Depositor preference remains a far greater subordination risk to senior unsecured creditors than balance sheet encumbrance, with a receding euro-zone crisis and enhanced liquidity among factors helping to mitigate risks stemming from the latter, said Fitch yesterday (Wednesday).

Fitch, Canary Wharf

The comments were made in response to a bank recovery and resolution framework proposal from the European Union Economic & Monetary Affairs Committee (ECON) last week, under which depositors would be ranked ahead of senior unsecured creditors. The proposal also introduced the possibility of covered bondholders’ residual claim being bailed-in, although market participants appear hopeful that this will not feature in the final directive. (See here for previous coverage.)

Depositor preference has a far greater influence on subordination risk than balance sheet encumbrance, said Fitch, which previously flagged the issue last August (see here). Regulatory reforms may also lead to a rise in encumbrance by increasing secured funding and collateral posting, but the risk is lower.

A preference for retail depositors over senior unsecured bondholders could substantially increase subordination risks for senior creditors, said the rating agency, pointing to figures released by the Bank for International Settlements on Monday. According to these the introduction of depositor preference can raise the median asset encumbrance ratio for European banks by about three times, noted Fitch.

“This is consistent with our findings last year that deposits raise the median encumbrance of funded banking assets to around 72% compared to 28% when only secured funding is included,” it said. “This shows how the relative size of a bank’s deposit base compared to other funding sources could limit recoveries for senior unsecured bondholders.”

However, policymakers’ views on which deposit categories should come under protection are likely to vary, said Fitch, especially because the definition of a deposit can include instruments that resemble capital markets investments. A narrow application would have a less marked impact on the encumbrance ratio.

Asset encumbrance could also increase if banks use more long term secured funding to comply with the Basel III net stable funding ratio, with regulatory reforms and market pressure adding to momentum for banks to increase balance sheet encumbrance. Collateral for OTC derivatives, for example, is increasing.

“However, these factors are unlikely to have as great an impact on subordination risks compared to depositor preference,” said Fitch. “In any case, they are being at least partly offset by a receding euro-zone sovereign crisis, collateral optimisation and enhanced capital buffers and liquidity.

“Weaker European banks that are able to restructure and improve their financial profile will see balance-sheet encumbrance decline if their need for central bank funding reduces.”