Encumbered sovereigns

The ECB’s Financial Stability Review for June 2012 is an interesting read. There’s a wealth of data and risk analyses. And one strange blind spot. Chapter III has a discussion of the market conditions for the issuance of senior unsecured bank debt. This market is at a trickle, which shows that whatever the reason the ECB has for insisting Ireland service legacy debt of this type in insolvent banks, it’s not to keep the current market open. Anyway, the chapter contains an extended box on the problem — as the review sees it — of rising asset encumbrance.

In other words, because banks are raising funds through various forms of secured borrowing, and tacit depositor preference is rising, the pool of money left to pay unsecured lenders in case of distress is falling:

Rising asset encumbrance levels have also led to concerns about the structural subordination of investors in senior unsecured debt. These concerns have been reinforced by uncertainty about the details of the forthcoming legislation on “bail-in” debt, which will probably involve unsecured senior bondholders sharing in the burden in the case of bank failures as part of plans to end taxpayer bailouts of financial firms. In addition, more countries may introduce depositor preference laws, thereby further reducing the volume of assets that would be left for unsecured creditors in the event of default. Taken together, all these factors would imply lower recovery rates on senior unsecured bank debt, and unsecured debt investors may thus start to demand higher compensation for assumed risks … As a consequence, unsecured funding appears to have the potential to remain expensive, thereby depriving banks of this historically important source of funding, unless they regain investor confidence through stronger balance sheets and higher capitalisation levels. (p77-78)

So to keep raising money by this route, banks will need more capital. Which is where this line of reasoning starts to unravel. In the current stressed conditions in the Eurozone, where will this capital come from? The state. Now, there’s another group of creditors looking at rising pre-emption of the pool of cash supposedly available to pay their claims, and that’s plain vanilla sovereign bond holders, who have been structurally subordinated, as the ECB puts it, to the Eurozone’s reluctance to have banks go bankrupt. By the same logic that the ECB sets out above, funding costs should thus be rising. As of course they are.

This is all basic stuff. It’s odd to go 3 pages on asset encumbrance in banks and not pursue the analogue for the sovereign.

One thought on “Encumbered sovereigns

  1. Interesting, since I don’t know much about this encumbered sovereigns.
    I just wondered how you got the guts for all of this infos.

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