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Do retail investors understand the resolution directive?

16 July 2018
Richard Kemmish

Clearly the average retail bond buyer doesn’t understand the implications of the bank resolution directive. This could become a big problem, bigger than the EBA thinks.


Would you buy a bond issued by a bank? Not for your company, in a mutual or pension fund that you might own, but for yourself? Maybe the years that I’ve spent dealing with banks makes me too cynical but I sure wouldn’t. Bank equity? Maybe. On a good day. But a bank bond? Never.

But then I’m not Italian. The average Italian owns over €2,000 of bonds issued by banks. Assuming that lots of Italians are too young, poor or sensible to buy these bonds, the average middle-class family must have a huge amount of its wealth tied up in the sector. Italy is the extreme, but not the only case. German retail owns €50bn of bank debt according to data from the ECB.

These numbers have clearly scared the EBA and ESMA who have issued a joint statement saying, basically: worry. (I’m summarising it slightly). What particularly concerns them is the fact that the average retail investor probably (!) doesn’t understand the implications of the bank recovery and resolution directive on their bonds which, unlike their deposits, are subject to potential bail-in and are uninsured.

For existing bonds this gives rise to, at best, a load of miss-selling claims. At worst it could make it politically impossible to implement a bail-in according to the plan. Sorry to pick on Italy again but given the political composition of the government there, can we really expect the resolution authority to impose huge losses on retail investors? Seems unlikely. Although the political approach to the problem of retail investors always seems to be predicated on them being small ticket investors with their modest life savings in the form of bonds. Whilst clearly there are plenty of people like that I suspect that there are also a lot of rich people (sorry, ‘high net worth individuals’) hiding in there with ‘six figure’ investments.

Going forward, the Mifid ‘assessment of suitability’ rule makes it tough to argue that it’s still ok to stuff retail investors with bonds that could be subject to bail-in. This tends to be quite short dated stuff, so across Europe in the next five years we should see about €260bn of bonds that might have to shift from the retail to the institutional investor market. Or, that has to switch from bail-in to preferred if it is still going to go to retail. That’s a lot of bonds.
We could question why the EBA/ESMA paper is framed in terms of the impact of the resolution directive on the problem. A fundamental principle of the directive is that no creditor should be worse off because of it’s implementation. So, if retail investor losses are a problem under the directive they should have been, at least, just as much of a problem before the directive. Maybe the EBA only just got around to worrying about this, what with everything else that they’ve got going on at the moment.

A radical solution would be to extend the insurance of retail deposits up to €100,000 to retail bond holdings. Small ticket investors would be protected but the high-net worth investors wouldn’t – that should make it politically acceptable at least.

Sounds expensive, but the €260bn of retail bond holdings is miniscule compared to the €9 trillion of retail deposits currently covered by the scheme. And it would be far cheaper than letting a bank fail because you can’t impose a bail-in.

As an aside, this whole topic underlines the importance of teaching basic financial literacy at school rather than the rubbish that they currently teach. Languages? Literature? Who needs it? I say we teach bond maths from the age of 5.

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