CYPRUS: Law protecting depositors in banking collapse is bad for bondholders

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A government law modifying the Business of Credit Institutions and transposing the EU's Directive into national legislation offers greater security for depositors but leaves bondholders in the lurch, says Moody’s.


As the directive requires, the law deals with the priority of claims in a bank resolution or liquidation and creates a new category of “senior non-preferred” debt (junior-senior debt) that is subordinate to senior unsecured debt but senior to Tier 2 instruments.

The new framework deviates from the standard version of the European Banking Recovery and Resolution Directive (BBRD) in that it introduces depositor preference, with even junior depositors ranking ahead of other unsecured creditors.

“Junior depositors such as pension funds, financial institutions, public authorities and large corporates will benefit from the buffer of senior debt, which will reduce losses for deposits in a resolution, a credit positive,” said a Moody’s analysis.

“However, senior unsecured bondholders will be negatively affected by the lack of loss-sharing with junior deposits and have a higher loss rate in resolution, a credit negative,” it added.

Moody’s said the lack of loss-sharing with junior depositors increases the credit risk attached to banks' senior debt obligations and is likely to make the cost of issuing senior unsecured debt for Cypriot banks more expensive than in other jurisdictions, where junior depositors rank pari passu with senior unsecured debt holders.

“The ultimate credit risk and cost of senior unsecured debt however will also depend on volume of more junior obligations available to absorb losses first.”

The Cypriot government's rationale for amending the ranking of liabilities in favour of deposits appears to relate to depositors' losses at the country’s two largest banks in the March 2013 bailout/bail-in crisis.

Bank of Cyprus, the island’s largest bank, converted 47.5% of its uninsured deposits into equity, while Laiki Bank, the second-largest bank, was resolved with most of its assets and liabilities transferred to BoC.

Moody’s argued that depositor preference will support still-fragile deposit confidence in the banking system.

“Although we do not expect significant debt issuance in 2019 and 2020, issuance is likely to pick up afterwards to satisfy the EU's minimum requirement for own funds and eligible liabilities (MREL).”

MREL requires banks to issue minimum volumes of loss-absorbing debt – which for Cyprus is likely to include senior unsecured debt – to protect taxpayers from the cost of bank failure.

“Cypriot banks' funding costs will increase from 2021 onwards once they begin to issue debt instruments to comply with the EU's minimum requirement for MREL, although the exact targets for Cypriot banks have yet to be announced.”

The EU has sought to harmonise national creditor hierarchies to reduce uncertainty for creditors, and to this end amended the BRRD in December 2017 by adopting Directive 2017/2399.

The new junior-senior bank debt was designed to remove a potential obstacle to resolution by adding a dedicated loss-absorbing layer in the creditor hierarchy that is subordinate to senior liabilities, including deposits.

In adopting the new framework, Cyprus is following Italy, Slovenia, Bulgaria, Malta and Portugal, all of which have adopted a full depositor preference framework that diverges from creditor hierarchies elsewhere in the EU.

“The absence of harmonised creditor hierarchies is a setback for efforts to achieve a level playing field within the EU and creates uncertainty for financial institutions, investors and depositors as to how they would be affected by a bank resolution,” said Moody’s.