Politically Good, Economically Bad: Depositors Ahead of Creditors

Britain is seeking changes to corporate law that would put bank depositors ahead of creditors in failing financial institutions, but the plans, while politically expedient, could end up costing the very customers they are designed to protect.

The new government legislation, confirmed Wednesday by financial secretary Greg Clark, was first proposed by the Independent Commission on Banking in a move Clark said would ensure that bank creditors take their fair share of losses and that British taxpayers would avoid the need for further bank bailouts while simultaneously protecting depositors.

Putting savers - normally treated merely as customers - ahead of bondholders - who are legally protected creditors that rank even higher than shareholders in a bankruptcy - is politically savvy considering the number of scandals that have had an on going impact ordinary Britons and small business owners. Watching Northern Rock collapse, as well as turning RBS and Lloyds turning into nearly state-controlled banks through taxpayer-propped funding, has also installed fear into the financial consumer.

However, some say there are implications for these sweeping changes in capital structure rules that could end up costing savers.

"Economically, a debate is raging between banks and policymakers about the merits of putting depositors before bondholders. Banks complain that this will raise costs for customers, since their own cost of funding will go up when bondholders require higher interest rates to compensate for losing out to depositors when the assets of a failed bank are divvied up," says the Economist Intelligence Unit (EIU). "Some countries, like Denmark, introduced measures to "bail in" bank bondholders only to later water them down when the impact on financing costs for banks effectively shut them out of funding markets.

New Regulations and Passing on the Cost

UK, EU and US regulators have spent the last few years crafting new legislation to hopefully prevent a similar credit crisis of August 2007 and in tandem increase supervision, monetary safeguards and protection for the consumer, in the event of a repeat of the financial crisis.

In Britain, the so-called 'Vickers Report', chaired by Sir John Vickers, introduced the idea of "depositor preference", as well as number of other measures such as ring-fencing retail operations investment banking, in order to protect UK consumers.

The European Commission is also looking to roll-out similar changes, but when the House of Lords questioned Mark Harding, group general counsel at Barclays and Richard Kibble, a director at the Royal Bank of Scotland, over the proposed reforms, both agreeded the implementation costs would be naturally passed onto the consumer as "there will be a removal of cross-subsidy benefits and therefore this will trickle down to the retail and wholesale market."

Capital Requirements and Debt Funding

Meanwhile, banking capital requirements is one of the most major changes being made to the global banking system.

In the UK and across Europe, banks will have to have a required cash cushion that is meant to provide a buffer against anticipated and unsuspected losses.

In Europe, so-called 'Basel III' commitment rules lifted the minimum tier-one capital ratio (a measure of equity capital against a bank's assets) from 2 percent to 4.5 percent and demanded an additional "conservation buffer" of 2.5 percent.

This month, the Financial Services Authority said Britain's banks will need to raise another £150bn - on top of the £186bn needed for Basel III - to maintain a safe financial system.

Earlier this week, Bank of England Governor Mervyn King warned that UK banks have "insufficient capital" and that the economy won't recover until they raise the cash needed to stabilize their wobbling balance sheets.

"Only then will it be possible to return to a more normal provision of the vital banking services so crucial to an economic recovery," King said during a speech in Cardiff.

Banks always need to raise funding but new capital requirements will mean they will have to shore up capital in many other ways, while still trying to remain profitable and solvent. Many have already sold off assets, pared down their workforces and reduced risk.

However, an important component of their capital costs is linked to their ability to borrow money in the bond markets.

Bondholder returns are fixed: the upside is capped (at par) while the downside is a total wipeout of the lender's capital. Shareholders, on the other hand, can be wiped out too, but their upside is unlimited (because a bank stock can, in theory, rise forever).

To compensate for this so-called asymmetric risk, and the lower returns it implies, bondholders rank ahead of shareholders and other creditors in the event of a bankruptcy.

Removing that position - known as seniority - would mean bondholders would ask for higher returns to account for the difference. This would add meaningful increases to bank capital costs - costs that would then, it is argued, be passed on to customers.