A new funding instrument is now available for Italian banks: senior non-preferred bonds. These securities have already been widely used since 2016 in France and from 2017 in Spain and Belgium by big (“significant”) banks and, in particular, by those of global importance (G-SIB). In Italy they were regulated only recently by the 2018 Italian Budget Law (which has introduced the necessary amendments to the Consolidated Banking Act).
The new law modifies the hierarchy of claims in case of resolution and allows the creation of a new class of Non-Preferred Senior (NPS) instruments between subordinated debt and senior unsecured debt (i.e. the preferred senior debt). Non-Preferred Senior notes are unconditional, senior and unsecured obligations and rank pari passu amongst themselves and senior to subordinated notes, but junior to senior preferred notes and any claims benefiting from legal or statutory preferences. Italian law outlines the features of senior non-preferred bonds, aligning them with the Commission's proposal . Namely they should have an original contractual maturity of at least one year, the instrument cannot be a derivative and can’t contain embedded derivatives, the relevant contractual documentation must explicitly refer to a lower ranking than that of unsecured claims and to a higher one than that of subordinated bonds. The only distinctive element introduced by Italian law is the minimum denomination of at least 250,000 euros, stressing that institutional investors are the target.
Once the law was passed, the first transaction was concluded almost immediately: on January 11th, Unicredit issued the first 1.5 billion euros of 5-year senior non preferred bonds (but the funding plan, updated at the end of 2017, foresees total issues for 6 billion euros). The issue was very well received: orders were collected at three times the value and the spread, initially reported at around 80 bps on the 5-year swap rate, was set at 70 bps. The previous day, January 10th, other issues by 3 European banks took place (fig. 1), including Banco Santander's for €1.25 billion, with a spread of 60 bps on the midswap.
These bonds were the missing piece to an effective resolution mechanism. The Bank Recovery and Resolution Directive had left Member States a certain degree of flexibility in the ranking of unsecured debt instruments in insolvency hierarchy paving the way for as many different rankings in national insolvency law as the number of Member States.
This made the resolution of cross-border institutions non trivial. In order to harmonize Union rules on banks’ creditor hierarchy and to facilitate the resolution of cross-border institutions, EU Commission proposal, finalized in November 2017 , choose the “French model” as the EU standard . It introduced a new class of debt called "non-preferred" senior debt, eligible to meet the subordination requirement (Fig.2) that is mandatory for TLAC eligibility.
For their own characteristics and according to Mifid2 requirements, only qualified investors can buy these debt instruments, while retail investors with low financial literacy are banned from these risky assets that will represent the so-called Tier3 capital.
As already mentioned, the issuance of senior non-preferred bonds has been constrained by the different pace of the transposition of the EU Directive and its recent amendments into national laws. G-SIFI banks should issue these instruments to comply with the Total Loss Absorbency Capacity (TLAC) requirement, that requires a subordination clause for liabilities to be computable. We expect that a great bulk of issues will take place in 2018 as the TLAC requirement will be mandatory from 1 January 2019 (with a phase-in threshold of 16% in 2019 and reaching the fully phased 18% in 2022).
As far as Italy is concerned, in 2018 the main issuer on the market should be Unicredit (the only G-SIFI bank in the country) that needs to finalize its funding plan with other placements of senior non-preferred bond amounting to 4.5 billion euros. Nevertheless these bonds could be appealing also to O-SII banks). Although their cost is higher than that of senior bonds, they could constitute a buffer shielding senior bonds from being bailed-in and could therefore decrease the cost of these safer bonds with a possible positive (or neutral) effect on margins given the elevated amount of these instruments in banks’ balance sheets. Over the next few months we will see how the funding strategies of the banks might adjust after considering the pros and cons of issuing senior non-preferred bonds. It is also possible that the Single Resolution Board rules that, to be MREL compliant, bonds issued by O-SIIs need to have a subordination clause.
Some European O-SII already issued senior non-preferred debt. For example last September Belfius Banks, a Belgian bank insurance group, issued 750 million euros of senior non preferred debt in order to be MREL compliant, build up a new layer of instruments, diversify its funding sources and investor base and optimise its liquidity profile and capital structure.
The positive response of the market to the issuance of senior non-preferred issues is not sufficient to dispel the doubts (expressed also by the EBA) about market's ability to absorb the amount of bonds that banks will have to issue in the next years in order to meet the requirements on loss absorption capacity (MREL and TLAC). The volumes of non-preferred securities issued are still modest compared to the funding needs emerging from the recent update of the EBA's impact study on MREL: European banks will need more than €200 billion of bonds to meet the requirement and at least half of these volumes will originate from O-SIIs.