BRRD: The first act

Financial Article 2 by Christopher Mallia - Jun 29, 2017

Investors holding local bank bonds may have been surprised by the letters they received over the past few months from each of the banks highlighting the introduction of the Banking Recovery and Resolution Directive (more commonly known as BRRD) as well as its hypothetical and potential implications on their investments.

BRRD was enacted on 2 July 2014 as part of the eurozone’s efforts towards the creation of a banking union and to avoid a repetition of the various bailouts undertaken by a number of European governments to those banks facing financial difficulties in the aftermath of the international financial crisis. Although the law was formalised in 2014, its main provisions became effective on1 January 2015 whilst the part related to the bail-in resolution tool became effective on 1 January 2016.

The main aim of the bail-in resolution tool is to force banks that are facing capital or liquidity deficiencies to first exhaust all options available to it to correct its situation before making a request to its respective state for a bailout. In other words, the bail-in resolution ensures that losses are first incurred by shareholders, then by bondholders (starting with the lowest ranked subordinated bonds) and ultimately by uninsured depositors before any public funds are utilised in a bank’s rescue. Furthermore, the EU directive states that the bail-in resolution tool may apply to any liabilities which are not backed by assets or collateral including subordinated and unsecured bank bonds as well as uninsured deposits. Additionally, before any request for public funds is made, at least 8% of the bank’s total liabilities must first be written-off.

Although this resolution was commended as a step in the right direction and also triggered various capital raising initiatives across the European banking industry, given that it was an unprecedented piece of legislation, uncertainty still reigned across financial markets on how this resolution would actually be enforced when the need arose and on its effectiveness to resolve material bank issues. Regulators got their first chance to prove the resolution’s effectiveness earlier this month.

The first resolution under this regime was triggered by the Single Resolution Board (SRB), a fully independent EU agency acting as the central resolution authority within the banking union. The SRB triggered the bail-in resolution tool on Wednesday 7 June after it declared that Banco Popular of Spain (i) is failing or likely to fail; (ii) there is no reasonable prospect to prevent failure within a reasonable timeframe and (iii) a resolution action would be necessary in the public interest.

The financial woes of Banco Popular are largely related to the bank’s real estate exposure. This had grown significantly during the property boom in Spain just before the start of the international financial crisis 10 years ago. However, concerns on the bank’s financial health increased drastically in recent months following comments made by the Bank’s Chairman, Mr Emilio Saracho, during its Annual General Meeting, held on 10 April 2017. During the meeting, Mr Saracho stated that the Spanish bank required a capital increase to plug an unquantified capital shortfall. The lack of information in this respect ultimately led to a bank run as depositors pulled out vast amounts of money. A total of €3.6 billion were withdrawn between Monday 5 June and the morning of Tuesday 6 June only.

The resolution meant that Banco Popular’s Tier 1 equity (together with additional instruments forming part of the bank’s Tier 1 capital) were completely wiped out. Likewise, the resolution led to the conversion of the €2 billion subordinated bonds into shares which were ultimately sold to Banco Santander for the symbolic price of €1. All this was executed within 24 hours, with the SRB receiving praise from various quarters for the expedient and effective action which had a minimal impact across eurozone equity and bond markets. It is important to highlight that while shareholders and holders of subordinated bonds were wiped-out, senior bondholders and depositors of Banco Popular were spared from any losses.

Nonetheless, certain commentators still opine that additional evidence is required before further judgments are made regarding this directive. In the aftermath of the Banco Popular resolution, critics stated that losses at other banks that would require a resolution, such as Liberbank in Spain, are potentially much larger than those at Banco Popular and therefore senior bondholders and uninsured depositors may also need to take the brunt of losses. Such a scenario is being dubbed as the real test of BRRD as the consequences could have contagion effects across equity and bond markets.

Various articles across the international media had also identified Banco Popolare di Vicenza and Veneto Banca in Italy amongst the European banks that are next in line to fail. Last Friday, the European Central Bank (ECB) declared the two Veneto banks as ‘failing or likely to fail’ on the back of repeated breaches of capital requirements and the lack of credible solutions to these breaches. The ECB accordingly informed the SRB of these findings which in turn announced that whilst the banks are failing, a ‘resolution action is not warranted in the public interest’ given that ‘their failure is not expected to have significant adverse impact on financial stability’. As a result, the two Italian mid-size banks were bailed out by the Italian government (as approved by the European Commission) drawing criticism that the move is circumventing EU rules. The bailout is estimated to cost up to €17 billion comprising a €4.8 billion capital injection into Intesa Sanpaolo (which assumed the ‘good’ assets of the failing banks), a further €0.4 billion in guarantees to Intesa Sanpaolo against potential future losses as well as up to a further €12 billion in guarantees to cover losses from bad loans. In the case of the two Veneto banks, shareholders and junior bondholders were also wiped out whilst senior bondholders and depositors were safeguarded.

As such, although the bail-in resolution tool seems to have passed its first test, other cases that are likely to emerge in the future will surely test its effectiveness once again.

So why did Maltese banks send out the letters with respect to BRRD? Since Malta is part of the eurozone, all Maltese registered banks fall under this regime including those securities issued by local banks prior to the creation of this legislation. The provisions of BRRD, which apply to all European Union and European Economic Area member countries, also oblige banks to inform all holders of their unsecured bonds of this new directive and its potential implications on their bond investments.

Apart from the shares of Bank of Valletta plc (BOV), HSBC Bank Malta plc and Lombard Bank Malta plc which are listed and traded on the Malta Stock Exchange with a total market capitalisation of €1.76 billion, BOV, HSBC, Mediterranean Bank plc and Izola Bank plc also have bonds listed on the MSE. These four banks currently have a total of twelve bonds with a total nominal value in excess of €416 million. All these bonds are unsecured and nine are ranked as subordinated. The maturities of these twelve bonds vary. Seven of these bonds have a maturity of three years or less whilst the longest dated bonds are those of Izola Bank plc which mature in 2025 and the 2030 bonds of BOV.

The letters were therefore sent out to satisfy a legal obligation intended to ensure that all bond investors are aware of this new investment characteristic. Nonetheless, the letter described a hypothetical situation which currently is highly unlikely to materialise in the local banking industry under present circumstances. Local banks have historically retained a strong capital base and sufficient liquidity. In fact, BOV, HSBC, Lombard Bank, MedBank Groups well as Izola Bank all have capital ratios in excess of current minimum capital requirements. Izola Bank plc tops the list with a Tier 1 Capital Ratio of almost 31% followed by Lombard Bank Malta plc at 16.2%

HSBC Bank Malta plc and Bank of Valletta plc, Malta’s two largest banks, have a Tier 1 Capital ratio of 13.2% and 12.8% respectively which was largely built over the years through retained earnings. HSBC’s management claim that the current level of capital is also sufficient to meet the more stringent requirements under CRD IV which come into effect on 1 January 2019 including additional capital buffers it may be required to hold given its systemic importance within the local economy. On the other hand, BOV is seeking to raise an additional €150 million in new equity capital ahead of the aforementioned additional capital requirements as well as to support other initiatives forming part of the Group’s reform plans.

The latest Annual Report of the MedBank Group as at 31 March 2016 indicates that the Group’s Tier 1 Capital ratio is at 12.8%

Local banks have also retained a high level of liquidity with all banks mentioned having a loan to deposit ratio of below 100%.

Therefore, given that the outlook for the European banking industry remains challenging in view of the more stringent regulatory and capital requirements, further cases of bail-in resolutions may hit the headlines in the coming months across Europe. Meanwhile, local banks seem to have adequate capital and liquidity levels in line with prevailing regulatory requirements and are also planning ahead to meet the more stringent capital requirements that come into force on 1 January 2019. Nonetheless, investors should constantly remain abreast of developments at local banks in which they are invested whilst also remaining cognisant of the investment characteristics as well as risk factors of their equity and bond investments.

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