Europe's new framework for ensuring no bank is too big to fail passed its first real test June 7, when authorities closed down ailing Banco Popular Español SA, wiping out its bondholders and selling it to Banco Santander SA for a nominal sum. But the swift action by Europe's Single Resolution Board may point to risky "CoCo" bonds being even riskier than thought, and may not be replicable in the bloc's weaker banking systems, such as Italy's.
Santander agreed to acquire Popular for the symbolic price of €1 after the European Central Bank determined that the long-struggling lender was "failing or likely to fail." Popular's existing shares were wiped out, as were its high-coupon, high-risk Additional Tier 1 bonds, which are designed to absorb losses in a crisis situation. In addition, Popular's Tier 2 debt was converted into equity that Santander then acquired.
People pass by a Banco Santander office in Barcelona on June 7.
The head of the EU's Single Resolution Board, Elke König, said the decision had been made to act overnight on a Tuesday, rather than at the weekend as would be more typical, because deposit outflows had reached critical levels, Reuters reported June 7. "Two sources familiar with the matter" told the newswire that some €18 billion of deposits had fled Popular in recent weeks, nearly a quarter of the €79 billion it had as of March.
"It is surprising that a solution was found at such short notice and, in retrospect, this underlines the tense situation at the bank," Matthias Melms, a credit analyst at NORD/LB, said in a research note June 7.
Credit markets shrug off deal; hard questions over AT1s
The sale marked the first time that Additional Tier 1, or AT1, bonds had been wiped out since the creation of the asset class in the wake of the global financial crisis. Such securities can be permanently or temporarily converted to equity or written off if the issuer's capital levels breach certain thresholds, and their coupons can also be suspended by regulatory order.
Yet considering what transpired, the credit market reaction has been surprisingly muted, said Larissa Knepper, a senior analyst for European banks with debt market research group CreditSights. She noted that prices on some AT1s, mostly in the EU periphery, fell by up to a point after the Popular deal was announced, while core names in France, the U.K. and others were down by around half a point.
But by later in the day June 7, most of the market was already bouncing back, with periphery AT1s up to a point higher and core names around a quarter-point lower. The periphery outperforming core "does smack of a small relief rally," Knepper noted.
Yet investors are likely to think seriously about their exposure to risky bank debt, she added.
"Many investors will be sitting and taking a second look, and really thinking about how much appetite they have to buy AT1s, and particularly periphery or smaller bank AT1s," Knepper said. "While the Banco Popular situation has been dealt with incredibly quickly by activating resolution mechanism, the question remains whether we would see some more pain further down the road."
Investors will likely focus in particular on the implications of the Popular rescue for determining the so-called point of nonviability on both AT1s and subordinated Tier 2 debt, said Tom Kinmonth, a fixed-income strategist at ABN AMRO. He noted in an analysis that even theoretically safer "low trigger" AT1s — which typically require a bank's CET1 ratio to fall below 5.125% before being bailed in — may not prove any safer, "if AT1 investors suffer full write-downs before the trigger is reached."
Popular had €500 million of low-trigger AT1s and a further €750 million of AT1s with a 7% CET1 trigger. The bank's common equity Tier 1 ratio was 7.33% on a fully loaded basis at the end of the first quarter, or 10.02% on a "phase-in" basis applying regulations as they stand at present.
Despite the concerns over AT1s, however, there was widespread relief that the EU's bank resolution powers had rather convincingly passed their first test. European stock markets ended the day broadly unchanged, and the STOXX Europe 600 Banks index was up 0.72%.
Even Santander investors were scarcely ruffled, the lender's shares off less than 1% despite the prospect of a €7 billion cash call.
"It's essentially a case of the regulation doing exactly what it was created for," said Laurent Frings, head of credit research at Aberdeen Asset Management, according to the BBC. "But it does show that there is real risk in investing in these second tier names in the banking sector."
"There was a problem in the system, and that problem was fixed, good news," said Francisco González, executive chairman of Spain's second-biggest lender, Banco Bilbao Vizcaya Argentaria SA. Spanish Finance Minister Luis de Guindos described the deal as a "good outcome" for Banco Popular, and also said there is "no danger of 'credit risk contagion' spreading to other banks," The Guardian reported June 7.
Yet although Popular's issues were largely perceived as specific to the bank, rather than as a reflection of the wider Spanish sector, the success of this exercise may not be predictive elsewhere, most notably Italy, Kinmonth wrote. That country is still scrambling for a solution for ailing Venetian lenders Veneto Banca SpA and Banca Popolare di Vicenza SpA, which appear in significantly worse shape, he said.
"The Spanish deal is facilitated by the fact that Banco Popular is actually strong enough to have buyers," he said, adding: "Crucially, the deal could be performed without the need for state assistance, and this is likely to be a reason why the European authorities stepped in so quickly."
By contrast, the balance sheets of Veneto and Vicenza are not nearly as strong, and "it would seem that the large institutions in Italy would be unwilling to take over the banks without the interaction of the Italian state," Kinmonth said.
Regional differences in the regulation of so-called domestic systemically important banks — those not quite as risky as their globally focused counterparts — also persist, warned Benoît Lallemand, secretary general of public interest advocacy group Finance Watch.
The SRB has "proven that resolution can work for a domestic systemically important bank and there is no longer any justification to use taxpayers' money when [such a bank] gets into difficulty," he said in a statement. "But there is no room for complacency. There are some 150 such banks in Europe designated as systemically important, meaning they could trigger a cross-border domino effect if they fail in an uncontrolled manner," Lallemand said.
He suggested that D-SIBs be subject, like their G-SIB counterparts, to EU-level harmonization of capital add-ons and rules for total loss-absorbing capacity, or TLAC, and the minimum requirement for own funds and eligible liabilities, or MREL.