Regulators want banks to be able to go bust like ordinary companies. That means bondholders taking the pain if a bank fails. But if debt investors are to shoulder the risk of suffering a loss, they will need more confidence about what lurks in banks’ balance sheets.
Assessing the true value of a bank’s assets is always hard. The financial crisis has thrown up an additional challenge â€" assessing which investors have first claim. Banks have become increasingly dependent on secured borrowings, such as covered bonds and central bank loans, in their overall funding mix. If it isn’t clear how much of a bank’s assets are pledged against secured borrowings â€" known as “encumbrance†â€" then unsecured bondholders can’t work out their potential losses if things go awry. Moves to protect depositors in bail-ins add a further layer of complexity.
One way of providing clarity would be to cap the proportion of assets that banks can pledge as security. The snag is that this ignores the fact that banks have differing business models. Lenders that don’t take deposits, like Danish mortgage banks, may operate with a higher level of secured funding than those that do.
A better solution would be improved transparency, as the Committee for the Global Financial System suggested recently. Disclosure of encumbrance would allow bondholders to price bank debt more accurately. That should make banks more disciplined about tying up assets, and make investors less jumpy in times of stress.
But what to disclose? Measuring secured funding as a proportion of total liabilities would not make clear which assets have been pledged. It would also overstate the riskiness of investment banks, which rely on short-term secured loans. The committee suggests measuring of a bank’s unencumbered assets as a proportion of unsecured funding. That would indicate what would be left for unsecured creditors after secured lenders had been paid.
Banks will of course say disclosure can be dangerous. Encumbrance data could expose secret central bank aid or erode confidence.
But unsecured bondholders will only accept the possibility of taking the pain in a bank failure if they can price their risk. More information is a must.
Neil Unmack is a columnist and Peter Thal Larsen is Asia editor at Reuters Breakingviews. For more independent commentary and analysis, visit breakingviews.com.
