BANK RESOLUTION: LESSONS FROM EUROPE

In a relatively short period of several weeks, European bank resolution schemes have been put to the test with different outcomes in Spain and Italy. This is not simply a financial markets issues but also a corporate governance one too, as losses from failed banks may be internalised, impacting creditors, or losses may be externalised with state funds protecting senior creditors, resulting in a negative wealth transfer to the tax payer. First a little history of the complex system that has been into place to facilitate resolution of European financial institutions.  

In January 2016, the Single Resolution Mechanism (SRM) was implemented on the back of the Single Supervisory Mechanism and part of the European Bank Recovery and Resolution Directive of 2014 (BRRD), ensuring the FSB's principles for effective resolution of European bank failure and resolution. The BRRD considers policy for banks in a normal operating state, early intervention, and finally for workout and resolution. One key issue for the later extreme state is the determination of how losses associated with failure are shared, internally and thus putting creditors and depositors at risk, or externally via a bail-out. 

Bail-ins, where a bank's savers and other creditors may be wiped out before taxpayers providing greater market discipline, can result in un-intended consequences of creating uncertainty in bank deposit markets. 

In the last month, Europe has experienced a failure of weakened banks in both Spain and Italy with different outcomes. In Spain, Banco Popular, a $200 billion banking firm was taken over for Euro 1.00 by rival Banco Santander, following a funding squeeze against its substantial mortgage book and stock market decline for the lender. Santander agreed to fortify the capital position of its new subsidiary. Markets and regulators appeared calm about this incident as losses were not externalised; instead, capital provided by junior creditors and shareholders were sufficient to cover losses. The NYT (June 23, 2017) argues that recent European bank stress tests reported that Popular enjoyed a 10.2% Tier 1 capital level, 200bps below averages but hardly predicting a default and surviving adverse stress test scenarios by over 600 bps, thus calling into some doubt their creditability. Another learning lesson according to the NYT is that European leverage requirements of 3pct is possibly too lenient compared to the higher ratios observed for US BHCs closer to 5pct.  

In Italy this weekend, the ECB indicated the enough time had passed without sufficient improvement or an effective rescue plan for Banca Popolare di Vicenza and Vento Banca, so it handed the problem over to Italian authorities for winding up. This is were things get interesting. In doing so, assurances were provided that depositors and senior creditors would be protected suggesting that senior debt prices would rally on the market open next week. If Intesa, as reported, mounts a Santander-like purchase of the rump of good assets in these two banks and remaining losses remain, either those losses will be fully funded by the equity and junior capital of the two lenders or remaining losses will be need to be funded by the Italian state (i.e., state tax payers), unlike the above Spanish case. Taxpayer bourne losses appear inconsistent with the aims of the SRM, BRRD and drive to leave bank losses with investors and could further hinder the external monitoring efforts of the markets. This may be an important template as other Italian banks still face uphill challenges given high NPL rates in this country and suggests something less than a consistent European approach to resolution.