Rushed Popular resolution casts long shadow over Europe's banks
At
8:33am on Monday June 5 2017, an email landed in a mailbox at Banco de
Espana. A bank run was underway at Banco Popular, one of Spain’s biggest
banks. Barely three minutes into the working week, the situation was
already critical – Popular was running out of cash, and fast.
The
email contained a formal request: Popular was appealing to the Spanish
central bank for €1.9bn in emergency liquidity assistance.
For
officials at Banco de Espana, the request was not unexpected. They had
been working for more than two months with a team from Popular to
prepare for this moment, ever since an internal audit at the lender had
uncovered financial irregularities totalling hundreds of millions of
euros at the end of March, irregularities that included a web of
Luxembourg companies designed to hide the extent of Popular’s bad loan
problem.
By 11:41am the same morning, the money was with Popular.
The injection came just in time – according to people involved, the bank
wouldn’t have survived another half an hour. But any relief was
short-lived. As deposits continued to pour out, it soon became clear the
bank would need more help. At 3:32pm, Banco de Espana received another
email from the bank, this time requesting an increase in ELA to €9.5bn.
WITHIN THE LIMITS
Although
high, the amount was within the limits previously discussed. Popular
had €40bn of unencumbered assets available, and Banco de Espana had
earlier indicated that €26bn of those would meet its secretive ELA
criteria. Once haircuts – of between 35% for the best assets and 90% for
the worst – were applied, officials calculated the central bank could
lend Popular just over €10bn, albeit at a penal interest rate of more
than 12%.
But, first, approval was needed from the European
Central Bank, which had to sign off on any ELA request greater than
€2bn. Despite it being a public holiday in Germany, the ECB governing
council discussed the matter by phone. Popular was confirmed as solvent,
and the request was approved. But what happened next came as a shock:
Banco de Espana turned down the request, citing incomplete paperwork.
Popular
staff worked through the night to meet the central bank’s last-minute
demands, which were threatening its access to vital ELA. The bank still
had €21bn of acceptable collateral left - €5bn had been used to secure
the first tranche of ELA - and these issues with the paperwork hadn’t
been flagged before. Banco de Espana eventually gave the green light to a
further €1.9bn the next day, but it was too little, too late.
“It
was embarrassing,” said one person involved. “In March we started
discussions – in March! We were doing trial runs, going back and forth
with the collateral. They had checked it. But the truth is they were
absolutely determined not to take it. By the time they realised they had
to, they just weren’t ready. We started hitting all these little
hiccups, and then suddenly they told us they couldn’t do anything more.”
Popular had €26bn of collateral, entitling it to €10bn of ELA
Source: Banco de Espana
The sudden denial of ELA has puzzled many since.
“Crucially,
the bank was still solvent,” said Jerome Legras, head of research at
Axiom, an asset manager that focuses on banks and owned a small amount
of Popular bonds. “They mostly had a cash problem. If it was possible to
lend €80bn of ELA to Greek banks to keep them afloat when they were
completely insolvent, then why couldn’t they do the same with Popular?
There is a real problem of consistency.”
By the end of the day on
Tuesday, Popular bosses concluded the bank simply could not open the
next day. They notified the ECB, which declared Popular – a bank it had
deemed solvent a day earlier – as “failing or likely to fail”. That
morning Popular become the first, and to date only, bank to be put into
resolution using new European rules brought in after the 2008 financial
crisis to make bank failures more orderly.
STRUCTURAL WEAKNESSES
The
mess around ELA is just one in a series of mishaps in the Popular case
that have raised questions about whether the system to deal with failing
banks is fit for purpose. Through dozens of interviews and a trove of
confidential documents totalling thousands of pages, IFR has pieced
together what happened during Popular’s final days. It is clear that,
despite the bank’s problems being flagged many months in advance, when
the crisis finally hit authorities found themselves ill-equipped and
ill-prepared to adequately deal with the situation.
Indeed, far
from being an orderly resolution, the Popular case has since become a
legal quagmire. European institutions including the ECB and Single
Resolution Authority, which was set up in 2015 specifically to plan for
and oversee the resolution of failing banks, are now defendants in more
than 100 legal cases. One common theme is that, despite plenty of
warning and years of preparation, the approach of authorities was
piecemeal and ad hoc.
The issue goes much wider than just Banco
Popular; it has implications for the health of the entire European
banking system. Since the resolution of Popular, there has been a
dramatic increase in the cost of borrowing for even the healthiest of
banks. While a multitude of factors is doubtless in play, many believe
that the way the Spanish bank was dealt with is the biggest contributor.
Investors no longer trust that failing banks will be dealt with in an
orderly and legalistic way.
“It is absolutely critical that the
law is complied with,” said Richard East, a lawyer at Quinn Emanuel,
which is representing a group of disgruntled bondholders. “The SRB
cannot make up the rules as it goes along. The EU legislator took years
to design and lay down these rules in the wake of the financial crisis.
Investors cannot invest with confidence if they see that the regulator
is acting outside of its own rules.”
Former shareholders and
bondholders of the failed Spanish bank are leading the charge for
answers – and change. The two groups were hit hard: all shares were
annulled, while €2bn of bonds were bailed in then written down to zero.
The bank was then sold to Santander for a token €1. Investors argue that
the resolution process, overseen by the SRB, was flawed. They are
seeking billions of euros in compensation.
FLAWED VALUATION
Like
Banco de Espana, the SRB missed vital opportunities in the run-up to
Popular’s collapse that left it critically unprepared. It is clear that,
as early as April, the resolution body was so concerned about the
situation that, during a routine visit to visit Spanish banks in Madrid,
it thought it prudent to move its long-standing meeting with Popular
from the bank’s own offices to Banco de Espana, so as not to arouse any
suspicions.
During the meeting, Popular’s worsening liquidity
situation - more than €5bn of deposits would leave the bank that month -
was discussed. That should have been cause for concern, given that
almost all the SRB’s routine planning for a resolution of Popular had
revolved around potential solvency issues - not liquidity problems.
Despite that, the SRB critically saw no need to start a “special
dialogue” with the bank at that stage.
Perhaps one reason was
because the SRB knew it was seriously under-tooled to deal with a
liquidity crisis. Due to a slow phase-in of funding for the resolution
agency, and despite having been set up more than two years previously,
the SRB had only €10bn of funds to fight a crisis, less than a quarter
of its planned firepower. Internal rules also severely limited how those
funds could be used.
“This was the first case in our history and
all the elements were not in place,” said one person involved with the
resolution process. “We built our strategy on the bail-in tool. But due
to the characteristics of the crisis, it would have been difficult to
implement. And we were not sure that all the tools would have been
available from a liquidity perspective. At that moment, the available
amount was limited.”
The person said that the SRB quickly realised
that only one of the potential options in its resolution toolbox was
really available: a sale of Popular to a healthier bank that could
inject liquidity. Even then, it waited until May 23 to begin any serious
work, when it commissioned Deloitte to put together a detailed
valuation of Popular, which would inform any future sale of the bank.
HIGHLY UNCERTAIN
On
May 28 the SRB ordered Deloitte to “strictly prioritise … focusing only
on key assets and liabilities where there is considerable valuation
uncertainty”. Three days later it called to say it that the accountancy
firm had only two more days to complete its work.
As a result of
the compressed timeline, when Deloitte completed the report, it warned
that its findings were “highly uncertain”. It further prefaced its work
with the warning that it had “not had access to certain critical
information”. Reflecting this uncertainty, Deloitte’s report estimated
Popular could be worth as much as €1.8bn in a best case, a negative €8bn
in a worst case and a negative €2bn in a “best estimate” scenario.
Deloitte letter to Single Resolution Board
Source: Single Resolution Board
Despite
the caveats, the negative €2bn number formed the basis for the sale of
the bank and tallies exactly with the losses later imposed on
bondholders.
On June 3, while Popular and Banco de Espana were
doing final checks on the doomed ELA process, resolution authorities
made contact with Santander and BBVA, piggybacking on a failed sales
process (that involved five interested parties) Popular had run earlier
in May. After signing non-disclosure agreements the next day, the two
spent Monday and Tuesday going over Popular’s books. When Popular was
declared “failing or likely to fail” on Tuesday evening, both were
invited to submit binding offers.
Only one bid arrived: from
Santander, for €1, but only on the condition that shareholders, AT1
holders and Tier 2 holders were bailed in.
UPPER HAND
With
insufficient liquidity of its own to support Popular, and having already
concluded that a winding up of the bank under normal insolvency
proceeding would pose risks to financial stability, the SRB was left
with little option but to accept the offer. Reports in the Spanish press
allege that Santander’s own lawyers took the purchase agreement drawn
up by resolution authorities and rewrote it.
“The auction was
organised so quickly that it was difficult for anyone to make a serious
offer, and the valuations they used to justify the sales price were also
difficult to understand,” said Axiom’s Legras. “The range was enormous
and the methodology looked more like doing a firesale on the entire
balance sheet. With that sort of approach, any bank, even the most solid
one, will look very weak.”
Critically, investors allege that the
situation clearly compromised the SRB and its obligation to ensure that
shareholders and bondholders were dealt with fairly. Santander had been
given access to Popular’s financials as part of the private sales
process for weeks, and internal presentations show it had considered
paying up to €1.6bn for Popular just a few weeks before, but it held off
on making an offer.
One
person involved in that failed sales process said that because Popular
was suddenly no longer working with its own advisers to arrange a deal,
Santander held all the cards.
“Suddenly you change your
counterparty from professional M&A bankers, with a whole structure
of corporate governance and a board and shareholders to convince, to
civil servants of something called the resolution authority who have
never ever done anything like this,” said the person.
“These civil
servants, who barely have the capabilities to understand how a bank is
valued, are called in during the very last days with a mission – a
mission impossible – to dispose of assets according to rules that were
thought up years before and completely detached from the reality of the
way things work and the speed at which things happen. Santander must
have thought, ‘we have a great negotiating hand here’.”
INVESTOR PROTECTIONS
European
lawmakers at least foresaw the possibility of a rushed resolution, and
within the rules governing the SRB is a requirement to conduct an
“independent” valuation of a bank after the event to determine whether
or not shareholders and bondholders were short-changed, and whether they
might have seen a better outcome in an insolvency. If so, compensation
is due.
While the SRB says such an assessment was made, investors
believe it was not “independent”. Deloitte, the same firm that did the
first assessment, was asked to do it, which investors say is a clear
conflict of interest. The second Deloitte report concluded that
shareholder and bondholder losses would have been much greater under a
normal insolvency process.
“This is the safety valve of the entire
regime,” said East, the lawyer at Quinn Emanuel. “The SRB is simply
making things up as it goes along; it doesn’t really seem to know what
it is doing.”
“Unless there is serious and thorough review of the
Banco Popular case by the EU General Court, no lessons will be learned,”
he said. “This is our only hope because the SRB has vigorously denied
shareholders and bondholders access to documents and data for the last
two years … and will not admit that anything it did was wrong.”
The risk of botched resolutions will remain as long as the current regime remains in place, others believe.
“The
process gives so much leeway and flexibility to authorities that they
pretty much can do anything they want,” said Legras. “And the result is
that you can end up with something that is fairly reasonable and well
managed – or the exact opposite. There are very few safeguards for
investors and stakeholders. It’s an open bar for the authorities.”
