The recent resolution of Spain’s Banco Popular provides a terrific case study on the importance of banks providing transparency and disclosing their current exposure details.
Banco Popular was one of the largest banks in Spain. Its core business was retail and small business lending. However, prior to the beginning of the financial crisis, it decided to get heavily involved in real estate lending. When the crisis hit, the bank was stuck with 10s of millions of euros in bad real estate lending debt.
Fast forward to 2016 and the stress tests run by the ECB. According to statements made by the regulator at the time, these tests were designed to show each bank’s capital level under trying economic circumstances. With almost 40 million euros of non-performing real estate loans still on its balance sheet, Banco Popular’s stress tested capital level was dead last among the banks tested. While last, its capital level was significantly greater than zero (the test indicated its capital ratio was about 6.5%).
Also during 2016, the bank sold contingent convertible bonds that bank regulators could convert into equity and use to absorb losses. When these bonds were first discussed, I observed they were a “blind bet” as the banks did not disclose the information necessary to assess the risk they would be converted and subsequently written off by regulators.
And here is where transparency is needed.
- First, it is needed so the market can in fact confirm the results of an ECB run stress test.
- Second, it is needed so investors can assess the risk of the bank’s contingent convertible bonds.
- Third, it is needed so that only non-viable banks are closed.
Without transparency, investors rely on the bank regulators. In particular, they rely on the bank regulator’s saying the bank still has capital even under trying economic circumstances.
Fast forward to this past week. Bank regulators were saying how well the new bank resolution system works because they were able to “sell” Banco Popular to Santander, the largest bank in Spain, for 1 euro.
As part of the sale, the non-performing real estate loan portfolio was written down. First, it was written down by the reserves set aside for losses in that portfolio. Next, it was written down by the equity on Banco Popular’s balance sheet. Then, it was written down by the amount of the contingent convertible bonds (the bonds were converted to equity and the equity was then used to absorb losses on the loan portfolio).
Somewhat miraculously, this exhausted the losses on the non-performing real estate portfolio and the senior unsecured debt holders were spared from taking any losses.
For its part, Santander is going to raise 7 billion euros to support the acquisition. It says the acquisition will generate a 13-14% return.
Hmmmm …. this entire series of events raises more questions than it answers.
Why did Banco Popular need to be resolved now? The bank regulators claim there was a run on the bank. This is surprising even given the regulators’ efforts to promote such a run in the previous weeks. Recall the bank’s customer base is primarily retail and small business. Both of these provide a very stable funding base. In addition, the bank had been operating for almost a decade with everyone knowing its balance sheet was holding 10s of millions of euros of non-performing loans.
Why would depositors decide to suddenly run down and get their money back? According to Santander, they didn’t.
If Banco Popular provided transparency, we would know the answer to this question as the market could have seen if depositors were in fact fleeing the bank.
Next, was Banco Popular viable after writing down the non-performing real estate loans? A viable bank is able to generate positive earnings after paying all its expenses. Santander’s return estimate strongly indicates Banco Popular would have been viable. Santander’s return estimate includes any expenses and additional losses Santander expects to take as it disposes of Banco Popular’s non-performing real estate loan portfolio.
Why exactly would the bank regulators want to close a viable bank?
Of course, if Banco Popular provided transparency, we would know if it was viable post writing down the non-performing real estate loans.
Was it really a miracle senior debt holders escaped without taking any losses?
Of course, if Banco Popular provided transparency, we would know.
When I raised this issue on Twitter, I received pushback against the idea we would know the value of the non-performing loan portfolio. The observation was made the market could not value these loans.
For this to be true, competing banks who have knowledge of the market and the relevant expertise must not be able to assess the borrower even when the information they need to value their own loans is being disclosed. In addition, the bank regulators who valued the Banco Popular portfolio must have a super secret methodology for valuing non-performing real estate loans that they are unwilling to share with the banks or investors.
Of course, this is not remotely believable.
The market is fully capable of valuing even dud bank real estate loans. In making this statement, I am not saying every market participant will assign the same value to these loans. I am simply saying the market can value these loans.
Once valued, we know if a miracle occurred or not.