During the financial crisis, political and financial authorities were back against the wall when facing the global deterioration of the financial sector. When a bank was about to default, two options were on the table: either let them fail with (often) unpredictable consequences on the financial and real economy, or rescue them using taxpayer money. The EU country members were not aligned in their choices, taking sometimes inconsistent decisions. In any case, when the second option was chosen, it resulted into durable reputation damage.
In the aftermath of crisis, the European Financial Stability Board worked on a better approach, trying to escape the “too big to fail” situation. It resulted in two directives that lay the foundations of the single rulebook to harmonize bank resolution: The Bank Recovery and resolution Directive (BRRD) and the Deposit Guarantee Scheme Directive (DGSD). These directives allow national or European authorities to start a resolution process for a bank. Resolution is defined by the application of a plan to deal with a bank’s insolvency while safeguarding public interest and limiting the impact on the economy.
Single Resolution Mechanism : One mechanism to rule them all
The final step to complete the creation of the Single Resolution Mechanism was the establishment of the Single Resolution Board (SRB) in Brussels, that supervises the National Resolution Authorities (NRA). The SRM is one of the 3 pillars of the banking union, alongside with the Single Supervisory Mechanism , and the European Deposit Insurance Scheme (EDIS).
The primary role of the SRB, and the NRAs, is to anticipate crisis by drawing up resolution plans and work in collaboration with banks on how to improve their resolvability. It differs from the role of supervisory authorities that seek to improve a bank’s solvability. Resolution plans must follow a series of principles listed below. The target of these principles is to ensure that shareholders, creditors and public interest are considered with the adequate priority. Basically, it limits the use of public funding to rescue banks that are too big to fail: shareholders and debtors should be impacted before taxpayer money is used.
When the ECB and the SRB jointly determine that a bank is failing, the board steps in to determine the best approach to safeguard public interest. It considers whether the bank recovery plan or any private initiative could restore solvability, and if the resolution is in the public's interest. If the conditions are met, then the resolution plan is initiated by the application of one of the tools described below, and /or the provision of emergency liquidity from the Single Resolution Fund (SRF). If not, the bank is put into liquidation according to national insolvency proceedings.
The SRF is funded by levies on European banks and allows the SRB to provide emergency funding from bank contributions instead of public money. It also sets a European level playing field when it comes to emergency liquidity provision.
A last tool the SRB has in its arsenal are Additional tier-1 (AT1) hybrid securities, also called Contingent convertible bonds (Coco). These are hybrid securities that can be converted into shares when the issuing bank's capital ratio falls below a certain threshold. This makes CoCos the riskiest type of debt a bank can issue, just behind shares. Even if Cocos are not per se in the SRM toolkit, we will below see how they act as an additional buffer to absorb losses in case of need.
How Europe's SRB handles bank failures : practical cases
Now that we have outlined the theory, let’s see how this translate into real cases. Fortunately, bank defaults are not common: only 3 defaults recently occurred in the European financial sector: Banco Popular Espanol, Veneto Banca & Banca Popolare di Vicenze. Though these few cases already show the strengths and weaknesses of the single resolution mechanism.
The Banco Popular case
On 6th June 2017, the ECB notified the SRB that Banco Popular (BPE) was failing or likely to fail (FOLTF). The liquidity of the bank had been severely deteriorating since the beginning of 2017 because of material cash outflow across all customer segments and rating downgrades. It is worthy to note that, while the Liquidity ratio requirement of 80% was breached, the capital ratio was still well above the regulatory requirement.
6 Months earlier, during the preparation for a potential resolution, the SRB noted that, given the volume of deposits and customers, a liquidation of BPE would impact significatively the real economy and Spain's financial system. At that time, an independant assessment of the economic value of BPE under a normal insolvency proceedings resulted in an estimate of -2 Bln €. So when the FOLTF notice was issued, everything should have been in place to start the resolution by the SRB.
But, the anticipative resolution plan SRB regrettably focused on a scenario where the capital situation of the bank was deteriorating. In June 2017, BPE was facing a different scenario of liquidity shortage. So the SRB had to improvise and applied a different plan, using the sale of business tool (see above). The point of resolution planning is exactly to prevent rushed decisions under a failure event. Here, the SRB missed the point by focusing on a scenario that did not happen.
So the SRB (in collaboration with the FROB, the Spanish NRA), decided to
· write down all share capital : 2.1 Bln €
· convert all AT1-CoCo instruments into shares, and write them down as well : 1.35 Bln €
· Convert Tier 2 debt into shares and sell these to Banco Santander for 1€ : 685 Mln €
In a nutshell, the SRB forced the shareholders and low-rank creditors to take losses, while minimizing the impact on clients and counterparties. In this regard, this first-time resolution is a success. Of course, shareholders and creditors have a different opinion, and challenge SRB’s decision:
- Why was BPE denied additional emergency liquidity funding ?
- Why is there such a large difference in the bank’s net asset value between its 2016 annual account and the independent valuation ?
- Why were the AT1 hybrid instruments written down although the capital ratio was still above the threshold ?
- Was the intervention of other banks such as Deutsche Bank or BBVA duly considered ?
Some investors argue that this resolution hit bondholders with higher losses that a normal insolvency proceeding. They also criticize the communication errors that aggravated the bank’s problems. It leaves the SRB with the delicate task of explaining a difficult decision taken in a very limited timeframe.
The Veneto Banca & Banca Popolare di Vicenze cases
The same month, the ECB announced that two Italian banks, Veneto Banca & Banca Popolare di Vicenze were likely to fail. Contrary to the BPE case, the SRB considered the banks presented no systemic risk, and that resolution was not in the public's interest. It decided not to trigger a resolution plan and to let them through the Italian insolvency procedure.
But the Italian government stepped in to restructure the two banks and pumped 17 Bln € of state aid in the process. So the banks were ultimately bailed in using taxpayer's money instead of going bankrupt. Banks' senior bondholders were preserved from any loss, breaking the promises of the BRRD. The motivation behind this move are linked to local politics and interests. The debtors of the banks were mostly retail investors, and part of the bonds was guaranteed by the Italian State. In case of liquidation, the taxpayer would have had to pay anyway, leaving little choice to the government. This introduces false incentives and brings discredit to the whole resolution framework and, in particular, on the ability of the SRB to enforce its decisions.
Why is this so important ?
Credit issuer risk and dealing with bank failures has always been more a subtle art than a science, in which the ability to estimate default probability and recovery rate is key. The SRM, with its principles and toolkit was promising a more stable and structured environment. In this regard, the stark contrast between BPE and the Italian banks cases in a single month is problematic. Even if the situations are hardly comparable, it gives the signal that bank failure proceedings are still as unpredictable as before.
The Italian move also highlights the loopholes in the European resolution process. Governments are able to get around principles adopted by the EU, by taking profit of conflicts between different legislative silos. As a consequence, the “Too big to fail” paradigm is not over.
Due to the low number of bank failures in the Eurozone, the SRM is still a young and barely tested framework. However, the analysis of these cases draws a roadmap for future improvements of the SRM. As recently explicited by the SRB chair, the legislator should focus on harmonizing national insolvency procedures and EU resolution regimes, and also revise outdated provisions and guidelines that were hastily set up in the aftermath of the crisis and are now standing in the way of the SRM. Without this effort, the SRB will be unable to enforce the required stability and certainty whenever a failure event occurs in the European Financial sector.
About the author
Thomas Dufresne hold a Master's Degree in Engineering - Computer Science (Ecole des Mines de Nantes, France) and worked for 5 years Paris in life insurance and asset management. Thomas moved to Brussels in 2008 and joined ING, where he worked for 8 years in risk management and financial markets before joining Initio in 2017.