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Saturday, 22 November 2014

Burden-sharing: the making of hybrid capital

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Capital securities have to work as planned, argues IFR editor-at-large Keith Mullin

IFR Editor-at-large Keith Mullin

IFR Editor-at-large Keith Mullin

THE INCLUSION OF burden-sharing language in the draft Memorandum of Understanding with Spain with regard to the EU bank rescue attracted a lot of angst and gnashing of teeth from hybrid capital and subordinated debt holders. But what do they expect?

If investors choose to buy capital securities that are supposed to absorb losses in the event of distress and the bank becomes distressed – erm, that’s kind of the point and why they pay a premium. During the global financial crisis, hybrid securities failed to act as a buffer and didn’t absorb losses as expected. Capital securities have to work as planned this time around.

If investors playing in the nether regions of the capital structure experience losses, it will establish the bank capital asset class once and for all – and not detract from it as some have suggested.

The more important issue here is that senior debt will be unaffected in this exercise. That will help to keep the senior in senior debt. There needs to be clear water between different layers of capital and funding from a pricing and a ratings perspective. Whether you get smacked or not in times of stress is a pretty clear differentiator.

I reckon the MoU is sensible and has laid out a series of reasonable steps that over time will resolve the dreadful mess the Spanish banking sector has got itself into.

The notion of burden-sharing may well have shocked, upset or otherwise put hybrid capital and sub debt investors ill at ease, but if a bank is non-viable even after shareholders have been wiped out, equity participations sold and non-core businesses run off, it’s only right that junior debtholders are bailed in to prevent taxpayers being on the hook.

It’s also right that, before a cent of taxpayer money is forthcoming, banks are prevented from paying dividends and discretionary hybrid capital coupons; prevented from engaging in M&A activity, and that executive pay is capped.

WHAT’S MISSING FROM the entire process is the notion of allowing banks to fail. Even the blackest fall-back option in the MoU is state bail-out. Banks that remain non-viable after all potential remedies have been applied should be allowed to fail. This continues to be taboo in Europe and I don’t understand why.

In the absence of failure, the point of the bank recap is to increase the long-term resilience of the Spanish banking sector. Making this happen will require some tough steps and some smart and bold management. This has been singularly lacking so far. In the circumstances, it’s right and proper that the heavy lifting required is taken out of management’s hands through legislative means and mandatory arrangements where necessary.

It’s only right that junior debtholders are bailed in to prevent taxpayers being on the hook

If part of the process is future risk identification and proper risk monitoring, there needs to be a root and branch overhaul of the quality of managers running Spain’s local banks. The cosy arrangements between banks, local government and corporates need to end and management needs to be professionalised.

ONE THING THAT did strike me about the MoU is that for all its positives, the timelines are pretty tight for identifying bad assets, conducting asset valuation tests and comprehensive bank stress tests, and coming up with recap and resolution plans. I suspect they will slip.

We’re already in mid-July. The legislation to activate the Subordinated Liability Exercises that will determine the extent of hybrid capital and subordinated debt bail-ins is tabled for August (incidentally, the Bank of Spain will only “discourage” banks that may need state aid from paying a premium of more than 10 points above secondary market levels on their hybrids and sub debt. For securities trading at huge discounts, this could be a potentially lucrative opportunistic investment play).

The blueprint for the asset separation scheme and creation of AMCs is also set for August. Stress tests are scheduled to be completed by late September and recapitalisation plans for those banks with capital shortfalls are due in early October.

The government is committed to presenting restructuring plans for banks already in state hands (Group 1 banks) for EC approval in November. The approval process for banks that have no access to private capital (Group 2) runs to December and the state recap will be expected to have been completed in an orderly fashion.

Banks that do have access to private capital markets but which have significant capital needs (more than 2% of risk-weighted assets) have until December to issue CoCos that will be subscribed in full by FROB.

Once these Group 3 banks have completed their capital raisings, they will have until June 2013 to redeem their CoCos; failing that, FROB will mandatorily convert them into stock. Banks seeking more limited capital raisings have a June 2013 deadline to complete them.

On the issue of the tens of billions of euros of sub debt and hybrid capital sold to Spanish retail as savings products – this is a scandal that regulators should clearly have acted to prevent.

The problem is that, if government (for political reasons) or the courts (on the basis of mis-selling claims) prevent the banks from imposing losses as planned, retail customers will end up paying in the end as the banks will get them through taxpayer-funded bailouts. Alas, they always get you in the end.

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