Retail holdings of bail-in-able debt have caused concern for a number of years for supervisors and resolution authorities. From the perspective of supervisors, conduct risks arise from the fact retail investors may not fully understand the risks involved.Partly because of this, and because of high volumes, resolution authorities are concerned that retail holdings of bail-in-able debt have created impediments to resolution.
The Single Resolution Board (SRB) has re-affirmed its opinion that large retail holdings of bail-in-able debt create impediments to resolvability – flagging the potential franchise damage to the restructured bank and the risk that litigation (e.g. for mis-selling) offsets the capital benefit of bail-in. To these impediments could be added the practical difficulty of bailing in a large number of individual investors, and the added political scrutiny it would bring.
The problem is sizeable. The European Banking Authority (EBA) and European Securities and Markets Authority (ESMA) recently found that €262.4 billion of bail-in-able debt, or 12.7% of total issuance, is held by retail investors1 .
2019 will see progress made in addressing this issue, including through the introduction of restrictions on the sale of bail-in-able debt that will be brought into law by changes to the EU’s Bank Recovery and Resolution Directive (BRRD), and through the enforcement of rules in MiFID II. The SRB also plans to analyse banks’ exposure to retail bondholders as a part of resolvability assessments2.
Banks should therefore expect to have to address any impediment to resolvability created by retail holdings of bail-in-able debt. This applies both to the existing stock, and new issuance - despite the progress made so far by European banks in meeting minimum requirements for own funds and eligible liabilities (MREL), many will be required to issue more bail-in-able debt in the near future.
Bail-in, in practice
Since the financial crisis we have seen several examples of the difficulties involved in bail-in execution, particularly where there are large retail holdings of bank debt. These difficulties have been particularly acute in Italy, where, for reasons of historically favourable tax treatment, retail investors hold €132.3 billion of bail-in-able debt – just over half of all the retail-held debt in the Eurozone. Other countries facing high levels of retail holdings include Germany (€49.4 billion) and France (€31.7 billion).
In November 2015, four regional Italian banks were wound down, involving the bail-in of junior bondholders, many of whom were individual savers and pensioners. The imposition of losses on non-professional investors resulted in political backlash. In the summer of 2017 two more regional Italian banks, Veneto Banca and Banca Popolare di Vicenza, were deemed failing or likely to fail. According to reports3, the potential repercussions of bailing in senior debt - including the risk of a deposit run that a bail-in could create4 - played a role in the choice of strategy to wind down the banks. The wind down deal ultimately comprised a proposal by the Italian government to inject €4.8bn in cash and to provide a further €12 billion of state guarantees (which was approved by the European Commission). Compensation was also provided to investors who were judged to have been mis-sold €200 million of junior bonds.
While both cases involved the sale of bonds to retail investors, the 2017 case demonstrates most clearly the concern that bail-in of retail investors can have significant implications for financial stability. The EBA and ESMA have acknowledged as much5, noting that even in the absence of mis-selling, the bail-in of debt held by retail investors can have implications for financial instability, including increasing the likelihood of bank runs. They also acknowledged that retail holdings can create impediments to resolvability given the threat they could pose to both the feasibility (i.e. the operational ease) and credibility (i.e. the market reaction and potential for contagion) of implementing resolution plans.
New retail holdings
Given the conduct and prudential implications from bailing in retail debt-holders, authorities have begun to bring in restrictions to manage the flow of new retail investment. This move is particularly timely given the volume of debt banks are set to issue in order to meet the incoming subordination requirements in the Capital Requirements Directive (CRD) V. The EU legislative package of risk reduction measures will implement the Financial Stability Board’s total loss absorbing capacity (TLAC) standard, and the UK’s departure from the EU may mean that debt issued under English law may no longer be eligible for MREL6. This is in addition to estimates by the SRB that banks will need to issue €125 billion of additional debt to meet the current shortfall7.
These new restrictions are not the first to be implemented. In 2015, the UK’s Financial Conduct Authority introduced restrictions on the sale of contingent convertible securities (CoCos) to retail customers8. The restrictions were introduced due to the opacity in features related to the bank’s capital position, amongst other reasons. In 2016 ESMA raised concern about retail holdings of bail-in-able debt, noting that self-placement, or direct selling of bonds to a bank’s existing clients, was of particular concern. ESMA further found that as bail-in-able debt does not always have liquid secondary markets, it can be difficult for investors to perceive and react to changes in the condition of the issuing bank9. Despite this, ESMA did not introduce any restrictions on the sale to retail investors.
Moreover, in their recent joint statement, the EBA and ESMA state that the proper implementation and enforcement of the MiFID II regime will address the conduct concerns involved with the sale of bail-in-able debt to retail investors. MiFID II includes requirements for institutions to identify and mitigate conflicts of interest when selling financial instruments; disclose additional information when selling instruments included in prudential requirements, such as an explanation of the differences between the instrument and bank deposits in terms of yield, risk, liquidity, and deposit protection; and conduct suitability tests when providing investment advice during self-placement. MiFID II also includes product governance obligations, which require institutions to identify a target market of clients for whose needs, characteristics and objectives a product is intended.
Potentially more significant though will be new restrictions on the sale of retail MREL holdings that will be included in changes to the BRRD in 2019. The changes will give Member States the option either to limit the initial amount that retail investors with an investment capacity below €500,000 can invest, or introduce a minimum denomination amount of €50,000.
Addressing the existing stock
Addressing the existing stock of retail-held debt is even more complex than stemming any new flow. The EBA and ESMA found that even under an assumption of no new issuance to retail investors, retail holdings would stand at 38% of the current level of senior unsecured debt and 68% of subordinated debt in Q3 2020 – equivalent to €80.7 billion and €34 billion respectively.
While resolution authorities do have the ability to exclude certain MREL-eligible debt during resolution planning it can only be done in exceptional circumstances. Given the scale of retail holdings, widespread exclusion of this debt could potentially cast doubt over the effectiveness of the resolution framework as a whole.
The EBA and ESMA noted that MiFID II requires firms to disclose retroactively information on the risks involved to existing retail holders of debt eligible for bail-in. However, the degree to which this new disclosure will help reduce retail holdings remains unclear. In cases of self-placement, retail purchasers may have a long-established relationship with their local bank, meaning that specific written communications on the risk involved, as suggested by the EBA and ESMA, may not be effective.
Where retail holders do want to dispose of debt after receiving this enhanced disclosure, the means of doing so remain unclear. In some cases banks may be willing to buy back bonds. But where they are not, or where purchasers feel that a buy back represents poor value for money, it may be difficult for retail investors to access secondary markets at all. There may be limited liquidity in secondary markets and trade data can be opaque, making resale particularly difficult for retail investors.
Looking forward: removing the impediment of retail holdings
Given upcoming supervisory attention to the issue of retail holdings, including provisions in the new MiFID II regime and changes to the BRRD, banks should consider whether the benefits of issuing new debt to retail investors outweigh the risks from a conduct and resolvability perspective, if they have not done so already. In practice, we have seen indications from the market that, in a number of cases, the costs do in fact outweigh the benefits. Several banks have moved towards a more cautious approach to new issuance, including restricting distribution to institutional investors only.
Workout of the existing stock is clearly more complicated than stemming any new flow. Here, unfortunately, there is no simple answer. Given the SRB’s stance that large retail holdings create impediments to resolvability, banks should expect to address any significant retail holdings during the resolution planning process, if they have not done so already.
Once the new investor protection arrangements are in place, concerns about the bail-in of newly issued MREL capital should be allayed by the argument that these instruments will have been marketed as risk-bearing products subject to limits on purchase by retail investors and/or minimum denomination amounts.
1 Figure published in the EBA/ESMA joint statement on retail holdings of bail-in-able debt, available at: https://www.esma.europa.eu/sites/default/files/library/esma71-99-991_eba_esma_statement_on_retail_holdings_of_bail-inable_debt.pdf
7 Figure published on SRB website, available at: https://srb.europa.eu/sites/srbsite/files/srm_boardroom_dialogue_mrel_d_laboureix.pdf