How does EU move to protect deposits impact bondholders?

Last week, European regulators took another step in their long journey towards a single European banking regime, otherwise known as “banking union”.

As a recap, after the global financial crisis, European Union (EU) regulators embarked on a process to integrate the bloc’s banking sector and reduce cross-border differences. By transferring certain aspects of banking regulation from local to EU level, the idea was to encourage harmonisation in the region’s notoriously fragmented industry with the aim of creating larger, more resilient banks whose credit quality would be less tied to that of their respective domestic governments. This would ease the flow of funds across Europe and improve access to credit for the real economy.

Last week’s adoption of amendments to the EU Bank Recovery and Resolution Directive (BRRD), which introduced depositor preference vis-à-vis senior unsecured obligations across all EU member states, is the next major step in a banking union that has effectively remained incomplete since the European Central Bank became single supervisor to all EU banks in November 2014.

Under the new framework, all deposits – regardless of size – will rank above ordinary senior unsecured claims, a material structural shift from the previous regime in which non-guaranteed deposits were treated as ordinary unsecured claims ranking equally with banks’ senior unsecured bonds in some jurisdictions. Previously, insolvency treatment of non-guaranteed deposits varied across member states, creating inconsistencies in creditor hierarchies and scope for regulatory arbitrage. As per EU rules, this new directive will need to be transposed into domestic law over the next two years, at which point it will take effect in the individual jurisdictions.

Implications for banks, and bondholders?

Depositor preference is a significant shift given deposits are widely regarded as a critical determinant of a bank's standalone creditworthiness. Deposits represent not only an important and stable source of funding, but a key pillar of confidence in the banking system which becomes especially relevant in times of market stress. Therefore, the greater protection of deposits in the creditor hierarchy should help reinforce depositors' confidence and reduce the risk of future bank runs.

Specifically, the change strengthens resolution credibility by protecting deposits from losses, making outcomes more transparent and predictable if or when an EU bank runs into trouble. Deposits can now be transferred intact to acquiring banks or bridge institutions, helping preserve customer relationships and operational continuity during resolution.

Clearly, the move also reduces recovery prospects for senior unsecured bondholders, who would expect to absorb higher losses in a failure scenario. In response to the directive, Moody’s last week upgraded deposit ratings and downgraded senior preferred ratings across the EU banking system (see Exhibit 1).

For holders of subordinated Additional Tier 1 (AT1) and Tier 2 bank debt, we do not see a direct impact. Ultimately, changes to the expected recovery values of different types of senior debt do not necessarily change the expected recovery values of subordinated claims. In the case of AT1 bonds, we have always assumed that recovery rates in cases of severe trouble would be close to zero anyway.

That said, at the margin it is fair to say all bank bondholders will benefit indirectly from the reduced risk of deposit flight that comes with depositors’ greater confidence in the safety of their deposits, and the positive impact that has on the broader financial stability of the banking system.