BRRD in Germany: key details undecided

In spite of a clear, early signal of its direction of travel, the German goverment has yet to finalise implementation of the BRRD, in particular details as to how and just which senior unsecured creditors will be subordinated. Here, Moody’s analyst Bernhard Held, assistant vice president in the financial institutions group, assesses the state of play and possible ratings impact.

Germany has been an early adopter of the Bank Recovery & Resolution Directive (BRRD) within the EU. It finished its original parliamentary implementation process in November 2014, and the BRRD and bail-in tool took effect on 1 January 2015. In Moody’s view, this early introduction of the bail-in regulation — one year before the 1 January 2016 deadline — sent a clear signal that the German government intends to limit government support for banks and to share potential losses with owners and creditors.

Even so, some details of the precise implementation remain in flux, in particular the proposed amendment of Article 46f of the German Banking Act (KWG), as outlined in a draft law (Abwicklungsmechanismusgesetz) that the German Finance Ministry published on 30 April. If amended as proposed, KWG-Article 46f would introduce a legal distinction within the senior unsecured class that creates a separate layer of senior unsecured bonds containing “tradable” capital market securities that would absorb losses ahead of other senior unsecured debt, whether in insolvency or in bail-in. It remains uncertain which instruments would form the tradable debt layer, but we expect that the majority of senior unsecured debt would be included.

A direct consequence of this proposal would be that German bank liability structures would contain an additional building block immediately senior to Lower Tier 2 debt, but subordinated to operating debt and wholesale deposits, because no form of “grandfathering” is foreseen for outstanding issuances. For large parts of the German banking sector, this would imply a head-start in the quest to build sufficient amounts of Minimum Required Own Funds & Eligible Liabilities (MREL) and Total Loss Absorbing Capacity (TLAC). This would not only buy German issuers additional time to build an adequately tranched debt structure compliant with regulatory bail-in amount requirements, but the TLAC and MREL-compliant status of senior debt would furthermore broaden the issuance options of banks beyond the range of instruments eligible for regulatory capital purposes.

That being said, the draft law is subject to the ongoing parliamentary process in Germany. It has already undergone one important change since the first ministerial proposal, as the proposed tranche of future subordinated senior debt has been broadened to include promissory notes and registered bonds in addition to bearer bonds. Initial feedback from both houses of the German Parliament suggests that the envisaged priority treatment of issued certificates with variable payment promises will be subject to intense parliamentary scrutiny.

If enacted, depositors would — in insolvency as well as in bail-in — benefit from the subordination of senior unsecured debt instruments, reducing further the loss severity or, in the words of Moody’s new bank rating methodology, the “loss-given-failure” (LGF) expectations for deposits. In contrast, the subordination of senior unsecured debt instruments would increase the LGF expectations for senior debt instruments, offering lower protection for senior bondholders.

In Moody’s ratings for German banks, this proposed depositor preference has been reflected since 19 June with mostly positive rating outlooks for bank deposit ratings and for the most part negative outlooks for the same entities’ senior unsecured ratings. According to Moody’s estimates, the average pari passu ranking volume per bank for senior unsecured instruments would decline by five percentage points, while it would increase the subordination volume for deposits by 15 percentage points, driving the potentially diverging future LGF notching outcomes for debt and deposits.