The Good and Bad of Spain's Bank Bailout!
The terms of Spain's bank bailout are being finalized and this draft memorandum is a near final version that lists the timeline and details of how this bailout would be conducted. While the draft looks rather comprehensive on first glance and does have several positive elements, it is also afflicted by a number of glaring omissions.
The first of these is that the memorandum fails to understand or acknowledge the link between the macroeconomic policies being pursued by Spain, for example on cutting its fiscal deficit, and the stability of the financial sector. In fact, many of the new austerity measures adopted by Spain will undermine the objectives of its bank bailout program. It also fails on take note of the social and political realities. Crucially, it makes no reference whatsoever to the direct injection of equity by the European crisis funds, now or in the future.
Some key points about Spain's bank bailout
- The draft memorandum of understanding  for the bailout of Spain’s banks looks rather comprehensive, at least on paper, but contains several glaring omissions
- The three glaring omissions are 1) that it makes no reference to any direct injection of equity by the ESM, the most important step in breaking the downward spiral that Spain’s banks and government are trapped in and 2) that it seems to be independent from the austerity measures being enacted by Spain despite the fact that these will clearly undermine the objectives of the bank stabilization program 3) that it shows no political or social awareness and is purely technical in nature
- However, it does embody a new approach to conditionality which uses existing obligations under recently adopted enhanced economic governance packages as a basis for the program – a baby step towards an economic union of sorts
- It makes no direct reference to efforts to minimise the overall size of losses as an objective of the program, which depends crucially on macroeconomic policies that Spain pursues
- It seems to place unrealistic expectations on what more transparency alone can achieve
- It foresees that Spain will set up a new legal framework for recapitalization, restructuring and resolution within a period of months and that this would be modelled roughly on the crisis management framework the European Commission has proposed only recently
- However, the tight timeline of the memorandum seems rather unrealistic and it is likely that there would be slippage
- The MoU refers to a long-term economic value of assets but this is very hard to calculate to any degree of accuracy and the biggest omission of the MoU is that it fails to relate this to broader macroeconomic policies being pursued. For example, there is no doubt in our mind that the additional austerity measures announced yesterday will have a significant impact on both the short term and the long term value of Spanish bank assets
- The memorandum makes no explicit reference to the fairness of burden sharing which we believe is critical for reasons of political feasibility, social acceptability and ethics
- The measures to minimise burden on taxpayers are mostly sensible and include inflicting losses on equity holders, banning dividend payments, some limits to compensation and most importantly bailing in hybrid securities and subordinated bondholders
- But there is no reference to capping compensation for bank staff beyond those in the board. The other even more serious glaring omission is that there does not seem to be an intention to inflict losses on senior bondholders which we believe is outright wrong – financially, politically, socially and ethically
- The program also does not recognize the fact that a vast majority of the hybrid securities and subordinated bondholders that it envisages will share in the losses are retail investors many of whom were mis-sold these securities
- The program envisages the setting of a bad bank, but fails once again to draw the connection between the value of assets and the broader macroeconomic environment
- It contains a serious tightening of oversight by the European Commission, the EBA and the ECB that could be seen to be a step towards a banking union
The planned Memorandum of Understanding between Spain and its Eurozone partners that would form the basis for Eurozone aid to recapitalize Spain’s banks breaks fresh ground on a number of issues. On the whole, it embodies a rather comprehensive approach, at least on paper, which sets several useful precedents and takes some baby steps in the direction of the economic union and banking union that are now on the agenda of Eurozone policy makers. At the same time, it suffers from some rather serious and glaring omissions. This commentary addresses the good and the bad.
First, the MoU uses a new approach to conditionality which is a combination of sector specific conditionality for the financial sector since the aid would be used to support banks as well as more general macroeconomic and policy conditionality that derives from Spain’s existing obligations under existing EU economic governance mechanisms, some of which, such as the EU semester, have only been introduced recently. Given how deep reaching some of the newly agreed Member State commitments under the revised Stability & Growth pact, the Fiscal Compact and the Six-Pack governance reform package are, this approach is a step forward in the right direction.
This was what Re-Define had called for when we demonstrated that Member State obligations under the expanded economic governance regime were comparable in how comprehensive and onerous they were to the more explicit conditionality embodied in the full bailouts of Portugal, Ireland & Greece. This is also politically easier for the recipient governments since it refers to existing obligations compliance with which will be monitored more stringently and on a specified timeline. The sector specific conditionality is also appropriate and represents a move towards a more Eurozone-led approach as would be needed under a banking union.
Second, the objectives of the program as defined is to increase the long-term resilience of the banking sector 1) effectively dealing with legacy assets 2) improving transparency to facilitate an orderly downsizing of exposure to the real estate sector, restore market based funding and reliance on central bank liquidity 3) to enhance risk identification and crisis management to reduce the likelihood and severity of future financial crisis, seem broadly appropriate with some exceptions and gaps.
There is no reference to trying to minimize losses which seems rather odd given how losses are contingent on what happens in the economy and how the financial sector is treated. Perhaps this is what is meant by ‘effectively dealing with legacy assets’? The objectives seem to embody an unrealistic expectation of what simply increasing transparency can achieve. The point about protecting against future crisis is important but that can only be a secondary objective.
Third, the program would be operationalized via a three step process namely 1) identifying individual bank capital needs through a comprehensive asset quality review and bank specific stress tests 2) recapitalizing, restructuring or resolution of weak banks 3) transferring the impaired assets of banks needing public support to a ‘bad bank’ which all seems entirely sensible but the devil of course will be in the detail.
The banks will be classified into four categories 1) those that need no new capital 2) those that can meet shortfalls without state aid 3) those that would need state aid and 4) those that are already owned by the state. Under the timetable specified the lists would be finalized by October 2012 after the external stress tests and asset review is completed in September. The banks are expected to submit plans identifying how they will meet capital shortfalls with 1) internal measures, such as earnings retention 2) asset disposals 3) liability management exercises such as converting preferred shares and convertible bonds and other hybrid securities to equity and bailing in subordinated bonds 4) raising new equity and finally 5) state aid. The viability of these will be assessed jointly by the European Commission and the Spanish government.
The plan is for the recapitalization, restructuring and resolution of those institutions that need state aid or are already under state ownership to be finished by the end of 2012, a very ambitious timeline that we find hard to believe can be adhered to.
For banks that need capital but may not need state aid, a distinction would be made on the basis of how much additional capital they may need – those needing less than 2% Risk Weighted Assets worth will be given until end June 2013 to raise it and those needing more than this will be forced to issue Contingent Convertible Securities (CoCos) to FROB, the Spanish bank rescue fund by December which will be redeemed if the banks are successful or converted into equity in case they fail to mobilize targeted capital.
Fourth, the process of how the size of the problem would be calculated has been specified and seems sensible but the big caveat here is that this is necessarily a highly imperfect exercise. While the audit, verification of information and data checks are all sensible and will add real value, arriving from there to the economic value of assets would require some heroic assumptions.
This also highlights the most glaring gap in the MoU which is that the economic value of the assets depends very strongly on the evolution of the nominal GDP and (related) unemployment in addition to what goes on in the financial sector. The program makes no reference to these and this is the big elephant in the room.
Fifth, the restructuring of banks will be done following the principles of 1) viability 2) burden sharing 3) limiting competitive distortions and 4) promoting financial stability which all sound sensible. However, there is no reference to trying to minimise losses or to the fairness of burden sharing, which seem to us to be glaring omissions.
Sixth, any restructuring will draw on the banks own resources before any state money is injected – this makes sense if it is followed rigorously though the idiosyncrasies of the Spanish banking system mean that it will almost certainly create additional problems.
The process will involve asset sell-offs, bans on dividends and discretionary payments to hybrid capital instruments – and may involve losses for equity and hybrid capital instrument holders in the case of viable banks. For non-viable banks, the Spanish authorities will submit resolution plans to the European Commission. Pay for board members of banks that receive state aid will be capped. Here the memorandum falls short – it makes no reference to what levels pay would be capped at and makes no mention of capping pay beyond the board level.
In order to have better burden sharing, the MoU specifies that losses will be allocated to equity holders, hybrid capital holders and subordinated bond holders for banks that require state aid but says nothing about senior bondholders.
The decision to first concentrate burden sharing on hybrid capital instruments and subordinated bondholders makes sound legal sense as they rank lower than senior bondholders in seniority so it would really not be possible to avoid bailing them. The logical thing would then be, if there are still losses that need to be absorbed, to haircut senior bondholders who are next in line in the creditor hierarchy. Uninsured deposits may also be bailed-in though the entities holding them have got fair warning and would probably have the chance to move these to safer banks, if they haven’t already done so.
However senior bondholders are not mentioned in the draft memorandum which to us makes little legal, economic, financial or political sense. The ECB together with the European Commission had forbidden the Irish authorities to impose any losses on senior bondholders for fear of contagion and for fear of inflicting losses on banks in the rest of the Eurozone. Could the same thing be at work again? We think this decision is misguided, will worsen public indebtedness, will have a regressive footprint and does not make economic sense. There is still time to rethink this.
The problems with this decision are particularly serious in the case of Spain. This is because rather uniquely, Spanish banks sold a vast majority of the Euro 67 billion  or so estimated hybrid securities and subordinated bank bonds outstanding to retail investors. While some of these investments were made with eyes open, there is mounting evidence that a significant amount were mis-sold, most notably in the case of Bankia one of the banks in the most serious trouble now.
The losses from bailing-in these securities are likely to fall on ordinary citizens including a number of pensioners who may lose most of their savings. This will not only have a very large regressive impact but is also likely to lead to a lot of social and political unrest. Because there was mis-selling involved in at least some of the cases, it is very likely that there will be some legal recourse and at least some of the losses will need to be made whole by the banks, which in most cases would mean the state as the banks that inflict losses on the holders of these securities are the ones that are essentially bankrupt without state support.
Even if there is no legal recourse, the government may be forced to shell out funds to part compensate retail investors for these losses as it is unlikely that politically and ethically such investors can be allowed to fall below subsistence level. This means that the true economic loss absorption capacity of such instruments is less that the headline figure as some of the losses will need to be made whole by the government.
Seventh, the MoU envisages that Spain will put in a legal framework for setting up an asset management company, a bad bank, by the end of August and once this is done the impaired assets from banks getting state aid would be transferred to this with losses being crystallized at the time of transfer. The transfers will take place at what the MoU is calling a real (long-term) economic value. There are several interesting elements here.
The long-term economic value, as we have stated before, is very hard to estimate and is highly contingent on other macroeconomic policies. For example, the new austerity  announced by Spain yesterday will undoubtedly magnify the losses in the real estate sector in the short term and will also cast a downward pressure on the longer term fundamental value given that this is path dependent. Any macroeconomic measures that increase unemployment or push nominal GDP into negative territory will undoubtedly have an impact on the economic value of the housing stock.
Banks will be given small equity stakes, or state guaranteed bonds or cash equivalents in exchange for assets transferred to the Asset Management Company (AMC) which will have the capacity to hold the assets to maturity. A very important point here is that AMC bonds will be acceptable to the Euro system so the AMC’s funding capacity to hold assets to maturity is likely to come from repos with the ECB and/or Emergency Liquidity Assistance (ELA) from the Spanish central bank. This funding is essential and the decision to hold assets to maturity will mean that fire-sales, which may otherwise be necessary, can be avoided. This will limit losses and is a good, sensible and necessary step.
Eighth, the MoU calls for a toughening of bank regulation and supervision in Spain, which is now likely to happen on an accelerated time frame compared to the rest of the Euro area banking system. For example from the 1st of January, Spanish banks will be required to meet the tougher definition of capital as laid out in the Credit Requirement Regulation (CRR) that is still being negotiated at the European level. Spain’s once feted dynamic provisioning framework that has now been discredited will also be revised and it is also foreseen that the lessons learnt in recent months will be applied to tighten the loan loss provisions framework.
Other reforms that are foreseen are 1) a tightening of the liquidity regime 2) greater transparency 3) improving the governance structure of the Cajas 4) increasing the operational independence of the Bank of Spain in its role as bank regulator and supervisor 5) strengthening supervisory practices at the Bank of Spain 6) strengthening consumer protection 7) improving the public credit register 8) improving the governance of the FROB (the financial stability fund) and the deposit guarantee scheme.
It’s hard to argue with any of these but of course the most obvious point here is that this comes far too late.
Ninth, the memorandum rightly says that macroeconomic developments and the financial sector are linked but instead of focussing on the critical relationship between unemployment and nominal GDP developments, it refers to the usual rhetoric on public and external imbalances and the need to correct these. Thus it fails to draw any link between the adjustment path followed and the size of the losses and the stability of the financial sector which is a glaring omission.
Tenth, the memorandum foresees regular surveillance by the European Commission, the European Banking Authority and the European Central Bank and has an appendix detailing the pieces of information that Spanish authorities will need to provide to these entities on a regular basis. It’s hard to argue with this and in fact this does seem like a step towards a Euro-wide bank supervision structure.