Financial media around the world spent last Wednesday celebrating Banco Santander's purchase of failing Spanish lender Banco Popular, billing it as a successful first test of the eurozone's new system for dealing with failed banks. Known as the "Single Resolution Mechanism," (SRM) it is supposed to be a clear, predictable process for winding down banks without tapping taxpayer funds. When Santander bought Popular for €1 after shareholders and junior creditors were bailed in, markets simply shrugged, leading observers to conclude the system had passed with flying colors. For now, the Banco Popular acquisition does help clear some of the lingering uncertainty over eurozone Financials, and it has clearly helped sentiment-both positive. However, over time, we believe there remain several details to iron out, and we'd caution against presuming the SRM will magically fix the next banking crisis whenever it occurs.
The SRM has been around since 2014, but until now, it remained largely untested. Italy had a chance to use it when determining how to address Monte dei Paschi di Siena and other struggling lenders, but instead the government got special permission to inject state funds into the bank to keep it afloat (a move the European Commission just rubber-stamped June 1). The SRM requires banks' junior bondholders to take losses as part of any formal resolution. In Italy, this was politically untenable since most junior bondholders are retail depositors-normal mom and pop savers-who were sold bonds pitched as safe, high-yield alternatives to a traditional bank account. When a smaller Italian bank failed in 2015, wiping out bondholders, there was a huge public backlash. One saver committed suicide, blaming the bank in his note. This tragedy and the general outcry took a bail-in for the much larger Monte Paschi off the menu.
No such drama surrounded Banco Popular. Consistent with the SRM, shareholders, junior bondholders like contingent-convertible (coco) bondholders and even holders of AT-2 bonds-higher in the pecking order than cocos-were wiped out (depositors and senior bondholders were spared). Instead of injecting capital into Banco Popular to allow it to remain a going concern, regulators brokered its sale to Santander, which is raising €7 billion in new capital to handle Popular's obligations. Spanish stocks ticked down on June 7, the day the deal was announced, but Spanish Financials rose 0.3%.[i] Investors didn't panic, depositors didn't flee banks, and the entire process seemed seamless.
On the surface, this seems positive, and we believe eurozone stocks should overall benefit from the improved confidence it brings. Investors have been preoccupied with eurozone bank balance sheets for years, and having evidence the financial system can handle a large bail-in without experiencing material disruptions is a plus. However, in our view, Banco Popular's resolution doesn't answer some key questions that have surrounded SRM from the start. Here are three main issues that appear to remain outstanding.
According to the ECB's official statement, "The significant deterioration of the liquidity situation of the bank in recent days led to a determination that the entity would have, in the near future, been unable to pay its debts or other liabilities as they fell due."[ii] In other words, the bank was illiquid-it didn't have enough cash on hand or coming in to pay the bills each day. However, we haven't seen any evidence that it was technically insolvent, owing more than its assets were worth. As of Q1 2017, Popular had a Tier-1 capital ratio of 10.02% and 11.9% total capital.[iii] Its €147.9 billion in assets exceeded its €136.8 billion in liabilities-it did not owe more than it owned.[iv] This is the textbook definition of a solvent bank, and it stretches credulity that it would have become technically insolvent merely two months later, particularly as its net interest income and nonperforming loan ratios improved in Q1.[v] Treating illiquid banks as bankrupt even if their balance sheets don't fit the traditional definition of bankruptcy potentially raises more questions than it answers in the long run. Like the next one...
2. Are national central banks still lenders of last resort?
One of central banks' primary responsibilities is providing liquidity to solvent banks that experience a liquidity pinch. Through the ECB's Emergency Liquidity Assistance (ELA) program, illiquid banks can receive funding from national central banks if they post acceptable collateral, making national central banks the lenders of last resort. It doesn't appear Popular used this feature as the end neared this week, and we can't help but wonder why. Do eurozone central banks now consider this type of funding to be a taxpayer bailout? Did Popular simply not have the necessary collateral? Or did Popular not qualify since its large non-performing loan portfolio was such a well-known albatross? ELA has kept Greek banks alive for years, and there were plans in the works to extend it to French banks in the event of chaotic election results in April and May. If central banks aren't free to pump banks with liquidity during the next crisis, that could compound a panic, the opposite of their intent.
3. Will Italy still be considered a special case?
While the Banco Popular bail-in previews how resolutions will work in countries where institutional investors are banks' main bondholders, we still don't know whether the new rules will apply uniformly across the eurozone-including in Italy. If Italy's concerns about retail bondholders prevent further bank bail-ins, investors could start seeing the SRM's decisions as arbitrary and unpredictable. This could also have unintended consequences during the next crisis. In 2008, the US Fed and Treasury seemingly picked winners and losers on a whim, with no apparent consistency. They arranged for JPMorganChase to buy the illiquid Bear Stearns, then forced Lehman Brothers to fail when it was in a near-identical predicament. They brokered sales of several large banks, then quasi-nationalized insurer AIG, wiping out shareholders in the process. The lack of predictability, in our view, made the panic much worse than it would otherwise have been if they had used a consistent playbook. Europe potentially risks similar if SRM is applied haphazardly.
4. How will regulators handle possible unintended consequences on other institutions?
After the bail-in, investors fled Spain's smallest publicly traded bank, worried it would be the next shoe to drop-and resurrecting questions over whether SRM would make bail-ins a self-fulfilling prophecy. While its shares eventually recovered somewhat after market regulators implemented a ban on short-selling it, easing the speculative frenzy, it still shows how the SRM isn't guaranteed to prevent panic. Nothing is, but it is conceivable that if the ECB isn't ready to act as lender of last resort, SRM could serve as a playbook for future bank runs.
In our view, none of these questions should diminish the potential for eurozone Financials stocks over the foreseeable future. They are much longer term and might not come to a head for years or even decades, depending on when the next financial crisis occurs-impossible to know today. So for now, we too can appreciate the immediate reduction in uncertainty, and we think the confidence boost is a positive for eurozone stocks. But we would encourage investors to bear these questions in mind the next time the eurozone must deal with a raft of bank failures.
[i] MSCI Spain Financials daily price return in EUR on 6/7/2017.
[ii] "ECB Determined Banco Popular Español S.A. Was Failing or Likely to Fail," European Central Bank, 7 June 2017.
[iii] 1st Quarter 2017 Quarterly Report, Grupo Banco Popular. https://www.grupobancopopular.com/ES/AccionistasInversores/Documents/Quarterly%20Report%201Q17.pdf
[v] 1Q17 Results Presentation, Grupo Banco Popular. https://www.grupobancopopular.com/ES/AccionistasInversores/Documents/Results%20Presentation%20Fv.pdf
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