Rescue of Spain’s Popular is the start of Europe’s banking test

For more than two years, investors, financiers and regulators have been waiting to see which of Europe’s struggling banks would be the first to test new rules for rescuing failing lenders. Some even wondered if the new regime would work.

Now they have some answers. European regulators took control of Spain’s Banco Popular this week, wiping out the lender’s shareholders and junior bondholders, and selling it for a symbolic €1 to its bigger rival Banco Santander.

The sale was agreed within 24 hours, winning praise for how swiftly the eurozone’s relatively new regime for failing banks dealt with Popular’s problems without using taxpayer funds and leaving depositors and senior bondholders unscathed.

Yet some investors and analysts argue that Popular does not represent a true test of the system because it was sold before a full resolution — the process by which the authorities can intervene to manage the failure of a bank, including imposing losses on depositors and senior bondholders.

Others point to tougher challenges ahead for the still nascent regime from problem banks in Italy — where two banks in the Veneto region of north-east Italy need rescuing — as well as in the UK and Portugal.

“The big question is when is there going to be a real application of the resolution framework in Europe,” says Claudio Scardovi, co-head of financial services at restructuring adviser AlixPartners. “I’m seeing a lot of appetite [among regulators] to test if the new architecture works.”

While shareholders in Popular lost everything and its €2bn in junior bonds were wiped out, there has been little sign of contagion in either equity or debt markets.

“It was done overnight under strong time constraints,” says Valdis Dombrovskis, the EU’s financial regulation chief.

“We believe this test is passed with success,” he adds, noting that the bank had been able to “fully continue its business activities”.

Elke König, chair of the Single Resolution Board, the new body for dealing with failed eurozone banks, says: “This shows that the tools given to resolution authorities after the crisis are effective to protect taxpayers’ money from bailing out banks.”

But there are still worries that the congratulatory backslapping that greeted the transaction is premature. Questions are emerging about why regulators were not quicker to spot the impending crisis at Popular or to push it to raise capital earlier.

Since EU authorities and Italy agreed a deal to allow a state bailout of Banca Monte dei Paschi di Siena last week, the focus has shifted squarely on to the plight of two banks in Italy’s north east: Banca Popolare di Vicenza and Veneto Banca.

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If European authorities and Italy fail to come to agreement by the end of this month — which they have failed to do after months of talks — the banks risk being put into resolution, say people directly involved.

In the UK, the Bank of England is also closely watching the Co-operative Bank, which is seeking to raise £750m by issuing new shares and imposing losses on bondholders, without which the regulator could put it into resolution.

While the UK is outside the remit of the new eurozone regime, it is still subject to the EU’s Bank Resolution and Recovery Directive (BRRD), which stipulates that 8 per cent of a bank’s liabilities — including bondholders and uninsured depositors — need to be wiped out before taxpayer money can be used to rescue a bank.

This means that the Co-op Bank’s existing bondholders are likely to invest enough in the lossmaking lender to avoid being wiped out in a resolution process, according to bankers involved in the negotiations in the UK.

In Portugal, meanwhile, the central bank has agreed a deal to sell control of Novo Banco, the lender rescued two years ago from the ashes of Banco Espirito Santo, to US private equity investor Lone Star.

But the deal requires its senior bondholders to suffer more losses on top of those stemming from a previous restructuring. They are now trying to block the deal, which could leave Novo Banco needing a resolution by European authorities.

Filippo Alloatti, senior credit analyst at Hermes Investment Management, says that while the Popular deal was “draconian” for investors, it provided “a blueprint” for how Europe will handle failing banks in the future.

Both Novo Banco and the Co-op bank have limited amounts of junior debt available to absorb losses, meaning that any full resolution is likely to hit both senior bondholders and uninsured depositors of more than €100,000 or £75,000 respectively.

This would make the process much more politically sensitive. For instance, many of the Co-op Bank’s biggest depositors are charities, mutual groups and other co-operatives — hardly ideal groups to absorb losses in a bank resolution.

In an effort to avoid this scenario, regulators require European banks to raise special debt that can absorb losses before deposits are hit in a crisis. The problem is that at the start of this year, they still needed to issue €276bn more of this so-called MREL — or minimum requirement for own funds and eligible liabilities — according to the European Banking Authority. But analysts worry that smaller, riskier banks will find it prohibitively expensive to issue the new debt.

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Mathias Dewatripont, an academic who was Belgium’s representative on the board of the European Central Bank’s Single Supervisory Mechanism, says that wiping out deposits as part of a bail-in solution is “really very dangerous”.

The EU needs to make sure its banks issue enough lower-ranking debt that can be bailed in ahead of depositors, he says, adding that he was not commenting on the situation of specific banks.

Other short-term options include copying Germany’s approach of giving deposits greater protection from losses than senior bondholders, or temporarily relaxing the 8 per cent rule set out in the BRRD, he adds.

In the case of the two Italian banks, there is a further complication because many of their senior bondholders are retail investors who have put much of their life savings into the securities, attracted by their higher yields over sovereign bonds, making it politically unpalatable to wipe them out.

Europe’s new system for saving its struggling banks has passed its first test with the rescue of Popular but greater challenges await. “We analysts thought this [European failed bank regime] would never work, but it turns out that it can work quite well,” says Mr Alloatti at Hermes. “The real question now is what happens when you need to bail in senior debt and even deposits — that is the real read-across from Popular.”

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