The European Commission strikes back

September 4, 2009

Reeling from the humiliation of failing to stop Belgian bank KBC paying interest on some of its subordinated bonds, the European Commission has won a new victory in its bid to see bondholders share the pain of bank bailouts.

Acting as a sort-of policeman for Brussels, the UK’s Financial Services Authority has prevented the Royal Bank of Scotland from repaying four subordinated bonds at their first opportunity, causing prices to plunge by up to 15 percent. The Upper Tier 2 euro-denominated bonds fell to between 70 and 75 cents, depending on who you ask.

Behind all this lies the long arm of the European Commission, which recently launched a crusade to see banks’ subordinated bondholders share the pain of public-sector bailouts.

Brussels is very uncomfortable about the idea that banks that have accepted state funding should then use some of that money to pay discretionary dividends on, or redeem at par, bonds they have issued that are trading at a discount to face.

While it works out what to do with the banks, it doesn’t want to see them pay dividends or call bonds. In the case of the RBS, the FSA seems to be acting as its enforcer.

Coming up with a simple approach is far from easy. It’s a tricky negotiation process between the banks and the EC, made harder by the sometimes fiendishly complex nature of the debt in question, in which bondholders’ rights vary enormously depending on the instrument.

This week KBC managed to side-step the Commission, saying it would pay interest on some bonds after lawyers were able to convince Brussels that they were mandatory, not deferrable.

RBS’ failure to call takes the debate over burden-sharing to a new level. It’s the first time a bank has been prohibited from calling Lower Tier 2 bonds, a higher ranking form of subordinated debt, as a result of state-aid restrictions.

Today’s news could imply the EC wants to extend the pain right the way across the spectrum of subordinated debt, not just confining it to the lowest-ranking Tier 1 debt.

However, the FSA’s decision not to call should not be taken as a sign that it, or the British government, agrees with this approach. The agency’s decision was largely a political one and shouldn’t necessarily be seen as a clear indication that all Tier 2 bondholders of bailed-out banks will get hosed.

Remember that the UK government and RBS are locked in discussions with the EC over state-aid approval for the bank’s restructuring. The FSA and government probably reckoned it was better to keep Brussels sweet rather than jeopardize talks by letting RBS call the bonds.

That said, it’s hardly good news for subordinated bondholders of RBS and Lloyds, with the odds shortening on the banks’ being compelled to not call other bonds or defer interest payments.

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