A word from Barclays on LTRO subordination of senior unsecured debt in the Euro bank funding market

Daily Collateral's picture

The European Central Bank's recent LTRO programs have effected a significant increase in the amount of encumbered assets -- those pledged as collateral in repo transactions, central bank funding operations, and covered bond issuance as lenders increasingly demand over-collateralized borrowing arrangements to protect against credit risk -- on balance sheets across the pan-European banking system.

According to Barclays, average encumbrance across banks has risen dramatically to around 21% of assets. German banks, which are actually less encumbered than in 2005, and those in Finland, which are roughly around the same levels, are the lone exceptions in the eurozone:

The effect this is having -- which has been noted many times at this point -- is that as banks continue to trade their eligible collateral with the likes of the ECB, repo lenders, and covered bond markets in exchange for short term funding, they are increasing the loss given default (LGD) to unsecured creditors (those who have extended loans that are not collateralized) who face a shrinking pool of recoverable assets and are therefore less willing to extend credit at lower rates.

Barclays has also arrived at the conclusion that unsecured debt will eventually be viewed no differently as subordinated debt as it's likely that LGDs in the European banking system will approach 100%, especially if laws are passed as part of regulatory reform measures to strengthen depositor protections. Here is their reasoning:

There isn’t a statistically significant sample size of recent European bank failures on which to estimate LGDs more accurately. But looking at the US experience points to LGDs for unsecured investors in banks being high. Of the 422 bank failures in the US since 2008, all but one forced a loss upon the FDIC (Figure 10). Since the FDIC only has to pay claims if assets are insufficient to cover deposits, this implies a 100% LGD for unsecured creditors in almost all cases.


However, applying the 100% LGD at US banks to Europe is probably a step too far. Depositor preference laws in the US means that depositors have to be made whole before bondholders can be repaid – meaning that the LGD for the unsecured investor is increased. But since approximately 75% of US banks’ liabilities are in the form of deposits, we can extrapolate that the LGDs at US banks, in the absence of depositor preference laws would be c50%.


Depositor preference is not yet law across most of Europe but would clearly be a further headwind for bank funding costs if they were to be introduced. If depositor preference laws were adopted globally, Figure 12 shows that the amount of unencumbered assets available for unsecured investors would fall dramatically, particularly for more deposit-rich franchises. To be clear, this takes the size of outstanding senior unsecured bonds relative to unencumbered assets from Figure 9 and then nets out deposits (including retail bonds).

Figure 12 amply illustrates the knock-on effects to bank funding of implementing depositor protection in jurisdictions within the eurozone that currently don't offer it (everywhere except Germany). So, either depositors outside of the safe German banks will be left open to subordination in the event of default in the eurozone -- and thus capital flight as evidenced in widening TARGET2 imbalances will continue -- or depositor protection laws will essentially wipe out the market for bank funding via senior unsecured debt in Europe, thereby continuing to drive de-leveraging as this structural shift in funding is sorted out and continually increasing dependence on the likes of the ECB for funding.

Barclays on where this leads:

What are banks’ other options if unsecured funding costs don’t come down to economical levels? Terming out unsecured funding offers some respite in reducing roll-over risks for the banks but does little to offset structurally higher funding costs from higher LGDs. So banks may try to replace wholesale funding with deposits. But this is a slow process and becomes difficult to execute if it’s a system-wide issue. This suggests that there could be on-going pressures on banks to reduce wholesale funding reliance via balance sheet shrinkage – the very thing that the LTRO was designed to prevent.

Deposit flight from the periphery to Germany has been observed for quite some time now as peripheral banks are increasingly viewed by depositors as unsafe. Europe can choose to address this by enacting greater protection for depositors in countries other than Germany, but doing so will likely cripple the funding market for eurozone banks further and increase reliance on the ECB, whose over-collateralized refinancing programs are driving the de-leveraging they were ostensibly designed to prevent. It's a tough spot.

Greece is up; Spain is on deck.



Recent articles:



Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
AgShaman's picture

Didn't Barclays "pawn off" some of their collateral a few years back for being encumbered?

BlackRock and JPM thanks you for the SLV etf

Confundido's picture

Yes, someone has written extensively about this at a macro blog: www.sibileau.com

Essentially, he says that the EU has destroyed its capital markets to save its currency. Which one will be easier to rebuild? Because from now on, the EU will look like an emerging market, with only the big conglomerates having access to the capital markets, in US dollars. Just like Latin America in the '80s....Now, if this conclusion is correct...Do you see the Fed being able to raise rates?

undertheradar's picture

The LTRO is for any bank that wants cheap euros for 3 years, of course there may be what seems to be practically a non-existent stigma attached. Nordic banks are dipping in, the Brits, everybody. I guess citizens of the eurozone can claim we are saving global banking and start up some kind of movement like Ron Paul's and see what the ECB is actually about. I dunno, I don't know how it all fits together, but I like your posts DC, they are insightful. We hear rumours about a clearing house for CDS which would cost the big 14 billions, we sense LIBOR taking off, and an investigation of that. Then there's Greece and all the law suits I expect whatever the declaration is. It is almost impossible to know when reality hits somewhere. I know that Dutch Finance Minister De Jager doesn't want to split up Dutch banks into Commercial and Investment banks for the exact reason you're talking about - he says the Commercial banks would face a funding shortage since they wouldn't have the deposits. There's also a huge mortgage bond market in NL that has to keep floating. But as far as I know, we all have depositor insurance up to a hundred grand here so where does that fit into your Germany vs the rest story? Depositor money from all over the eurozone in each others' banks, with certain noteworthy directions. I've probably upset a few people already or displayed my ignorance.

falak pema's picture

the mad world of banking exposure and the only logic in the market today : fukk those who are exposed; take on prisoners! 

And all it does is make the system more berserk; the Titanic goes Costa ConCordia belly up. Well played you HF and PD shills!

Long live the market!