- The first week of October 2016, could be the potential first date for a new class of debt
- There is a EUR 93bn capacity for the new debt class, for the top French banks
- BNP Paribas is likely to be the greatest issuer of the new class
- The top four French banks have a EUR 50bn total capital shortfall for TLAC 2019
- We believe, senior unsecured (preferred) should continue to trade well
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The French bank debt market has outperformed many of its European peers in 2016. As we await a new debt class (senior non-preferred) to sweep Europe, we take a look at the reasons behind the performance and the impact the new debt class could have on the future of the fixed income market.
Why are resolution hierarchies being changed across Europe?
Across Europe we are witnessing countries organising their resolution hierarchies in a different manner. The overall goal is to facilitate bail-in and protect taxpayers from bank failures. From the perspective of bail-in, there is doubt in the ease by which senior unsecured debt could be treated. If a resolution would occur, as senior unsecured debt ranks parri passu with a number of other senior liabilities it may be legally and physically difficult for these senior bondholders to take losses.
Therefore, for the purposes of regulatory frameworks there is a discussion on the full eligibility of traditional senior unsecured debt. There are a number of ways countries have thought about solving the issue. In Germany, senior unsecured debt has been arranged to be subordinated to other senior liabilities. Whereas in France and Spain, there is a proposal for an additional layer of debt that could be used, this layer would be subordinated to traditional senior liabilities. Furthermore, in the UK and Switzerland, a HoldCo / OpCo structure has been implemented. All the strategies aim to make bail-in possible, easier and cleaner.
How are the French organising their order of resolution?
In December 2015, the French Ministry of Finance announced a resolution framework that would allow for a new form of unsecured debt to be created. The new class of debt is professionally referred to as senior non-preferred, however, other names such as senior junior, senior subordinated and Tier 3 are sometimes used in commentary. Part of the reason for the designation is that some banks, under their Tier 2 clauses, are not allowed to issue further ‘subordinated’ debt that ranks superior to Tier 2 debt. Therefore, it is not desirable that ‘subordinated’ is applied.
The existing French bank senior unsecured debt, would be then referred to as senior preferred debt. The change in name of the senior unsecured debt, does not affect any existing documentation of the debt class. For example, the pre-existing senior unsecured debt (under its new name, senior preferred debt) would remain parri passu with other senior liabilities. Senior non-preferred debt would be positioned in the hierarchy of creditors between subordinated debt and the pre-existing senior unsecured debt.The French law proposal is not fully confirmed, but it is just awaiting the finishing touches, in our view. The law was adopted by the upper house, the French Senate on 8 July, but with slight modifications. Consequently, the bill has to return in September 2016 during an extraordinary parliamentary meeting to reconcile the versions.
When could we expect to see the new senior non-preferred enter the market?
At present, we believe, the earliest that French senior non-preferred could enter the market is the first week of October 2016. This would be a number of days after the potential first day that the bill could be passed on the 26 September 2016. Hence, the October date would be the earliest date, but only if the law passes without delay.The new debt class will bring some technicalities to existing operations
The new class of debt, we believe, would not qualify as collateral for repo operations with the ECB, as the debt class is subordinated to the other debt instruments (see below). Although, the existing and future senior preferred debt would nevertheless still be eligible for collateral positings. Furthermore, senior non-preferred debt is set not to be included within the iBoxx Euro Banks Senior universe, for the same reason.
Eurosystem Monetary Policy Framework
Title: Non-subordination with respect to marketable assets
Eligible debt instruments shall not give rise to rights to the principal and/or the interest that are subordinated to the rights of holders of other debt instruments of the same issuer.
Source: EUR-Lex, ECB
How does the resolution hierarchy affect regulatory capital?
The senior non-preferred level of debt, is essentially a way of reducing impact to existing senior preferred debt holders whilst also being eligible for regulatory capital requirements. Upcoming capital requirements include the total loss-absorbing capacity (TLAC) and the minimum requirement for own funds and eligible liabilities (MREL) frameworks.
We envisage that the senior non-preferred will have 100% TLAC loss absorbing capacity eligibility for capitalisation requirements. Therefore, the new resolution hierarchy that France may apply, has direct repercussions for amount of TLAC eligible capital held by the French banks. TLAC requirements are currently only applicable for the globally systematic important banks (GSIBs). France has four GSIBs; BNP Paribas, Crédit Agricole, Groupe BPCE and Société Générale.How are the French banks positioned for regulatory capital requirements?
If we take a look at the GSIB banks in France (the ones which have to follow TLAC guidelines) there is a variety of regulatory capital amounts that are held on balance sheets.
We calculate, that the total eligible capital shortfall for the four French banks is EUR 50bn, in regard to their 2019 TLAC requirements. Under our calculations, BNP Paribas currently has the largest shortfall, and they would require EUR 26 bn of eligible capital. The other three French banks also all have eligible capital shortfalls, albeit a smaller shortfall (EUR 24bn for the three other banks combined), approximately 1% of their risk weight assets.
A capital shortfall can be fulfilled either via; equity (CET1) issuance, a reduction in risk weighted assets, or with debt instruments (including AT1 hybrids). Please see the capital overview below, whereby the requirements assume the cheapest form of funding for a banking institution.he current balance sheets, lead us to believe, that BNP Paribas will be the most active issuer over the next two years of senior non-preferred debt in the French market. The other three French banks are more likely to take a more gradual approach to their senior non-preferred issuance.
In response to the capital shortfall, BNP Paribas has announced it plans to issue EUR 30bn TLAC eligible senior debt before the 1 January 2019. Allocations would be EUR 10bn per year, including this year. Consequently, for the EUR 10bn figure in 2016, it would be made up of senior preferred that could be used for future TLAC requirements and senior non-preferred. Therefore, from October to December 2016 BNP Paribas, may come to the market with EUR 3-6 bn of senior non-preferred issuance. This issuance however, is absolutely dependent on the confirmation of the law in French parliament, and on market conditions.
The reason for both senior non-preferred and preferred issuance is because under TLAC requirements, 2.5% of senior preferred debt is allowed to be counted towards capital requirements (although this may change in future clarifications). All four French banks already have sufficient senior preferred capital that would be eligible in 2019. However, after this date and towards 2021, as senior preferred debt matures, further senior preferred debt would have to be issued by the banks to make up any shortfall. For TLAC eligibility, one rule is that debt has to have over two years left to maturity to be fully TLAC eligible (see below).
Federal Reserve Framework
Eligible external LTD with a remaining maturity of between one and two years would be subject to a 50 percent haircut for purposes of the external LTD requirement, and eligible external LTD with a remaining maturity of less than one year would not count toward the external LTD requirement.
Source: Federal Reserve
How could the size of the new debt class evolve?
Using current risk weighted assets (RWAs), we believe, there is capacity for EUR 93bn of senior non-preferred debt across the four largest bank institutions in France. Although, this figure will emerge over time, and could take over a decade to fully establish itself. This figure is liable to increase (perhaps significantly), once the updated Basel III (referred to also as Basel IV) framework is announced at the end of 2016.How could the new class of debt price in the market?
Although France is creating a new debt class, there is already a similar precedent in European markets. Nykredit Realkredit, the Danish financial services provider, brought a similar type of class to the market with a number of deals in 2016. They referred to the layer of debt as Resolution Notes. Yet, these are similar in character to the French senior non-preferred, as they too are subordinated to senior unsecured debt, but would be superior to Tier 2 debt in resolution. The pricing of the debt will naturally be, as with in resolution, between Tier 2 and senior preferred debt.
The Danish issued notes, were well bid in the market on issuance, and have performed well in the market since. They trade in present market conditions at a multiple of 2.5 times the implied senior unsecured spread. However, Nykredit Realkredit does not have any senior unsecured notes outstanding, and therefore, we estimate the Resolution Notes perhaps are trading slightly richer due to this. What we would glean from this methodology however, is that in current market conditions the new class of debt could price at approximately 3 times the senior unsecured spread.Has the new debt class already impacted spreads?
In anticipation of the new debt class, in our view, France continues to see non-fundamental performance of their traditional senior preferred debt . French banks have been one of the best performers in 2016. For instance, French bank debt was trading 25bps inside the standard European banks senior index one year ago, and at present it is trading 50bps inside the index.
Meanwhile, the importance of French banks in the euro denominated bank market cannot be understated. French issuers, with their high weighting, continue to be a fundamental driver of returns in the euro denominated bank indices. Due to this, we believe, that senior non-preferred issuance will benefit not just the senior preferred spreads in France, but contribute to supporting the senior bank and broader financials indices of Europe.Senior non-preferred issuance will support, and enhance, the present senior preferred spreads. An increase in the amount of senior non-preferred issuance, reduces the senior preferred loss given default in resolution; and less so, it increases the probability of tendering any short-term senior preferred outstanding notes.
We believe therefore, that is it unlikely that French senior preferred debt will witness spread widening, attributable to the large senior non-preferred issuance shortfall. This is despite the fact many French senior spreads are trading at all time tights.
We judge, that French investment grade performance could breach through the low that was seen in March 2015. However, due to the amount of issuance into the market of senior non-preferred debt, subordinated debt could be potentially impacted, and a slight decompression between senior preferred and subordinated debt may occur.Additionally, a focus on increasing capitalisation by the French banks, which is done ultimately to avoid taxpayer contributions, is supporting the bank fixed income markets in general. As capitalisation increases within a bank, the debt serviceability increases and this offers further protection to bondholders.
French economy outlook to be lightly supportive of French bank debt
So, looking forward for the year for French bank debt. We believe senior preferred debt will be supported as issuance of senior non-preferred commences. From a macro perspective, the French economy has seen slight positive growth in 2016 and we estimate that the economy should sit once again alongside the average growth for eurozone countries in 2017.
We believe this constructive domestic GDP outlook will remain supportive, but not greatly beneficial, to the net income of the banking entities. We estimate French GDP to be 1.1% and 1.0%, for 2016 and 2017 respectively. Furthermore, political risk, we estimate will affect all French banks, and is likely to come to the fore in pre-election discussions starting 2017. Despite, the slower than expected growth in France over the last year. The four main French banks have showed solid and rather resilient results, in Q2 2016. Operating income continues to remain solid and increasing. As with numerous Europe peers though, litigation charges and levy requirements (see below) continue to add headwinds.
European Commission: Levies
In October 2010, the European Commission (2010a, 2010b) evaluated options regarding the introduction of a harmonized Financial Sector Taxation framework. Among these options, the European Commission considered a Financial Activities Tax.
Source: European Commission
Overall, French bank debt has performed well over 2016, driven by capitalisation and the tightening of the European non-financial curve. French banks have shown that they can build returns in tougher financial conditions and look a steady source of returns in the face of fluctuating bank performance across Europe.
Trade Ideas For senior preferred debt, we favour BNP Paribas over Crédit Agricole until the end of year. On a relative basis BNP Paribas has continued its strong normalised return on equity since 2015, and maintains a stable net revenue stream. Meanwhile, Crédit Agricole continues to have a cost/income ratio consistently higher to its French peers. Accompanying this, on a relative basis, BNP Paribas will also require an extra 100bps of CET1 capital (due to GSIB its higher bucket), furthering protecting senior preferred debt. We therefore believe a divergence in senior preferred debt could begin to emerge for the two names.
Tomas Kinmonth, CFA
Fixed Income Strategist
Phone +31 20 628 1405 | firstname.lastname@example.org