BES: A nasty New Year’s resolution
The principle of pari-passu among bondholders lays dead and buried. The Bank of Portugal’s decision to select only five of Novo Banco’s 52 senior bonds for bail-in last week has established a new precedent for bank resolutions, and what a fine mess it has created.
In the aftermath of the financial crisis, regulators worked on establishing a clear resolution hierarchy. Depositors and covered bonds get top preference when a bank gets into trouble, followed by so-called senior, then tier two, additional tier one notes, and then the equity.
When a bank goes into resolution, creditors expect equal rights with others at the same level of the capital structure.
Imagine, then, the surprise of investors who checked their portfolios last week to find that five senior bonds, plucked from 52 bonds meant to receive equal treatment, could lose almost all of their value.
The bonds were rescued from the failure of Banco Espirito Santo (BES) in 2014 and transferred to become obligations of the "good bank", Novo Banco, which returned to health with a rescue from Portugal's resolution fund.
But the Bank of Portugal decided to transfer five of them back again, in the last days of 2015. The bonds immediately lost 80% of their value, as the handful of assets left in BES are unlikely to cover their redemption.
The original decision to resolve BES through a good bank / bad bank split gives the regulator the express right to move assets and liabilities between the old bank and Novo Banco, so it's hard to argue it acted unlawfully (though investors will surely try).
But choosing to target such a small set of bondholders has led to outrage and confusion. It may not be unlawful, but it certainly seems unfair.
Investors are now asking what the Portuguese resolution authority stands to gain from picking on the five, ahead of Novo Banco’s 47 other senior bonds.
The authority was left some €4.9bn out of pocket when BES was recapitalised in 2014 and may be keen to recoup the loss through a sale of the bank. But the sale process fell through in the autumn, while the 2015 stress tests identified a €1.4bn capital shortfall.
The bank had a plan to fix the shortfall with asset sales, but burning some bondholders raises capital faster, and may boost the eventual sale price.
Some argue that it was driven by politics, rather than the sale process. All five bonds selected for transfer carried a minimum denomination of over €100,000, so retail investors won't be hurt.
After recent events in Italy, where the collapse of four small banks led to the suicide of a pensioner whose life savings where wiped out in the chaos, avoiding risks to retail has to be uppermost in the minds of regulators.
Indeed, a distinction between the rights of retail and institutional lenders already exists in deposits, where retail enjoy the benefits of a state guarantee while corporate deposits risk bail-in.
But as soon as a regulator starts to preference some bondholders over others, without any contractual basis, and without any advance warning, it loses credibility, increasing funding costs for every institution it manages.
The problem deepens when you consider that many of the investors with positions in the stricken assets moved in after the failure of BES, buying into the Portuguese recovery story.
They were not bondholders who lent money to BES, the mismanaged and partly fraudulent basket case; they bought bonds which were obligations of the clean and recapitalised Novo Banco (perhaps overlooking the regulatory right of reversion).
The tools handed to resolution authorities to deal with failing banks are extensive, but they can undermine the very financial stability they are supposed to protect. Now, in 2016, all the resolution authorities in Europe can bail-in and burn bondholders at will, but they must use these powers sparingly and with good judgement.