13 January 2020

Financial Times: European banking, bonds versus deposits edition

The relationship between bank deposits and bank bonds was a major part of the financial crisis. Because senior bonds were often ranked alongside deposits, they were protected. Government bailouts benefited owners of these bonds, as well as bankers. This month, a new European Central Bank working paper has some insights that, while not exactly counterintuitive, have implications for the direction that banking regulation has taken post-crisis.

The paper finds evidence for the obvious (but still worth testing) claim that if a bank’s solvency worsens, its bond yields rise. Also unsurprisingly, it finds that “senior bond yields are more sensitive to a change in solvency than deposit rates”.

The classic explanation for this is deposit insurance, whereby the government protects retail creditors up to a certain limit -- in the eurozone, €100,000 -- in the event of a collapse.

All of which would be welcomed by regulators, who want senior bondholders to get the message that their money is no longer as safe as that of depositors.

Another explanation of this phenomenon, however, is that bond investors are paid to analyse banks, while retail depositors are not. Even if retail monitoring has disappeared because of the introduction of insurance, the sheer volume of bonds professional managers hold gives them greater access to management, or information, than a widely dispersed retail base. They are also participating in a price discovery process which is quickly absorbing new information, unlike depositors.

Still bond investors are clearly more sensitive to solvency, a proxy for the stability of the bank, than retail investors. Why does this matter? Because the regulatory framework (via MREL) now depends on the bond market, but does not necessarily factor in how these sensitivities might complicate things.

Banks, under MREL, must issue a certain amount of loss-absorbing bonds, relative to their total balance sheet. If the market becomes sensitive to their current or future solvency, it may prove difficult for banks to refinance these liabilities or access the market at all - as has been the case for the Italian financial sector.

And while bond yields are already sensitive to solvency, current sensitivities might be numbed by ECB support for the banking sector, especially via its targeted longer-term refinancing operations.

Full article on Financial Times (subscription required)

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