I was flipping through a report from the Bank for International Settlements (BIS) recently (ht Torsten Slok) and came across this fascinating six-pack of charts:
The charts show how much banks have had to pay in interest on their senior, subordinated, and guaranteed debt, relative to the interest rates of comparable government bonds. For example, the chart shows that banks in the United Kingdom have recently had to pay about 250 basis points (i.e., 2.5 percentage points) more on their senior debt than the UK government pays on its debt.
There are many interesting stories spread across these charts. For example, the red lines suggest that the first wave of investors in guaranteed bank debt in the United States and France did well for themselves (since the decline in yields implies an increase in bond prices).
But the thing that really caught my eye was the behavior of the senior debt (green) and sub-debt (blue) lines. In the five European countries, you see what you might expect: the sub-debt trades at a higher spread than the senior debt. That makes sense, since the sub-debt faces greater risk of losses. Investors demand compensation — a higher yield — for bearing that risk.
And then there’s the United States.
According to the chart, the spreads on senior debt and sub-debt are almost identical. In other words, investors are acting as though senior debt and sub-debt have equal risks for U.S. banks.
What’s going on?
Whenever two economic variables appear out of whack, you should always ask which of them seems most culpable. In this case, for example, do the spreads mean that investors perceive that the sub-debt in U.S. banks is almost as safe as the senior debt in those banks? Or that investors perceive that the senior debt in U.S. banks is almost as risky as the sub-debt in those banks?
I posed this question to some financially savvy friends, and they favored a combination of the two explanations, but leaning toward the second:
- The chart indicates that the spreads on senior bank debt have been higher in the United States than in any of the five countries (e.g., the U.S. spreads have recently been around 300 basis points, while those in the Netherlands have been around 200 basis points). That implies that investors see more risk in U.S. senior bank debt.
- However, the chart also indicates that the spreads on U.S. sub-debt are relatively low. The U.S. spread is a bit more than 300 bp, much lower than the spread in Germany (700 bp) or United Kingdom (500 bp), but a bit higher than the spreads in France (about 225 bp). This implies that investors see more risk in the sub-debt of many European banks than they do in the sub-debt of U.S. banks.
In principle, one of the benefits of sub-ordinated debt is that it can provide a market-based signal of bank’s financial health. Because they are more likely to get wiped out — and less likely to be bailed out — investors in the sub-debt have more financial incentive to act as an early warning system than do investors in senior debt.
That system appears to be alive-and-well in Europe. For example, the sub-debt markets are signaling significant challenges for German banks.
In the United States, on the other hand, that system has ceased functioning. A full autopsy is beyond my scope today, but suffice it to say that debt holders in U.S. banks have not always received consistent treatment during the financial crisis.