* Senior debt in spotlight following Cyprus bailout agreement
* Haircutting retail depositors seen as major issue
* Weaker lenders could face market lockout
By Christopher Whittall and Natalie Harrison
LONDON, March 19 (IFR) - Weaker financial institutions in Europe's periphery that had begun to see primary markets edge open for them could see that door slam unceremoniously shut as the market reassesses the risk to senior debt in the wake of Cyprus' plans to haircut savers.
The market reaction to Cyprus' bailout agreement has so far been pretty muted compared to stressed periods over the past couple of years. Peripheral bond yields retraced somewhat after initially widening, and the Senior Financials index only pushed out 11bp this week to 154bp.
But bankers warn the huge volumes of cash swirling around the system could be papering over the cracks.
Investors are concerned the rule book for sovereign and bank restructurings has been thrown out the window and replaced with a whatever-it-takes mentality from policymakers, where everything from senior bank debt to retail deposits is at risk.
This could further exacerbate the divide in weaker countries between national champions and second and third tier lenders, which could again find themselves locked out of primary markets.
"If you are a bank in a weak country, and you're non-SIFI, then deposits are at risk," said one FIG banker.
"This will just accelerate the process that we've already seen where big national champions get even bigger, while business models for second and third tier issuers just don't work. If their deposits are not safe, they will have to run such huge capital levels that they just will not be able to compete on the asset side."
DRAWING THE LINE
The 6.75% tax on all depositors below EUR100,000 - aimed at softening the blow on high net worth Russian depositors - is what really spooked the market. Cyprus has since adjusted its stance and is now seeking a 3% tax on deposits under that amount.
Eurozone leaders had previously indicated deposits under EUR100,000 would be protected in bank bail-outs. Analysts at BNP Paribas wrote that riding roughshod over this assumption represents a "dangerous and negative outcome". Senior bank paper could be particularly hit "on the basis that if deposits below EUR100k are not safe, neither is senior."
"People might say Cyprus is an isolated case, but where do you draw the line? Up until the weekend the EU said deposits of up to EUR100,000 would be protected. It's very difficult to say what the impact is going to be," said another FIG syndicate banker.
"Some of the second and third tier banks in Italy and Spain will become under pressure again - and bear in mind the market had only recently reopened for them."
IGNORING THE RISKS
Given the severity of the depositor tax, and the risk that this poses for senior bondholders, it is surprising that the sell-off has been so tame. Even more so when politicians in Germany, Finland and the Netherlands have been so vocal on senior haircuts.
As is usually the case, weaker peripheral institutions are bearing the brunt of any risk-off sentiment.
CDS on Monte Dei Paschi has widened 36bp to 580bp since the start of the week, according to Markit, while protection on Banco Popolare has moved out 34bp to 503bp. Traders say this could be a sign of things to come.
"It's very clear the market is not reacting enough - there's a lot of complacency," said one credit hedge fund manager.
"Until people in Spain and Italy start queuing outside weaker banks and moving deposits to stronger ones, we won't see an impact, and at that point it'll be too late."
The Cypriot government had to weigh up a series of unpalatable options when constructing its bailout agreement. Its outstanding sovereign debt is less than EUR4bn, much of which is subject to foreign law and so could not be restructured cleanly.
Meanwhile, its domestic law bonds are predominantly held by Cypriot banks, making any bail-in self-defeating.
While subordinated bondholders in Cypriot banks will be bailed in - reinforcing the precedent set by Dutch lender SNS Reaal last month - EUR1.7bn of senior paper remains untouched.
Analysts at CreditSights wrote in a report that this may be because there wasn't enough senior debt to make much difference, and highlighted there could have been legal obstacles as well. Instead, the government took aim at depositors in an effort to raise EUR5.8bn.
"The fact is, the situation in Cyprus is fundamentally very serious. We were told that the Greek PSI was a one-off, and that Cyprus is also very unique, but what is to stop other countries from doing something similar?" said the DCM banker.
"Anyone can do this. All the talk around regulatory rules on bail-in becomes irrelevant." (Reporting By Christopher Whittall and Natalie Harrison; editing by Alex Chambers and Julian Baker)