BOV’s midsummer shock

Over the past ten days, several articles were published in the media regarding the unfortunate developments at Bank of Valletta plc.

Undoubtedly, since last week’s announcement, many of the 20,000 BOV shareholders would have various concerns on the eventual outcome of the litigation cases, as well as on the financial strength of the BOV Group and the bank’s ability to distribute cash dividends until the cases are resolved. As such, in today’s column I will seek to highlight a number of important considerations arising from the recent developments.

Unfortunately, the main highlight from last week’s publication of the interim financial statements was the fact that BOV accounted for a litigation provision of €75 million and for the first time in its history as a publicly traded company, it failed to declare an interim dividend to shareholders. Moreover, the bank’s Board of Directors have already warned that they do not intend recommending a final cash dividend with respect to the current financial year ending 31 December 2018. The announcement also made reference to “extensive discussions with regulators” and the decision not to distribute a cash dividend is presumably very much driven by the views of the local and international regulators.

It is worth recalling that BOV is classified as a systemically important bank falling within the regulatory framework of the Single Supervisory Mechanism (SSM) and thus jointly supervised by the European Central Bank and the MFSA.

BOV explained that the €75 million charge is not an accounting provision but consists of a prudential provision against potential losses arising out of ongoing litigation cases. The bank’s CEO Mr Mario Mallia was quoted in a newspaper interview last Sunday as having stated that “this is obviously a judgement call, an estimate of possible eventual losses made in the present circumstances and given the present state of knowledge”.

In particular, the bank noted in the interim report published last week that it is currently possibly involved in three material litigation cases, namely the Deiulemar case, the La Valette Multi Manager Property Fund case and the Falcon Fund SICAV case.

In the case of the Deiulemar litigation, the bank stated that although it continues to believe that it has a strong legal defence on the merits of the case, a change in circumstances recently led BOV to revisit its previous stance. The Italian courts had issued a precautionary warrant on 27 March 2018 for the amount of €363 million and on 20 July 2018, BOV announced that the Italian court had rejected the bank’s appeal and confirmed the issue of a precautionary warrant of €363 million. Although the amount in any judgement or eventual settlement is unknown, the bank resolved to recognise a provision in the interim financial statements.

The most disappointing aspect in my view is the ineffective communication by the bank in recent months regarding some of these material items. Although the potential liability related to these three cases including the significant claim by Falcon Funds SICAV had also been included as note 33 on page 91 of the 2017 Annual Report circulated to shareholders ahead of the Annual General Meeting on 10 May 2018, the Falcon Fund case had not been openly explained either to financial analysts during the presentation of the annual financial statements in late March or to shareholders during the presentation at the AGM.

Senior executives within any public company should regularly communicate in an open manner with all shareholders both the positive financial highlights as well as any negative issues including potential risks such as litigation. It is not right to assume that all shareholders read an entire annual report or have the ability to understand the technicalities within the financial statements. In fact, few shareholders and financial analysts may be aware even today about the background of the Falcon Funds case and the allegations that may be lodged against BOV.

Last week’s announcement by BOV brought about an immediate reaction by the international credit rating agency Standard & Poor’s. In a report on 1 August 2018, the rating agency revised its industry score rating downwards for the Maltese banking sector and specifically downgraded BOV’s long-term Issuer Default Rating to “BBB” from “BBB+”. S&P also mentioned that its outlook on BOV was maintained as ‘negative’. This negative outlook surprised investors since few may have realized that on 4 April 2018, S&P reacted to the bank’s announcement on 27 March 2018 regarding the precautionary warrant by the Italian court and changed BOV’s outlook to negative from stable. The rating agency had argued in April about the “risks for BOV’s franchise and capitalization from potential reputational damage and litigation charges”. Moreover, S&P also warned that “if the lawsuit succeeds, we believe the financial impact could be substantial relative to BOV’s total equity of €962 million as of 31 December 2017”.

In my view, this should have been another matter that ought to have been highlighted at the AGM on 10 May 2018 especially since the change in outlook by S&P in April had not featured anywhere in the local media.

Furthermore, some investors may be confused by the fact that a few days after the S&P report, another international credit rating agency FitchRatings maintained Malta's rating at 'A+' and also kept a ‘stable’ outlook but failed to mention any possible impact of these litigation issues on the overall banking sector. In particular, FitchRatings remarked that “the banking sector remains sound” and “capitalisation remained strong”.

It is unfortunate that these litigation issues overshadowed an otherwise very commendable operating performance. The BOV Group generated a core operating profit (before impairment reversals and litigation provisions) of €63.8 million during the first half of 2018 which represents an increase of 18% over the same period last year. This came about from growth in both its net interest income sources as well as fee and commission income.

The strength of the bank’s core operating performance is a positive aspect for shareholders as it could cushion the negative impact of any further litigation provisions that may be necessary in future years. In fact, S&P commented last week that “the potential length of the lawsuit might allow BOV the time needed to build a capital buffer to counterbalance any eventual extraordinary charges”. Further, the international credit rating agency added “we anticipate BOV’s resilient profitability and contained credit losses will enable it to maintain by 2020 its risk-adjusted capital ratio before adjustments at close to 2017 levels”. This is a very important observation since it may help to avoid another rights issue immediately which could be a further cause for uncertainty among shareholders.

Since these litigation issues may carry on for several years, the bank may be required to periodically set aside further reserves to reduce the eventual impact in the event of an unfavourable judgement or a settlement arising from these litigation cases and the sizeable core earnings may cushion such an impact. On the other hand, however, it would also seem that the bank may find it hard to justify with their regulators the re-instatement of its cash dividend policy in the near term until sufficient reserves are set aside or until such time as these litigation issues are cleared.

BOV has regularly paid dividends to shareholders since the early 1990’s and given the bank’s resilient performance in recent years, many investors regarded BOV’s equity as a very sustainable income yielding instrument. Last week’s decision to suspend cash dividends for 2018 was a harder blow for those shareholders who opted to take up additional shares earlier this year rather than receive a cash dividend following the decision by the bank to offer this option to them.

Meanwhile, Mr Mario Mallia also explained in last Sunday’s interview that similar to other banks supervised by the European Central Bank, BOV will be subjected to a stress test in the coming months which would aim to measure the strength of the bank in an extreme negative scenario. Should a bank fail an ECB stress test, it would be required to boost its capital within a determined time period. The CEO commented that BOV is working on a contingency capital plan that could be activated to meet any short-term capital requirements including a rights issue, the issuance of hybrid capital and the management of the balance sheet towards lower risk assets. The bank’s CEO stated that “it is probable that the bank will opt to use a combination of options.”

The upcoming stress test is therefore a very important development in the coming months as it could highly influence investor sentiment towards BOV’s equity.

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