The prospect of bail-ins of being legislated for in the EU and an increase in subordination risks resulting from the possible introduction of depositor preference regimes justify a greater focus on asset encumbrance, Fitch said in a report today (Wednesday) surveying levels across Europe.

Just over a month after publishing a report on banks’ use of covered bond funding in 2011 – showing it was broadly stable – the rating agency today released a study on asset encumbrance and subordination, entitled “Major European Banks’ Balance-Sheet Encumbrance and the Creeping Subordination of Senior Bondholders”.

The report acknowledges that encumbrance of European banks’ balance sheets and related subordination implications for senior unsecured creditors are a high profile concern for fixed income investors, and sifts through a range of considerations relevant to such concerns.

The rating agency said it believes “there is a growing risk that asset encumbrance, bail-in concerns and possibly even depositor preference will trigger an ever-increasing cycle of asset encumbrance at European banks and that low or even ‘zero recovery’ assumptions for senior bank debt might become the norm”, which would reduce the supply of senior unsecured debt in the long term.

Fitch notes that asset encumbrance and unsecured bondholders’ potential recoveries relative to secured creditors only matter if a bank actually defaults, and that such events are rare, as demonstrated by the chart below. This plots the five year global cumulative default rate over 20 years to the end of 2009 (0.9%) for the banks that Fitch rates against the five year global cumulative failure rate (7.1%).

“Consequently, that secured creditors benefit from collateral protection has, historically, only rarely mattered in concrete terms for unsecured bondholders,” it said, adding that it would hardly be worth progressing with an analysis of encumbrance if such a very low bank default rate could be confidently predicted to continue.

However, James Longsdon, co-head of EMEA Financial Institutions at Fitch, said that bank defaults are likely to become more frequent as legislators move to make shareholders and creditors, rather than taxpayers, bear the losses of a failed bank.

“This gradual erosion of implicit sovereign support for senior debt is in fact a greater threat to senior unsecured debt ratings than subordination risk,” he said.

In its report Fitch said that the explicit possibility of bailing-in certain creditors in a going-concern scenario adds “a whole new dimension” to the debate about encumbrance, as eligible bail-inable creditors will be exposed to enforced write-down or write-off, while other excluded liabilities are not.

“The European Commission’s recovery and resolution directive proposals appear very restrictive in terms of the unsecured liabilities that would be excluded from the scope of the bail-in,” it added.

Under the EC’s draft directive on bank recovery and resolution secured liabilities of a failing bank are explicitly excluded from being bailed-in, with covered bonds the only secured liability granted an exemption from the option to bail-in any amount of the secured liabilities exceeding the value of the assets securing them.

Balance sheet encumbrance varies widely, according to Fitch’s analysis, with high encumbrance not necessarily stress-related.

“As a percentage of funded banking assets, encumbrance is highest in parts of the peripheral euro-zone, Scandinavia and specialist property lenders,” it said. “Across a sample of major European banks, Fitch estimates median encumbrance to be around 28% of funded banking assets.”

Having established the importance of an asset encumbrance debate and analysis given the implications of bank bail-ins, Fitch went on to stress the relevance of other, non-balance sheet encumbrance subordination risks that accompany the EU bank resolution agenda, namely the “threat” of some sort of deposit preference measures being introduced.

“In the ‘subordination of senior creditors’ debate,” said Fitch, “depositor preference is every bit as relevant as balance sheet encumbrance, if not more.

“[F]itch believes that subordination risks by way of depositor preference have the scope to be a more material (and at least more universal) influence on subordination than balance sheet encumbrance.”

De jure depositor preference does not exist in the EU and only in a limited form in Switzerland, said Fitch, but the prospect of, as a minimum, de facto depositor preference becoming a reality is significantly higher as a result of the EU bank resolution legislative agenda.

“While uncertain,” added Fitch, “the potential for some form of de jure depositor preference ultimately to emerge as part of the EU bank legislative agenda cannot be entirely dismissed, if nothing else in order to get round the presumably undesirable bail-in ‘problem’ of depositors and senior bondholders currently ranking pari passu with each other.”

As regards the rating implications of some of the aforementioned considerations, Bridget Gandy, co-head of Fitch’s EMEA financial institutions team, noted that while rising subordination risk makes negative actions increasingly possible on senior unsecured debt ratings, it does not represent a “cliff risk”.

“Vulnerability to default carries much greater weight in Fitch’s ratings than loss-given-default,” she said. “Bonds are unlikely to be notched down more than twice for loss-given-default.”

The rating agency said that, without a strengthening of standalone risk profiles, the gradual erosion of implicit sovereign support for sovereign debt – for example under evolving resolution/bail-in agendas – represents a greater threat to senior unsecured debt ratings than subordination risk, with over a third of western European bank issuer default ratings (IDRs) receiving uplift often of multiple notches due to sovereign support.