Think Cyprus is unique? Think again warns Citi's Matt King
The sound and fury of a European leadership denying the template-nature of Cyprus was deafening last week following D-Boom's comments and while we suspect the Cyprus deal was from unique and exceptional, it is clear, as Citi's Matt King notes that Cyprus’ significance was always going to stem more from the precedent it created than from its size. In choosing a relatively conventional good bank, bad bank model, the authorities have done much to alleviate the damage that would have been caused by an arbitrary tax on uninsured depositors. But the very “success” of the solution now being adopted seems likely to lead to its replication elsewhere. While arguably good news for the sovereigns and for longer-term growth prospects (though the chasm to be crossed to that growth is treacherous), its negative repercussions for senior bank bondholders still seem far from being priced in.
Via Matt King, Citi,
So much for existing statutes
The Cyprus model has three key features, which highlight the effective elimination of many of bondholders’ supposed protections:
- Hasty implementation under national legislation: the rapid passage of new national laws effectively re-writes existing bankruptcy legislation, reducing bondholders’ rights in the process. Even if bonds have been issued under UK or US law, this emphasis on the bankruptcy regime itself effectively dilutes or negates many of their protections.
- Application to all bonds by statute: Cyprus again demonstrates that, when backed into a corner, the authorities are willing to impose losses by statute on all bonds, even at senior level. This contrasts with the previous official EU line of more or less waiting until 2018 to issue new, bail-in-able senior bonds, with their bail-inability set in contract rather than established by statute.
- Extremely low recoveries: the decision to move bonds to the bad bank, together with uninsured depositors and equity, is likely to result in extremely large losses. Even if bonds are not actually converted outright into equity, as seems possible, the decision to protect not only insured deposits but also €9bn in ELA (both of which are going to what is effectively the good bank) is likely to result in near-zero recoveries.
But isn’t Cyprus “unique”?
Against this, of course, is the argument - noisily voiced by the authorities - that Cyprus is unique. We disagree. Yes, the Cypriot banking system was unusually large; yes, concerns over the Russian depositor base are unlikely to be a feature elsewhere; yes, losses for bondholders will likely be exacerbated by the unusually small proportion of the capital structure they represent (Figure 1).
But to us, the similarities with other countries are far stronger than the differences. First, almost all EU countries have banking systems that are outsized by global standards, and which might prove difficult to save if they got into difficulty (Figure 2). We see it as no coincidence that one of the chief advocates for senior bail-in to date has been the UK.
Second, the likelihood of low recoveries for bank bondholders in the event of restructurings is something we have been writing about since 2008. Even without the formal application of bail-in and creation of good and bad banks, the tendency towards covered bond issuance by weaker banks, and the growth in both private and public sector repo (ECB and ELA) has led to far greater asset encumbrance than used to be the case historically, particularly by the time any bank gets to the point of requiring resolution. Add in the removal of pari passu status with depositors, and there is very little left.
How many one-offs make a trend?
Investors still seem reluctant to assume that the precedents being set will be applicable elsewhere. Perhaps this makes sense — even at Bankia last Friday, senior was spared losses for now, and while sub debt suffered haircuts, it was not wiped out completely. But the very fact that the market has responded so positively makes us think the very next bailout requiring approval from Brussels is likely to see elements of a similar model being requested. The fact that it was creditors like Germany, not the European Commission, who were pushing for the good bank, bad bank solution in Cyprus (as opposed to a deposit tax) is telling in this regard. So too is Djisselboem’s statement today that the “Cyprus bank restructuring plan should be seen as a template for the rest of the Euro zone”.
The market seems to be coming around to this view, but is not completely there yet.