Rough policy notes on Veneto Banca and Banca Popolare di Vicenza (V&V)

More questions than answers. Stuff in square brackets as footnotes.

ECB decision: better late than never?

With Banco Popular (POP), the ambiguity in the ECB assessment that it was “failing or likely to fail” (FOLTF) was in what constitutes “significant deterioration of liquidity”—the course of events that played out in the preceding days that left the bank unable to meet near term liabilities. With V&V the ambiguity was time: “the two banks repeatedly breached supervisory capital requirements”—the duo had struggled for over a year to shore up capital levels over the regulatory minimum due to provisions required against legacy NPLs. The primary question for the ECB is: why was the FOLTF trigger only pulled a week last Friday?

It is clear in retrospect the decision should have been made in spring 2016 when capital raises (initially to be underwritten by Intesa Sanpaolo (ISP) and UniCredit (UCG)) failed to attract sufficient private investor demand. Instead, what followed, was the birth of Atlante. As Silvia Merler wrote: “By acting as an underwriter of last resort, Atlas prevented bank resolution in the short run, but it also spread the risk across the balance sheets of the rest of the Italian banking sector. The cost of that is now evident, as some of the participating banks have been writing off the value of their stakes in Atlas (in some cases at a loss). And in any case, Atlas did not end the two banks’ problems. Both announced in 2017 that they would need yet more capital.”

Fast forward to April 2017 and the ECB declared that V&V would need €6.4bn more equity.. against a €3bn tangible book value. Despite this math, the duo were apparently solvent. This ECB sanction of solvency required for the Italian government solution of a precautionary recap had been foretold by the recent issuance of government guaranteed senior debt. At the time, this led to an interesting conversation with Nicolas Veron: “My understanding is ECB didn’t try to rewrite the balance sheet on basis of its own AQR, & took financial statements at face value.” My main argument was in such solvency decisions the ECB should at the least release the methodology and assumptions (eg. GDP forecasts) behind the assessment—crucial, in my opinion, to credibility. [Asked to justify the V&V analysis, Ignazio Visco, Governor of the Bank of Italy did offer up one number: “they have a combined 1.5 million account holders”] Such disclosure in December 2016 would of course also been helpful in understanding the solvency decision that underpinned the Banca Monte dei Paschi di Siena (MPS) precautionary recap.

DG COMP put its foot down and demanded €1.2bn (only—very generous as government guaranteed senior included in calculations) be raised privately to cover pre-existing losses in order to be state aid compliant. Like a year ago, there was no genuine private investor interest, but the Italian government tried to cajole the stable bits of the Italian financial services sector into another round of Atlante—this failed.

No doubt feeling emboldened by the procedurally successful resolution of POP, the ECB had finally had enough and felt confident enough to pull the FOLTF trigger. From the perspective of evaluating solvency under the point of non-viability (PoNV) test, what had changed between April and June?

An aside: I believe it would have been more damaging for the overall credibility of the resolution framework if the precautionary recap had succeed as it was premised on the fact V&V were solvent. If this duo were solvent and eligible for precautionary recap, who wouldn’t be?

From a policy perspective, I think both POP and V&V raise a very interesting question for the ECB on the optimal level of FOLTF ambiguity. On the one hand, in the case of V&V, more transparency on its solvency decisions and FOLTF criteria would likely have forced sooner action — in retrospect the better outcome—through prompting a fact-based (as opposed to press leaks), candid public debate. On the other hand, via Owen Sanderson: “Think if you predefine you just create death spiral slightly above that as people worry about getting close to trigger. Also if your job is to fix banks in unpredictable times, why would you bind your hands more than absolutely necessary?”

Yet even getting information about its decisions from the ECB about its V&V decisions ex-post may prove difficult (“professional secrecy requirements”). “The SSM is already very transparent”, Draghi said at a recent dialogue with MPs in Hague —indeed so transparent it won’t even disclose certain supervisory decisions to to the EU body mandated to audit it.

Litigation is already emerging in the case of POP, and will soon likely follow for V&V—hopefully this will lead to interesting public disclosures on these past decisions and spark a wider policy debate on transparency going forward.

SRB decision: opening a can of worms?

In a nutshell: V&V has set a precedent for banks avoiding SRB jurisdiction in situations where there is not sufficient bail-inable debt to facilitate resolution. The decision reinforces the bank-sovereign nexus that the BRRD was constructed in part to be the first step on the road to severing.

The most interesting element of the SRB decision is that V&V were effectively non-systemic (“neither of these banks provides critical functions, and their failure is not expected to have significant adverse impact on financial stability”). This is in contradiction to DG COMP’s own assessment—in order to qualify for a precautionary recap the duo were deemed systemic—two European institutions with two quite different views of systemic risk: Schrödinger’s Italian bank intervention.

I think the non-systemic argument is quite weak. As a starter, FT: “And some bankers and officials in Italy believe the Veneto banks did pose a risk to Italy’s banks. A resolution under EU rules would have required them to find €12bn for the country’s deposit guarantee fund [protecting covered deposits up to €100k]. UniCredit, Monte dei Paschi di Siena and UBI Banca, which have all recently been, or are going, to the market for extra capital, would have had to make further capital calls and may have been deserted by investors, bankers argue.” [The contribution for ISP alone would have been ~€2.5bn.] Coupled with, as Brad Setser said, possible “run on deposits of weaker banks in system, sales of seniors that create pressures for a broader guarantee program.”

A funny quote from the Popolare di Vicenza CEO at the start of June: “The effects of not solving the crisis at the two banks would not be smaller than those created by a default by Greece.”

Of course the debate around if the SRB was under any political pressure is already simmering in the Italian press. The official response to these accusations will be interesting to watch.

National insolvency laws: a new friend for seniors?

When ISP first set out its conditions for the V&V acquisition on the Wednesday prior to the Friday ECB decision, the question on everybody’s mind was: “What is Liquidazione Coatta Amministrativa?

(At which point most analysts thought that V&V would be sold through a SRB-led resolution, per POP—the question was when the ECB would pull the FOLTF trigger). The V&V seniors were having a hard time figuring it out too,

Source: Bloomberg, BAML.

Once details were released on Sunday evening and it became clear bail-in of prefered senior (and pari-passu ranked liabilities—most importantly deposits >€100k) would be avoided by using the aforementioned special national insolvency legislation (reserved for companies of public interest and banks—with built-in ability bypass judge and hold an immediate auction), the core problem this decision presents to the resolution regime was crystallised: resolution can be avoided and undertaken under national law subject to no specific restrictions apart from those of DG COMP [we will get to that in the ‘State aid’ section, but it raises an interesting point on democratic process, via Axiom Alternative Investments: “unlike BRRD, which was approved by the Council and the Parliament, the state aid guidelines are a simple Commission decision, established on competition grounds, which seems a bit weak and unusual for the more general goal of safeguarding financial stability.”]

Paradoxically, in the counterfactual that a decision was made in favour of SRB-led resolution, it is not clear senior would have been bailed-in either: the systemic exemption under BRRD could have been invoked.

That most bank debt investors spent the Monday brushing up on member-state insolvency laws could be seen as the very antithesis of banking union.

[Hypothetical question on the limits of arbitrariness: should Portugal government have rushed to transfer Banco Espírito Santo seniors to Novo Banco in December 2015 before BRRD was implemented? Could they not just have constructed a DG COMP compliant special insolvency regime to bail-out the seniors and avoided a year of more expensive funding for their banking system and legal headaches still ongoing?]

By Wednesday, Sabine Lautenschläger said in a speech: “Of course, the bank will also look closely at the different national recovery and resolution conditions. And they have only been marginally harmonised, so there is no uniform toolset for crises.”

Two possible policy paths…

(1) the pessimistic:

—in short: banking union as partially implemented and envisioned is dead. We must take a big step back in integration, single market and competition. Creditors can start assessing insolvency frameworks of member states and their financial capacity to determine likelihood of bail-out.

I think this underplays that the new generation of TLAC/MREL eligible senior (non-prefered) will not be bail-in exempt (see ‘Capital structure’ section). So provided Italy’s cyclical recovery stays on course (legacy NPL stock run down, investors have reason to absorb new generation senior) we are just in a tricky transitional phase of the resolution framework. Like the other key legacy problem.. “mis-sold” retail holdings of bank debt.. will resolve itself as stock matures.

(2) the optimistic:

“Now Germany will insist on bank insolvency law harmonization as part of the deal with EDIS etc. I say that’s good. Advocated it all along.”

[…]

—A fine balancing act in the very best of EU traditions. Good luck to Macron and Merkel(?) on delivering.

State aid: a nudge in the wrong direction?

In debates on bank resolution state aid is often spoken about in the abstract, but of course it is ultimately about trying to promote fair competition for the benefit of consumers. And the Italian banking sector sure could benefit from more fair competition to the benefit of mass retail consumers:

The immediate question for DG COMP (stripped of nuance) is: why is €17bn subsidy (including €5bn to ISP) better for competition than waiting the requirement of the Italian state to raise €1.2bn of private money before proceeding with the precautionary recap? You will not find the answer in the 2013 EU Banking Communication the agency used to justify its decision, and the decision seems in violation of the established precedent of “minimum aid amount”.

On the basis of being the “only viable bidder” [(1) why no UCG? (2) who knows, auction not transparent—as with POP questions abound over openness of process] ISP has seen a material increase in its market share, particularly in the Veneto region:

While ISP gave the state nothing explicit for its subsidy, there is an interesting implicit concession which throws up many additional state aid questions, via Paul Davies: “But while Intesa is being paid to look after senior bonds and depositors, it has promised €5 billion of new credit in the Veneto region this year in return for that support. That looks like state-directed help for companies through cheaper access to funding than the market alone would provide.”

Central to the idea of banking union is pan-EU banking and the ECB’s main policy lever to achieve this is promoting is large scale, cross-border integration through M&A. Obviously there has been no major cross-EU (post-GFC!) mergers to date, and that POP and V&V only attracted bids from their respective home jurisdiction national champions shows how far promoting this objective has to go. The question to ask is why a BNPP or SG did not see either POP or V&V as an opportunity to gain a foothold in the Spanish or Italian markets respectively—if not now, with such cheap assets on offer and during a cyclical recovery, when? Maybe only if/when there is EDIS in place and total fungibility of capital and funding across jurisdictions.

Economic nationalism is alive and well in the EZ, be that in the reported reticence of the Italian treasury to accept capital injection from non-Italian hedge funds into V&V on the basis of “having control of the governance and management team was a key point”, ISP’s misguided exploration into a Generali merger in early 2017 on the grounds of “defence of Italian assets", or DB’s “special role in German economy” [the relationship between national identity and the banking systems—the cultural limits of banking union—is a fascinating one I hope to find the time to write about at some point].

POP and V&V may also have distorted the M&A market at a time of much needed sectoral consolidation. Large banks who may previously had considered bidding on distressed names for their franchise value may as well opportunistically wait for them to be forced into SRB resolution or, even better, a national insolvency regime. In both cases we saw a large acquisition subsidy as the subordinated debt was written-off prior to the the auction process (see ‘Capital structure’ section for more) [shortly before the deal Hugo Cruz argued the terms would be an “important benchmark to assess the Intesa CEO [Carlo Messina] in terms of M&A and capital allocation” — I think he passed! “I don’t see any political risk in Italy” Messina said in August 2016 — turns out there was all along and he was able to shrewdly take advantage].

But while distorting the M&A transaction process, it may accelerate volumes, at least in the medium term. Both cases have reinforced the differential in funding costs between large and small through distressed periphery banks, primarily via the cost of subordinated issuance—driving wider returns on equity (RoE). Placing debt with retail clients, once an important part of the funding mix for small periphery banks, is no longer a viable option from a regulatory perspective [“Somehow those retail bonds should have been redeemed by banks upon the introduction of the new bailout regime” — agree. Also shows (yet again) that financial stability and consumer protection are inseparable].

Exhibit number one of a bank very confident about RoE prospects, the star of this post: ISP is on target for a FY17 dividend of €3.4bn = a dividend yield of ~8% > coupon on its AT1s! [why the ECB authorises this for a bank that is relatively strong by Italian standards but still has a legacy NPL problem of its own is an interesting question, but for another post].

Bad assets: making the deal good?

One of the more curious statements to come in the aftermath of V&V was from a “Bank of Italy’s senior official”, who Reuters quoted as saying that the state “could even end up not losing money as result of the Veneto banks’ deal, any losses would be for limit amount”.

The recovery for the state is a function of the recovery on the only asset it obtained in the transaction: the NPLs that ISP didn’t want and were transferred to the bad bank. Which raises an interesting policy question: recovery success in part a function of the aggressiveness of the recovery strategy (i.e. balancing losses on the aggregate vs hardship the few—the same equation the Italian government has had to evaluate to inform its overarching strategy of dealing with failing banks and has biased heavily in favour to benefit latter).

According to the technical report in the decree, aggressive: 47% recovery on sofferenze within ~10yrs (for comparison with commercial banks, via Reuters: “Italian banks on average recover in a year a sum equivalent to around 4 percent of their impaired loan stock”). Atlante set a more conservative ~8% internal rate of return (IRR) target. Of course more important to recovery prospects than aggressiveness of strategy is macro conditions, but none of the assumptions (GDP, HICP, etc.) underpinning the forecasts are detailed in the decree.

If the NPLs perform in line with forecasts other periphery banks will understandably feel short changed having sold (and are still trying to sell) at very low prices under aggressive ECB reduction targets.

In broader NPL market developments, the collapse of the private placement of MPS’ stock highlights the difficulty of selling a large block (of anything) into a dysfunctional market — turns out Silvia Merler was quite right in her “pawn sacrifice” assessment [UCG the notable recent exception as shareholders happy to absorb large losses, justification given: yes it will cost you in P&L, but offset by greater benefit of lower cost of funding/equity (..and the not said: brownie points with ECB — helpful for Pillar 2 assessment?)]. Hope from last year that the new Salva Banche legislation could help reduce market dysfunction now looks misguided.

Capital structure: times a’ changin?

Senior

The Italian government is seeking to fast-track amendments to the BRRD to include non-prefered senior. This could move the first issuance of the TLAC-compliant instrument from Italian banks forward from 2018 to 2017. UniCredit will probably be first having pre-announced plans to issue €13.5bn, but others will quickly follow to meet TLAC/MREL requirements that will be phased in over the next few years. The optimistic take: there will be enough of this next generation bail-inable senior debt (crucially is not pari-passu ranked with deposits and will not be sold to retail) to see us through future resolutions.. avoiding SRB jurisdiction just an interim measure. The key question is if there will be sufficient investor demand to absorb.

Tier 2

In resolution scenarios the SRB is required to commission an independent valuation to guide its actions. In the case of the POP (so in this instance via FROB), this was an extremely wide: -€2bn (base case) to -€8.2bn (stressed scenario). This provided scope for the SRB to determine, conveniently, the equity valuation was such that the subordinated debt goes to zero and the senior made whole. Under Liquidazione Coatta Amministrativa with V&V, there was no requirement for an independent valuation.

As @jeuasommenulle said, if “fair” valuations are predetermined such that the value of subordinated debt goes to zero, this is a violation of the NCWO principle—you could expect a better recovery under liquidation. Expect this to be at the least part of the POP Tier 2 litigation.

This surfaces the far larger question of the credibility of stress-tests: do the methodologies authorities currently use to value banks give a strong enough understanding of a bank’s health to inform optimal supervisory decisions?

Additional Tier 1 (POP only)

Stick with these comments, with one additional thought: the POP AT1s were not *contractually* triggered (i.e. converted into equity and impaired after a breach of CET1 trigger—in fact it’s not clear the trigger would have been have breached.. there was no CET1 ratio included in the FROB analysis).

Evolution of resolution?

It’s easy to say with hindsight that the bail-in resolution regime in Europe was introduced too early and at the worst possible time (i.e. amidst a systemic crisis—counterpoint: it was urgent) and ignoring heterogeneous bank funding conditions across the EZ… which although have subsided thanks to ECB monetary policy action is still true to a certain extent [Messina on recent earnings call: “we should have a lower cost of capital versus peers if market is rational… but I don’t know that markets are rational.”]—conditions that made circumvention of SRB jurisdiction to state financing inevitable when insufficient bail-inable debt (the first AQR failed to force loss recognition and adequate recapitalisation).

[The US by comparison did TARP, has a properly functioning monetary union and implemented a far sounder resolution structure].

But I think we risk missing the forest for the (as explained what are likely soon to be legacy) trees, as Brad Setser said:

Growth cures all ills.

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Many thanks to Nicolas Veron, Brad Setser, Silvia Merler, Richard Field, Peter Thal Larsen, Dan Davies, Hugo Cruz and the pseudonymous @jeuasommenulle and @griforiseup, among others, for their interesting thoughts and stimulating conversation over the last week.

Please post feedback on my mistakes/flawed arguments either directly on this post, Twitter or e-mail. I list corrections and additions based on feedback below:

  • 4 July: Clarified difference between “point of non-viability” (PoNV) and “failing or likely to fail” (FOLTF) (HT Dan Davies)
  • Added: “From the perspective of evaluating solvency under the point of non-viability (PoNV) test, what had changed between April and June?” (HT @jeuasommenulle)
  • 5 July: Anon PM in inbox: M&A rebut and NPL pessimism.