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The drop in price for Novo Banco (formerly Banco Espirito Santo) bonds to distressed levels reflects both bail-in and regulatory risk.

The new EU Banking Recovery and Resolution Directive (BRRD) which has to come into force January 1st 2016 is supposed to draw a line under taxpayer bailouts.

Commentators in the US and Europe sound regular warning bells about liquidity risk if investors in bond funds try to redeem in troubled markets.

European banks are criticised for holding back economic growth by being unwilling to lend, due in part to capital pressures. However, the real truth is that banks should be given (moderate) credit for being willing to increase risk and grow their books in the face of continued high levels of corporate defaults.

The European Banking Authority in a recent EBA report on Transparency highlighted that banks had been able to increase their common equity tier 1 (CET1) ratio by 1.7% due to increases in capital despite an increase in risk weighted assets.

The Basel Committee recently released the Quantitative Impact Study for the Fundamental Review of the Trading Book (FRTB) which should go live in 2019. As the chart below shows banks (from a sample of 44) could see market risk capital charges nearly double (mean increase of 174%) but the large investment banks could see charges increase 5 or even 8 times if they don’t adapt their portfolio.
The bank showing an 8 fold increase is not named but Deutsche seems an obvious contender.

Liquidity risk was the top risk keeping risk managers awake at night in 2008 but has since fallen down the list of priorities. Maybe banks have improved the stability of their funding driven by impending Basel III liquidity rules but maybe unknown unknowns lie ahead.

The chart below, based on data from Bankscope, highlights that median loan to deposit ratios for Eurozone banks remain high.

Basel III does a great job of reducing a bank’s ability to overstate or double count capital, however loopholes remain if regulators are co-operative.

Southern European countries are desperate to ensure their banks are adequately capitalised without having to inject taxpayer money. By guaranteeing to reimburse banks for deferred tax independent of whether the bank is profitable, Greece, Spain, Italy and Portugal have achieved just this. This guarantee is worth up to 40% of capital for some banks but what is it worth if from a sovereign like Greece close to default? Stricter Governments like the UK are doing the opposite and threatening to curtail a bank’s ability to recover these assets.

The FT reported this week on a life insurance contract written by the French insurer L’Abeille Vie back in 1987. Known as a “Fixed Price Arbitrage Life Insurance Contract”, the product was sold to wealthy individuals and offered them the special flexibility to switch at any time between different investment funds at the listed fund price, which back in 1987 was set each Friday. The catch was that a smart (or not even so smart) investor could watch the markets go up or down during the week and would have a whole week to switch in and out of the funds at the previous Friday’s trading price, thereby using hindsight to lock in profits.

EU’s Bank Resolution and Recovery Directive (BRRD), due to be implemented in 2016, will most certainly adversely impact the credit standing of senior, as well as subordinated bondholders.

The treatment of large creditors in the Cypriot banks provided the first glimpse into what can happen to bond holders when a bank gets into difficulty and the government can’t afford to, or chooses not to, support the bank.

Austria’s adoption of the BRRD, a year ahead of schedule, demonstrates how such rules will work in practice.

Regulators everywhere would do well to follow the Swiss Financial Market Supervisory Authority (Finma) in making public the minimum capital requirements for its banks based on the risk profile of the bank.

Last year Finma announced the UBS minimum capital targets at 19.2% of risk-weighted assets and an unweighted leverage ratio of 4.6%. For Credit Suisse it was set at 16.7% and 4% respectively.

The targets are substantially more demanding than those set by Basel III rules but it is an understandable position considering that the total assets of these two banks was 4xs GDP at the peak of the crisis. The banks have until 2019 to comply.