Covered bond demand could push ahead of senior debt thanks to new bail-in regulations written into a planned European Commission framework for crisis management in the financial sector.

An initial EC proposal was released in October and then a fuller plan opened up for consultation on 6 January.

European Commission, Brussels

“The possible options set out in this consultation would constitute a significant step for the EU in delivering the commitment made at the G20 summit in June 2010, by ensuring that authorities across the EU have the powers and tools to restructure or resolve (the process to allow for the managed failure of the financial institution) all types of financial institution in crisis, without taxpayers ultimately bearing the burden,” said the Commission.

A key aim of the plan is “fair burden sharing”, which “might include possible mechanisms to write down appropriate classes of the debt of a failing bank to ensure that its creditors bear losses”.

The consultation document proposes that in a bail-in situation senior debt holders would face losses. Covered bondholders are among those set to be excluded from such bail-in participation under the EC framework.

The bail-in concept for senior debt holders has already been introduced in Germany through the German Restructuring Act in August 2010, in which haircuts were applied to senior debt retroactively (unlike the EC proposals, which do not apply to outstanding debt). The Pfandbrief was clearly exempted under bail-in scenarios.

A formalised legislative proposal should be issued by the EC before this summer, following an end to the consultation period in early March, although market participants suggest that the framework’s induction into law could take much longer and probably will not occur until at least 2013.

However, a two year grace period has not prevented investors from taking immediate action.

“What I can see at this very moment, already, is that a lot of guys from the senior side are calling me up, wanting teachings on covered bonds and are seriously thinking of switching – at least some of their money – into covered bonds,” said Crédit Agricole analyst Florian Eichert.

“I don’t know whether those guys have actually started shifting their holdings, but at least they’re asking a whole lot more questions than they were in the past and they have been active in primary market deals like the recent UniCredit OBG.”

RBS analyst Frank Will said that he, too, had noticed a significant shift from senior unsecured to covered bonds.

“People are scared on the senior unsecured side” he said. “People are looking for alternatives now.”

Grodzki, L&G IM: We don't want to second guess national regulators

Georg Grodzki, head of credit research at Legal & General Investment Management, summed up investors’ fears at a Landesbank Baden-Württemberg covered bond conference in early February. Whilst he stressed that taxpayers’ money should not bail out failing banks and their debt holders, he was not impressed with the threat posed to senior debt by the wide ranging discretionary power afforded to regulators in the proposed bail-in legislation.

“We don’t really want to second guess what individual national regulators may do with that discretionary power”, he said. ”We are worried that a more aggressive regulator could be tempted to bail in senior debt because it is more convenient than to put a bank into administration and let creditors work out a solution according to their contractual rights and the insolvency laws.

“Senior debtholders would be at risk of losing money because of regulators moving the goalposts for a bank’s capital requirements. This additional risk would have to be compensated for through higher credit spreads. The access to wholesale markets and the funding costs for banks would also become more volatile.”

Although bail-ins are contributing to the challenges facing senior debt issuers and investors, which may make the covered bond market look more attractive, even covered bond bankers point out that this is not necessarily a positive for financial institutions in general.

And Ralf Grossmann, head of covered bond origination at Société Générale, said that he was concerned over too much of an influx into the covered bond market.

“Ultimately banks need to have senior unsecured funding opportunities, so it’s quite important that they have this instrument at hand,” he said. “I’m not sure whether the bail-in is really the right answer to that.”

The loss of interest in senior debt will also affect the financing of covered bond cover pools, said LBBW analyst Jan King.

“The question is how overcollateralisation will be funded going forward,” he said, “because senior unsecured is probably becoming more unattractive for investors or at least it should become more expensive.

“There is in the end still some remaining funding that is needed on an unsecured basis and I think that’s the challenge going forward.”