(Bloomberg View) -- The resolution of Banco Popular, a troubled Spanish lender, and its subsequent sale to rival Banco Santander for just one euro has been hailed as a success for the euro zone’s new regime in charge of handling bank failures. Still, the rescue of Popular has left at least three open questions for regulators. First: Could the European Central Bank have done a better job at supervising the bank? Second: Was an alternative solution possible or even preferable? Third: Has the risk of contagion been fully avoided? It’s worth pausing to answer them.
Last Tuesday, the bank faced a sudden liquidity crisis which meant it may have not opened the following day. The European Central Bank and the Single Resolution Board were quick to orchestrate an overnight rescue, which did not involve taxpayers’ money but wiped out shareholders and junior bondholders. When European markets opened in the morning, they were largely unperturbed. Job done, it seemed.
And yet critics noted that in its 2016 stress test of the EU’s largest banks, Popular did not come across as a bank that would fail, even though it was struggling under the weight of 37 billion euros ($41.4 billion) in non-performing loans, a legacy of Spain’s property bubble. The stress test projected that Popular would have a capital ratio of 13.45 percent of assets in 2018 under the normal scenario. This was only slightly lower than the sample average of 13.8 percent -- meaning Popular should have been able to carry on just fine in the absence of shocks.
This forecast now looks all the more absurd in light of the strong Spanish recovery over the past year and a half. Popular should have benefited in terms of both the quality of its loan portfolio and the ability to generate new and profitable business.
Still, one can point to at least two mitigating factors in the ECB’s favor. First, Popular fared badly in the stress test’s “adverse scenario,” the one that exposed the problems in other banks such as Monte dei Paschi di Siena: Its capital ratio fell to 6.62 percent, the fifth lowest in the sample. Second, the bank had announced a 2.5 billion euros capital increase months before the stress test results were released, meaning there was little point for the ECB to request further remedial action. It was later discovered, however, that some of the money raised appeared to be financed by loans funded by the bank itself. The ECB’s supervision then became more intrusive. However, the bank’s management was unable to find new capital and shore up its accounts.
The second question concerns whether regulators could have given Popular more time to solve its problems or, at least, find a different buyer for its assets. In some respects, the bank was in rather good shape: Its cost-income ratio, a measure of efficiency, was 46.7 percent at the end of 2015 -- better than Santander’s. Critics argue that a different kind of solution could have spared shareholders and junior bondholders the heavy losses they had to face because of resolution.
Perhaps that would have been the case under different circumstances, but Vitor Constancio, the ECB’s vice president, said last week that Popular had faced a bank run. Traditionally, central banks act as lenders of last resort to solvent banks which are experiencing a liquidity crisis, provided these can post sufficient collateral. In the case of Popular, the issue seems to have been that the lender had ran out of acceptable collateral. The only option for the ECB was to declare that the bank was “failing or likely to fail.”
Instead of pushing Popular into resolution, the Spanish government could have opted to extend a public guarantee on the bank’s bonds. This would have turned these securities into de facto sovereign debt, which could have been posted at the ECB in exchange for liquidity. This is exactly what the Italian government has done in the case of two small regional banks, Veneto Banca and Banca Popolare di Vicenza, which have just applied for a “precautionary recapitalization” from the government.
It is unclear, however, that Italy should be used as a good model here. The Italian government is essentially keeping the two banks on life support, in the hope that they will be restored to good health. This comes at a cost: Italy’s financial institutions have already contributed 3.5 billion euros in rescuing the two lenders via the so-called Atlante fund. They may now be asked to pay up a further 1.25 billion euros before the government can proceed with the process of recapitalization, which would amount to a further 6.4 billion euros. Were this strategy to fail, the government would also need to pay up the money it has pledged as a guarantee on liquidity.
Spain opted for a quicker route than Italy. Shareholders and junior bondholders have paid a hefty price, but the overall cost was almost certainly lower than it would have been had the crisis lingered on.
The final question relates to the risk of contagion from the speedy resolution of Popular. After all, junior bondholders were rapidly wiped out, showing that these debt instruments are indeed dangerous. The Italian authorities have been reluctant to do what Madrid has just done; they feared, without much justification, that any bail-in could have systemic effects.
There is little doubt that some weaker banks in Spain have seen their shares and junior bonds suffer. The shares of Liberbank SA lost 41 percent of their value last week before regulators banned short-selling, leading to a quick recovery of its stock. However, there is nothing wrong with a “bail-in” prompting investors to differentiate more carefully between banks. What needs to be avoided is widespread financial contagion, leading asset managers to sell any European bank shares or bonds they have, regardless of fundamentals or, indeed, widespread deposit runs. None of this has happened so far.
It’s right that there should be some soul-searching after a bank failure, and the crisis of Popular clearly is no exception. Last year’s stress test should have picked up more of the bank’s problems. The resolution of Popular may yet create problems for other weak banks, which supervisors should move fast to address.
All in all, however, it is hard to escape the conclusion that the alternatives facing Spain, the ECB and the SRB would have been worse than the quick solution which was implemented. Shareholders and bondholders will feel aggrieved, but, for once, the system worked.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Ferdinando Giugliano writes columns and editorials on European economics for Bloomberg View. He is also an economics columnist for La Repubblica and was a member of the editorial board of the Financial Times.
To contact the author of this story: Ferdinando Giugliano at fgiugliano@bloomberg.net.
To contact the editor responsible for this story: Therese Raphael at traphael4@bloomberg.net.
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