could threaten to axe coupons – currently paid at up to 13 per cent – to coerce take-up.

Investors will complain that they are being unfairly hit by losses. But as the continuing crisis is making ever clearer, bonds are set to be a crucial vehicle in banks’ capital structure – and bondholders can no longer expect a free ride.