Over recent weeks investors in the various bank bonds listed on the Malta Stock Exchange received a letter from the issuers of these bonds attempting to highlight some important changes in the conditions of their bonds. These changes arose out of a new EU directive (Bank Recovery and Resolution Directive, ‘BRRD’) that came into force on January 1, 2015, and whose bail-in feature applied as from January 1, 2016.
As background, it is important to keep in mind that after the 2007/8 financial crisis a number of EU banks needed saving from bankruptcy. Given the importance of these banks to the effective operation of the economy, governments were forced into providing the necessary financial lifelines to keep the banks afloat.
Naturally, governments were furious with this situation, especially after it transpired that many of these banks were taking unnecessarily large risks, the profits of which were taken through bonuses and shareholder dividends. The introduction of the BRRD was a way of ensuring that governments were not first in line to provide capital to EU banks in the event of a likely failure of these institutions. So how does the BRRD work and what are the implications for investors?
Essentially the BRRD authorises a resolution authority (the board of Governors of the MFSA) to step in when a bank or financial institution is failing or likely to fail and it is in the public interest for that institution to be saved. The key principle that the BRRD brings to the table is that the losses should be borne (bailed-in) first by shareholders and then by creditors. The ranking that would normally be used in the event of a distribution of assets to creditors when a company is liquidated would also be used in such situations.
Hence, what would happen is that the resolution authority would determine the degree to which losses need to be covered in order to keep the institution afloat. Once this amount is determined it would begin writing down (off) the various instruments that are available to it. These would be the following, in the order shown: 1) Ordinary shares (Tier 1 capital), 2) Other Tier 1 capital, 3) Tier 2 instruments, 4) Subordinated bonds, 5) Unsecured bonds, and 6) Deposits that are not covered by the Deposit Compensation Scheme.
Having sailed through the financial crisis, domestic banks remain extremely well capitalised
Given most local banks do not have Other Tier 1 and Tier 2 instruments, subordinated bondholders would quickly find themselves in the queue waiting to be bailed in. In essence this means that, depending on the extent of losses, holders of any of such instruments could find that their instrument is partially or fully written down and/or partially or fully converted into ordinary shares.
Depositors whose deposits are covered by the deposit compensation scheme and investors who hold secured bank bonds cannot be part of the bail-in process.
The reason for the letters issued to bondholders was primarily one of disclosure, in order to ensure that the holders of such instruments are made aware of these important changes to the conditions of the financial instruments they are holding. It is important therefore for investors to understand the type of investment, or deposit, they are holding and the risks associated with such instruments. In reality, there has been no change in the risk profile of the banking institutions as a result of the introduction of the BRRD and investors need not fret, in my opinion, about the presence of new risks within the banking sector.
The new risk comes from the financial instrument that investors or depositors are holding, which will manifest itself only in the event that the financial institution is about to fail. What investors should be thinking about is whether they hold too many of these instruments in their portfolios, bearing in mind the possibility of contagion in the very unlikely event that a Maltese bank needs saving. Any portfolio should be well balanced and diversified, with the investor aware of the risks resident within the portfolios.
Fortunately, the core Maltese banks are not a source of major concern or a provider of significant risk to the domestic economy. Having sailed through the financial crisis, domestic banks remain extremely well capitalised.
No bank is, however, completely without risk, it is, after all, the reason banks exist. The risks banks are today faced with are not only coming from the type of lending that the banks are undertaking but also from money laundering and other regulatory type risks. It is crucial to the ongoing stability of the banking system that banks remain vigilant on all fronts.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.
David Curmi is managing director of Curmi and Partners Ltd.