Draft legislation in Germany would mean senior bondholders face losses in bank resolution before other unsecured creditors such as large wholesale depositors and counterparties, Fitch Ratings says. This would make it easier to resolve banks in Germany and could become a blueprint for addressing total loss-absorbing capacity (TLAC) requirements for other global systemically important banks (G-SIBs) without the burden of setting up holding companies.On 10 March the German government released draft legislation, the SRM-Anpassungsgesetz, to address technical legal challenges to implementing the Single Resolution Mechanism (SRM) in the euro area. A key amendment is to section 46f of the German Banking Act (KWG). According to the draft amendment senior unsecured securities of all German banks with full banking licences would become subordinated to the bank’s other senior unsecured liabilities in insolvency.Existing legislation implementing the EU’s Bank Recovery and Resolution Directive (BRRD) in Germany, the Sanierungs- und Abwicklungsgesetz (SAG; also known as BRRD Umsetzungsgesetz), references the ranking of liabilities in insolvency as the ranking to apply in the bail-in waterfall in resolution (section 97 SAG).Therefore, it appears the proposed 46f amendment of the KWG would make it clear to investors and potential investors in German banks that senior unsecured bondholders would be bailed in ahead of other senior unsecured creditors in resolution. We would then expect the minimum requirement for eligible liabilities (MREL) to be met by German banks from core and subordinated regulatory capital plus senior debt.The draft may need to be more specific to identify instruments included in the Financial Stability Board’s (FSB) TLAC proposals, once these are finalised. In Germany, only Deutsche Bank would need to meet TLAC requirements, as they only apply to G-SIBs. But Germany’s draft legislation could also indicate how a statutory solution might address TLAC requirements in G-SIBs without holding companies in other countries. The FSB proposed that external TLAC could be contractually or statutorily subordinated to other (excluded) liabilities, or issued via a holding company (structurally subordinated).Our Issuer Default Ratings (IDRs) capture the default likelihood of any of a bank’s senior liabilities (with certain, limited exceptions). The draft legislation would therefore have no direct effect on our German bank IDRs. The legislation would weaken recovery prospects for senior unsecured creditors, but we do not expect any immediate implications for German bank senior unsecured debt ratings, which we rate in line with German banks’ IDRs, reflecting “average” corporate recovery prospects (typically 31%-50%).We usually require a high burden of proof to notch senior debt downwards based on recovery prospects due to the high uncertainty about what a bank’s balance sheet will look like on default. This is most likely to happen at low rating levels (‘B’ category or lower).But the legislation could raise funding costs or even reduce market access for banks dependent on senior debt issuance, which could be negative for ratings. We expect most banks to be able to offset this by raising interbank funding, institutional deposits and Schuldscheine (promissory notes, classified as deposits rather than debt instruments), which the draft legislation places in a more favourable position.The subordination of these securities would apply not only to new issuance but also to existing securities. Retrospective legislation is prohibited under Germany’s constitution, but the explanatory text to the draft legislation specifically says that the government views the inclusion of existing securities as “unechte Rueckwirkung”, meaning not really retroactive.We view the draft legislation as consistent with EU policymakers’ general progress in finding ways to resolve failed banks without disruption to financial stability and without requiring state resources. Application of the BRRD and SRM will be made more straightforward, especially in Germany where there is a large private and institutional savings base, by identifying senior debt as a distinct category of liability that can be “bailed in” ahead of counterparties and “uninsured” depositors rather than pari passu with them.In line with diminishing state support for banks, we expect to downgrade the IDRs of more than 50 EU banks and their subsidiaries, including many in Germany, in the next few months by removing or reducing likely support from our rating assumptions, as explained when we placed the IDRs on Negative Outlook in March last year.
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