Theme for 2018: Children of the resolution — lessons from Banco Popular

Banco Popular’s failure is likely to go down as a successful first case for the Single Resolution Board, but the process has raised big questions about transparency, liquidity support and capital. Learning from these issues is going to be crucial for the future of European bank supervision. Tyler Davies reports.

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A decade after the financial crisis, Europe’s shiny new bank resolution regime has been put through its first real test.

The framework was the region’s response to one of the most important questions prompted by an extraordinarily costly bailout of the global financial system after 2008 — how can a bank fail or be turned around without causing widespread economic disruption, and without taxpayers having to foot the bill?

In many ways, Europe has passed this test with flying colours. 

On June 6, the European Central Bank told the Single Resolution Board (SRB) that Banco Popular, a Spanish financial institution, was “failing or likely to fail”. The SRB, alongside the Spanish National Resolution Authority, then effectively wrote off the value of all the bank’s subordinated bonds and equity and oversaw its sale to Banco Santander for €1.

This process took less than a day, there was very little contagion to the rest of the banking sector, and there was no need for any support from the public pocket.

But the first major trial of Europe’s Bank Recovery and Resolution Directive (BRRD) was hardly an unambiguous success. The experiences with Popular have raised very important questions about how to deal with a failing bank, with different consequences for regulators, investors and bankers alike.


What’s in a number?

Perhaps the most serious contention is whether or not the SRB’s intervention was in breach of EU law.

The transition from bail-outs to bail-ins was always going to be controversial. Resolution regimes have created extraordinary powers to restructure and write down bank securities, chipping away at the property rights of the investors that hold them.

But Popular’s resolution has provoked an exceptional number of lawsuits, with more than 50 claimants looking to challenge the way in which authorities dealt with the bank. 

“Even if the Banco Popular lawsuits are not successful, it does not look good to have a large number of claims being launched,” says Jeremy Jennings-Mares, a partner at Morrison & Foerster in London. “It suggests that there might be merit, even if there is not.”

Much of the interest from claimants has revolved around the way in which the bank was valued before being put through the resolution process.

The BRRD rests on the principle that no investors should be made worse off in a resolution than they would have been had the bank been liquidated. So if someone were able to prove that there was enough value in Popular’s assets for it to have paid back some of its liabilities, it would seriously undermine any rationale for wiping out all the bank’s subordinated debt.

“The valuation is the starting point that justifies the entire resolution procedure, so it’s a really critical issue,” says Fernando Mínguez Hernández, a partner at Cuatrecasas in Madrid. 

“It is not so much about the number itself, but the assumptions behind that number. That’s what you actually have to test and eventually challenge. It is the only way to construe a sensible case.”

The independent expert reports suggest that there was some degree of uncertainty about this valuation. They estimated that the bank had an economic worth of between minus €2bn and minus €8bn, which is quite a wide range.

Aggrieved investors have been particularly keen to get a hold of the valuation report prepared by Deloitte, and have filed a number of requests for the document to be made public. But the SRB has so far refused to give further details about its reasons for putting Popular through a resolution.

None of this has gone unnoticed by the European Parliament. It has called on the SRB and the European Commission to provide more transparency in future resolution decisions, because it is starting to worry that the high number of legal applications surrounding Popular could “endanger the effectiveness” of the region’s resolution framework.

“You need transparency for people to have confidence in the way the BRRD works,” says Jennings-Mares. “The less transparency there is, the more suspicion people will have that they are not being told something.”


The liquidity puzzle 

But Popular’s demise was also a wake-up call for some investors, who were looking the wrong way when the SRB intervened in early June.

Everyone was aware that the bank’s capital position had been under pressure for months. It was facing increasing demands to raise provisioning levels on its large book of non-performing loans.

Some market participants nonetheless took comfort in the fact that Popular’s last reported common equity tier one (CET1) ratio had been well above its regulatory minimums. They were therefore blindsided by the resolution decision, in which the SRB made no mention of capital ratios when explaining its actions, citing Popular’s “stressed liquidity situation” instead.

This was a surprise. Banks have had access to almost unlimited liquidity since about 2011, when authorities started to expand the range of assets they could pledge as collateral for the ECB’s main refinancing operations.

So it might have seemed reasonable to discount the idea that liquidity problems could tip Popular over the edge, even as press reports suggested that major depositors were taking their money out of the bank.

Hernández says the Popular case should therefore prompt further discussion at the EU level about bank liquidity.

“There is something puzzling here,” he says. “A bank that is fundamentally solvent should have access to liquidity, either by recourse to ordinary provisions or by recourse to emergency liquidity assistance. This is what the rulebook says. So the idea that a solvent bank can be resolved overnight due to a liquidity crisis is conceptually challenging. 

“In practice, however, the line between a solvency crisis and a liquidity crisis is really thin, if it exists at all.”


Going, going, gone

There is less confusion about what happened after the SRB had decided that a resolution procedure was appropriate.

The BRRD describes a hierarchy of losses — equity investors should take the first pain, followed by additional tier one (AT1) bondholders, tier two investors and holders of the bank’s senior debt, in that order. And this is exactly the approach the SRB followed when dealing with Popular.

Seeing authorities apply the BRRD’s conversion powers for the first time has nonetheless changed the way investors think about the risk of losing money in bank debt instruments.

For Daniel Björk, a senior portfolio manager at Swisscanto Invest in Zurich, it was a clear reminder that banks are highly leveraged institutions. “When it goes wrong for them,” he says, “it typically goes very wrong.”

There has been a lot of focus on the fact that Popular’s AT1 and tier two bonds were effectively treated in the same way, despite radical differences in their terms and conditions. 

AT1s are designed to make sure that financial institutions could absorb losses while they are still a “going concern” — before they have failed. Tier two, on the other hand, is defined as “gone concern” capital. It can be written down only when a bank has reached a point of non-viability.

But there was little distinction between the different layers of capital when Popular was put into resolution in June, blurring the lines between the notion of “gone concern” and “going concern” instruments.You would have lost 100% of your investment in the Spanish bank, had you been holding either its AT1s or its tier twos.

Björk says these developments should not be too surprising for market participants.

“With the new banking regulations, we see on the one hand that loss given default has increased across the whole banking sector, but at the same time that the probability of default has decreased,” he says. “It is much lower today than it was 10 years ago.”

Mastering new tools

Even so, Popular is hardly likely to be the last financial institution to be wrung out through Europe’s new resolution regime.

Some corners of the market have been quick to contrast Popular’s demise with recent experiences in Italy — where no bank has yet suffered a resolution at the hands of the SRB, and taxpayers have been called upon to support struggling lenders. 

But Hernández cautions against drawing a straight line between what happened with Popular and what might happen with other banks in the future.

“The Banking Union has not necessarily simplified things,” he says. “It is a very complex set of arrangements.”

Hernández adds: “Different countries have different degrees of control over the banking sector and Spain is quite an extreme case. Because of the concentration process that took place before 2012, banks in Spain are so big in relative terms that virtually the entire system is under the control of the ECB and the SRB. That is not necessarily true in Italy or in Germany.”

There are lessons to be learned from the Popular resolution, however, and market participants should be focusing on the negatives as well as the positives.

The BRRD is an extremely powerful toolbox for fixing problems that simply cannot be dealt with in open market transactions. It is critical that everyone is clear on how it may be used.