FITCH: EU BANK SUB-DEBT AND RETAIL BUYERS - RISKS OUTWEIGH BENEFITS

Some EU banks are still selling their own subordinated securities to their retail customers even after retail investors were bailed in when Spanish banks failed in 2012. Conduct risks could far outweigh the benefit of raising debt in this way, says Fitch Ratings.

This is because reputational damage, and possible misconduct fines, could be significant if retail customers were able to argue that risks were not properly explained to them when they invested in the securities. Subordinated and senior debt carries a higher risk of bail-in now that the EU's Bank Recovery and Resolution Directive, passed at the outset of 2015, provides an effective resolution regime for banks.

Italian, Spanish and Portuguese banks have long sold debt instruments to retail customers through their branches. In the build-up to the financial crisis, increasingly complex securities were also distributed in this manner. Italy's retail bond market has grown into a significant funding source for Italian banks. Retail investors primarily buy bank senior unsecured debt but also invest in subordinated issuances.

Europe's three supervisory authorities, the EBA, ESMA and EIOPA, warned banks against "self-placement" of loss-bearing financial instruments to consumers as far back as July 2014.

The introduction of the EU's Capital Requirements Directive (CRD) IV has made it more onerous to issue subordinated debt that benefits from regulatory capital recognition to retail clients and these instruments are less attractive for such investors. But EU-wide regulation to prohibit the distribution of bail-inable securities to retail customers does not appear to be on the cards, although some jurisdictions, notably the UK, prohibit the practice.

Spanish retail investors in failed banks lost money, notably the holders of roughly EUR6.5bn BFA-Bankia bailed in preference shares and subordinated bonds. Portuguese retail investors also suffered losses when they bought around EUR6bn senior securities sold through BES' branches. The securities, allegedly fraudulently packaged to look like BES debt, consisted of commercial paper issued not by the bank but by Espirito Santo group companies. Exposures to many of these companies were left in the "bad bank", and bailed in following official intervention of BES in August 2014.

Bank branches in Spain have not distributed debt securities to retail customers recently but subordinated debt was sold to Italian retail clients through branches of UniCredit (EUR2.5bn in 1Q15) and ICCREA Banca (EUR200m in 1Q14). These instruments have no mandatory conversion features but are inherently higher risk than senior securities. We notch down from the Issuer Default Rating in rating subordinated debt.