05 October 2012

Fitch: Liikanen bail-in proposal would clarify bondholder status

An EU expert group's proposal to introduce a designated category of debt subject to "bail-in" would give bondholders more certainty about their position when a bank fails, Fitch Ratings says. It should also make other counterparties more comfortable with remaining exposed to troubled banks.

Stating that "In the future, bail-in should be the rule, and bail-out the rare exception", the Liikanen group called for clarity on the position of bail-in instruments within a bank's liability structure. This would ensure investors knew exactly which instruments could be written down or converted in to equity under most plausible scenarios. In so doing, it would also echo some of the principles embedded in the "Swiss finish". The extra certainty ought to make bail-in instruments and non-bail-in liabilities easier to price.

This extra buffer, provided it is sufficiently large, would be positive for senior creditors that are not subject to bail-in. They should therefore be more willing to remain counterparties to a troubled bank.

A new form of bail-in debt would have some potential downsides. For example, the further fragmentation of the debt hierarchy could create a thin market for some debt. With Tier 2 debt already performing the role of gone-concern capital, there is also an argument for simply making the Tier 2 capital slice larger.

A further challenge would be posed by banks with simple, deposit-funded business models. They would either have to raise relatively expensive bail-in debt at a negative carry or take more asset risk in order protect margins or find investors willing to fund their "bail in" requirement with equity.

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