The FIG Idea: assume the recovery position
When Banco Popular lost the market's confidence, it ran out of road. Realistic assumptions for recovery rates on bad assets plunged to super-conservative levels. Confidence is the greatest form of solvency, its withdrawal a precursor to insolvency.
At the start of the novel Anna Karenina, Tolstoy famously observes that “All happy families are alike; each unhappy family is unhappy in its own way.” It’s the same with banks. The generalisations that we can make about healthy banks tend to fall apart when a bank gets into trouble.
That’s why Banco Popular’s resolution on June 6 confused a lot of people.
Some market assumptions about the viability of the bank didn’t match the views of the European Central Bank, which pulled the plug on the bank and set in train the rapid resolution process that led to shareholders and hybrid capital holders being wiped out and Popular being handed to Santander to be assimilated and recapitalised.
A valuation shock is about time and confidence, two concepts inextricably linked when it comes to bank solvency. The value of a bank depends on the timeframe that one has available. When confidence is high, it’s fine to look at the long run. But if people get the jitters, only the near term matters.
When the timeframe shortens, the bank’s franchise value — the present value of estimated future profitability and the most important source of economic solvency — plummets. The chances of any bad debt hole being filled with future profits recedes.
Confidence is the single most important ingredient in banking. Without confidence, banks can’t perform their role of maturity transformation and they can’t run decent levels of risk in their loan books. Without confidence, banks just don’t work.
Provisioning levels rely on confidence, too.
To paraphrase Tolstoy: “All happy banks can be provisioned at the right level; each unhappy bank needs to be provisioned in its own way.” From industry experience, we can estimate realistic recovery assumptions for going concern banks. If the timeframe is shorter, the margin of error needs to be greater.
In Popular’s case, the numbers are tragic. Despite massive levels of provisioning financed by profits over several years, and a rights issue in 2016, Popular’s bad loan book hovered stubbornly around €20bn. Its acquirer, Santander, is taking a €7bn provisions charge on Popular’s assets, which boosts the coverage from 45% to 69%, well beyond the industry average of 52%.
The new owner is being conservative and looking to sell down the problem assets as rapidly as possible. The recovery assumption needs to be reduced and the provisions coverage needs to rise. It’s Economics 101 — selling quickly means a lower price.
In this case, the difference in confidence equates to boosting provisions coverage by half. That’s a huge difference and it represents the value of confidence. Once confidence in Popular had evaporated, it needed billions of euros of provisions to be deemed attractive as an acquisition — and then at a price of only €1.
With confidence restored, the tipping point can be reversed and the failed bank can be given a new lease of life.
The franchise value becomes once more a source of economic solvency as the timeframes extend. In effect, medium-term profits can again be used to absorb losses. The level of conservatism on asset recovery rates can be reduced as the timeframe for work-out becomes more relaxed and system-wide resilience increases.
Market players would do well to consider the forces at work here.
We should be surprised neither by the protracted nature of zombie banks’ zombiness nor by the suddenness of their failure, if that is their fate.
We should remember that reported solvency metrics can sometimes belie a latent and potentially hefty valuation adjustment, which coverage benchmarks don’t really describe. And we should heed Tolstoy’s wisdom in recognising that there will always be different levels of recovery assumptions for bad loan books at failing banks.
All this may seem terribly confusing and unfair. There are dangers and opportunities alike.
Some will enjoy good returns on sage, brave or lucky judgements. Some will inject the confidence and stability that enables higher recoveries and franchise values, reaping the rewards.
Others will suffer in the instances where they misinterpreted the level of confidence in a struggling bank and got stung — or were simply too rosy on recovery assumptions.
Clearly, there will be winners and losers: that’s the name of the risk game. To quote Tolstoy’s insight from Anna Karenina again: “All the variety, all the charm, all the beauty of life is made up of shadow and light.”
The FIG Idea is written by a market participant with more than 20 years' experience working on the financing of financial institutions