New European banking regulations put to the test

The Banco Popular ‘bail-in’ went smoothly but what are its long-term consequences?

Europe’s new banking rules, implemented to minimise the chance that taxpayers will again have to bail out failing European banks, faced their first test last week.

At the behest of the European Central Bank’s Single Resolution Board, Spanish bank Banco Popular – with assets of €147bn at 31 Mar 17 – was acquired by giant Spanish competitor Banco Santander (BME: SAN) – with ten times Popular’s assets – for €1.

Popular had an astounding €37bn in non-performing assets, particularly in real estate as a legacy of the bursting of the Spanish property bubble. So despite the rock bottom price, Santander will also raise €7bn via a rights issue to cover the capital and provisions required as part of acquiring Popular’s assets.

To its credit, Popular had tried to avoid a government bailout by turning to shareholders in recent years. Yet despite Popular supposedly satisfying the minimum capital and liquidity requirements, a sluggish share price suggested the equity market, at least, was well aware of Popular’s precarious state.

Ultimately, a sudden liquidity crisis last week pushed Popular into Santander’s hands: depositors started withdrawing funds at the rate of €2bn per day.

Believing Popular was ‘failing or likely to fail’, the regulators arranged the union with Santander.


The regulators used the new rules as part of the 'bail-in': ordinary shareholders and holders of Popular’s additional Tier 1 securities (AT1s) were completely wiped out. As for Popular’s Tier 2 securities, the regulators converted them into new ordinary shares in Popular which were subsequently sold to Santander for €1.

The wipe out of the AT1s and Tier 2 subordinated bonds appears to have come as a surprise to their owners: as a percentage of face value, these instruments were selling anywhere from the mid-40s-to-high-50s and high 70s, respectively, before the bail-in.

It's good to see the regulators using the new rules: what’s the point of having such a solution if the regulators lack the intestinal fortitude to utilise it?

As a result, perhaps this will reduce the moral hazard that has plagued the banking industry ever since the GFC-inspired bailouts. It may also lead to AT1s and Tier 2 instruments being priced more efficiently as investors revise their risk/return calculations based on the Popular bail-in.

And in contrast to when concerns over Deutsche Bank's (DB:DBK) potential capital shortfall arose last year, the European banking industry has more or less taken the Popular bail-in in its stride. 

Good for Santander

For her part, Santander CEO Ana Botin believes the deal is good for Spain, Europe, Popular’s 4.4m customers and her shareholders. I won’t quibble with the latter – Santander’s shareholders own a bank that is now the market leader in Spain, with 20% loans market share, and also now the second biggest bank in Portugal.

Santander should also benefit from €500m per year in cost cuts from removing duplicate roles, rationalising branches and so on, Santander being able to fund the acquired assets using its lower debt costs and the opportunity to use its increased market power to crank up fees and interest rates charged to customers.

With the Spanish economy growing again and property prices rising, the acquisition also comes at an opportune time in the cycle. Perhaps this will also offset the greatest risk to Santander’s shareholders: that, even with the incentive to over-provision now, Santander has nevertheless still underestimated the eventual losses on Popular’s non-performing assets.

Santander will increase provisions to 67% of Popular's non-performing assets, substantially above the peer average of 52%. This could lead to provisions being reversed as the Spanish economy and its property market continue to improve, providing a nice tailwind to earnings. 

Less so for taxpayers

However, while Spanish and other European Union taxpayers weren’t required to contribute, I’m not sure making a bank with €1.45 trillion in assets even bigger is good for either Spain or Europe over the longer term. (By contrast, Commonwealth Bank (ASX: CBA) had €660bn in assets at 31 December 2016.)  

With only €147bn in assets, Popular was too small to pose a systematic risk to the Spanish banking system.

The real test of the new regulations will come when – and if – the banks that pose systematic risks to their country’s banking systems – such as a Banco Santander, a JPMorgan Chase (NYSE: JPM) or a Commonwealth Bank – get into trouble. 

Despite regulators’ admirable intentions, I remain sceptical that governments will let these giant banks fail rather than, fearing a rerun of the Lehman Brothers fiasco, bailing them out using taxpayer funds instead. I'd guess that those who run these giant banks believe likewise. 

Hopefully, though, I'll be proven wrong. 

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