Scope expects that the introduction of a new CDS contract referencing the senior preferred obligations of German banks will lead to better pricing of counterparty risk and reduce hedging costs for Germany’s banks.

“The statutory subordination that existed prior to July 2018 had rendered all existing senior unsecured debt of German banks and their respective CDS contracts as non-preferred instruments subject to loss-absorption. The lack of differentiation had created an uneven playing field for German banks thereby increasing the costs for counterparties looking to hedge their exposure to German banks,” said Dierk Brandenburg, head of the financial institutions team at Scope Ratings.

“It also consigned German banks to higher funding costs, even if that meant at the same time that they were able to build up their MREL buffers,” Brandenburg said.

CDS costs for preferred obligations can be around 40% lower than for senior loss-absorbing debt from the same reference entity when traded as separate contracts, for example at French banks. Banking groups that issue their non-preferred debt out of holding companies realise similar benefits by creating separate CDS contracts for their banking subsidiaries.

Senior preferred debt issued by German banks sits at the same level in the capital structure as structured notes, derivatives and certain types of large deposits. That is the bucket above senior non-preferred (SNP) debt. Senior unsecured debt issued by German banks before 21 July 2018 ranks pari passu with senior non-preferred debt issued on or after that date. Similarly, CDS on German bank reference obligations issued as senior debt before 21 July or as SNP after that now sit at the same (non-preferred) seniority level.

There had been speculation that German banks would look at replacing some of their senior non-preferred debt with cheaper senior preferred instruments in order to lower their overall funding costs. Since the 2018 law change, Aareal Bank, Berlin Hyp, Commerzbank, Deutsche Bank, Deutsche Pfandbriefbank and DZ Bank have tapped the euro senior preferred market for EUR 7.8bn; some banks also looked at tapping other currencies while new issuers are considering this market.

Scope already assigns separate ratings to the senior unsecured obligations of German banks, with senior non-preferred debt being rated one notch lower than senior preferred debt. “The ratings differential reflects the higher likelihood of regulatory intervention for senior non-preferred debt that is part of a bank’s MREL requirement,” Brandenburg said. On this specific point, Deutsche Bank’s CFO James von Moltke is clear about how he sees senior non-preferred debt: “we think of non-preferred senior as essentially a capital instrument,” he said on the Q1 analyst call.

ISDA ran a German Bank CDS Protocol between 7 February and 26 April to harmonise documentation and reflect changes being made to CDS on German bank reference entities. As of the closing date, 343 entities had adhered to the protocol, whose implementation date is 11 May.

Scope rates Deutsche Bank’s preferred senior-equivalent unsecured debt at BBB+ with a negative outlook, in line with the issuer rating (BBB+, Negative). The bank’s senior non-preferred rating is one notch lower at BBB/negative. Commerzbank’s preferred senior-equivalent unsecured debt is rated A, in line with the issuer rating (A, Stable). Senior non-preferred debt is rated A-. As well as public ratings on Deutsche Bank and Commerzbank, Scope rates two additional German banks on the ISDA protocol on a subscription basis (available through Scope One).

Contracts referencing single-name CDS and index CDS referencing German banks at the senior non-preferred level can now use the ‘European senior non-preferred financial corporate’ transaction type. This includes the 8 December 2017 supplement that recognises three seniority levels for Standard Reference Obligations: senior, senior non-preferred and subordinated, thereby allowing for three levels of CDS trading.

Sensing the interest from clients and counterparties, Deutsche Bank’s group treasurer Dixit Joshi referred to the launch of senior preferred CDS in his presentation on the Q1 fixed-income call. He said that because current CDS referencing senior non-preferred instruments rank junior to counterparty claims in the creditor hierarchy, they overstate the risk to clients and counterparties.

He said the new CDS referencing preferred senior instruments “will bring CDS contracts for Deutsche Bank and other German banks in line with EU and US peers [and] will allow a more accurate reflection of the position in the capital stack for counterparties and clients and will lower the cost for hedging exposures with Deutsche Bank”.

Joshi referred to the costs that clients are incurring in hedging exposure to Deutsche Bank: “looking at the significant current spread between our senior preferred and our senior non-preferred, that is a material welcome development when it goes live on 13 May”.

APPENDIX
German bank Reference Entities within the scope of the ISDA Protocol*
Bayerische Landesbank
Commerzbank
Deutsche Apotheker- und Ärztebank
Deutsche Bank
Deutsche Hypothekenbank
Deutsche Pfandbriefbank
Deutsche Postbank
DVB Bank
DZ Bank
HSH Nordbank
Landesbank Baden-Württemberg
Landesbank Hessen-Thüringen Girozentrale
Landwirtschaftliche Rentenbank
Norddeutsche Landesbank
NRW Bank
UniCredit Bank
Volkswagen Bank

*List originally published 6 February 2019

Author: Keith Mullin: k.mullin@scopegroup.com