Banco Popular process is a model for failing banks

The credibility of Europe’s banking sector — both the solidity of the lenders themselves and the effectiveness of the institutions that regulate them — has been in question for much of the past decade. In the eurozone crisis, banks were bailed out by governments in Spain, Portugal, Ireland, Greece and Cyprus, at massive cost to taxpayers.

Shocked by the scale of that crisis, the EU drove reform. It set up a new Single Supervisory Mechanism under the auspices of the European Central Bank to regulate eurozone banks, and pushed for the creation of the Single Resolution Board, which could wind up, or “resolve”, failing banks.

The banking system has continued to struggle for profitability amid high levels of bad debts across much of the southern eurozone. But under pressure from the SSM, and a regime of stress testing, capital buffers have been increased, reassuring investors.

Until now, however, the system has not been severely tested. Several Italian banks, including Monte dei Paschi di Siena, and two Veneto lenders, have been limping along for years without the EU authorities being able to force through decisive rescues.

With expectations low, it has been encouraging that the potentially fatal problems of Spain’s Banco Popular have been dealt with smoothly by the authorities. Early on Wednesday, Popular was put into regulatory “resolution” and sold off for €1 to local rival Santander, containing a potential crisis swiftly and relatively painlessly.

Popular’s problems have been mounting for months as new management got to grips with a weak balance sheet stuffed with non-performing property loans. New capital or a new owner were vital but unforthcoming. By this week, with no commercial buyer evident, panic had set in among the bank’s customers, and deposits were fleeing. Worse still, after tapping emergency liquidity lines from the Bank of Spain on Monday and Tuesday, Popular had virtually no collateral left on its books to support further central bank credit lines.

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The way the European banking authorities handled the affair has clearly enhanced their credibility. Nevertheless, there is no cause for complacency. The SSM is open to criticism that it allowed a situation to develop gradually at Popular, which then necessitated sudden, dramatic intervention.

The monitoring system of stress testing once again appears to have been poor. Popular came fifth from the bottom of last year’s regulatory stress test of more than 50 European banks. Its headline core equity capital ratio halved when an “adverse scenario” of macroeconomic stresses was applied to its balance sheet.

But it was not red-flagged for special attention. The test reflected the inflated asset valuations of the old management team, undermining the results and suggesting regulators’ data gathering should be more rigorous.

The other lesson to learn is around the transparency of the resolution process. Though such work must be discreet and swift, openness after the event would engender trust, particularly among investors whose bonds can be wiped out in resolution. Disclosures should cover why the process was triggered and how the valuation — in this case a negative €2bn — was arrived at.

It is right that investors, rather than taxpayers, should bear the brunt of a failing bank. And it is encouraging that the European structures have proved fit for purpose. But to retain credibility, the process must be clear and predictable, and applied consistently across different markets. Italy’s two failing Veneto banks will provide the next test.