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Explicit, implicit

31 March 2016
Richard Kemmish

When it comes to implicit support for the banking system the Germans have always been the most explicit: ‘No pfandbrief issuer will be allowed to fail’.  Note the totally superfluous word in that sentence - ‘issuer’. The sentence achieves its intent without that word. In fact, I would argue that it means you should never buy a pfandbrief because junior, cheaper debt of the same issuer has exactly the same state support, it’s the issuer, not the bond that Frau Merkel guaranteed to support.

Which is odd, really.

For one thing it implies that all of the excellent legal work that has been put in to make pfandbrief bullet-proof is superfluous. The issuer won’t be allowed to fail, so what’s the point? If it were pfandbrief, not pfandbrief issuers that were explicitly supported, the point of the structure would be to minimise the loss to the German taxpayer when they have to fulfil that promise. But again, it isn’t the bond, it’s the issuer.

I think there is a comparison to be made to the post-crisis deposit guarantee fund. There it is explicit, not implicit, there it is the deposit, not the deposit taker that is guaranteed.

One could also compare both the pfandbrief comment and the deposit guarantee fund with what actually happened during the crisis and see that both were better to the extent that they at least provide clarity for investors and depositors. De facto ‘rescues’ of banks through the crisis bailed out a wide range of products, usually senior bonds were safe, occasionally they were not. Sometimes rescues even differentiated within classes of debt that should have been pari passu. That is far from ideal.
Legal, political and supervisory certainty is a good thing (and an endangered thing post-crisis, with potentially disastrous consequences, but that’s a different topic) so both the pfandbrief pledge (if I can call it that) and the deposit guarantee fund are better than what has gone before.

Before I get to the elephant in the room though, why is the support granted? Presumably in both the pfandbrief and the deposit cases politicians believe that the act of granting the guarantee means that thing guaranteed won’t fail. There won’t be a run on the bank by angry depositors, the pfandrief issuer will always be able to issue bonds. Otherwise the governmental guarantee is as much a zero-sum as a credit default swap – the tax payers loss is the depositors / creditor of the pfandbrief bank’s gain.
About that elephant: moral hazard. Any guarantee that is provided irrespective of the risk of the thing guaranteed generates a moral hazard, specifically encouragement to take more risks. There has been plenty of debate about contributions to deposit guarantee funds being risk-based.

But moral hazard is minimised if the creditors more junior to deposits are exempt from the guarantee, not just senior debt but management shareholdings, for example.

I think you see what my concern is here.

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