At the end of June, the EU summit was generally considered a step in the right direction. The main items proposed included direct recapitalisation of banks through the European Stability Mechanism and increased expectations of a single supervisory system. However, more details and a plan of action are required to reduce investor concern.
The ESM’s ability to recapitalise banks would avoid piling states with increased debt- Karl Falzon
The ability of the ESM to recapitalise banks would break the link between the sovereign and banks, and avoid piling states with increased debt. In a related proposal, it was also suggested that this approach could be applied retroactively – this position being particularly beneficial for Ireland.
For the ESM to fund weak banks directly, a single supervisory framework is necessary.
Proposals for this structure are being considered. Another positive suggestion made during the summit relates to seniority – the aid Spain received will not subordinate other existing bondholders.
During the subsequent eurozone group meetings, further agreement was reached on the €100 billion bailout for Spanish banks. The draft EU memorandum (final version expected tomorrow) provided some insight on how the bailout would work.
The initial €30 billion in aid will be made available by the end of July. According to officials, the cash will “be mobilised as a contingency in case of urgent needs in the Spanish banking sector”. This first tranche will be sourced from the European Financial Stability Facility, to be then transferred to the permanent ESM.
The assessment of individual banks’ capital requirements will be based on detailed analysis and stress tests. This will also involve an appraisal of collateral values and foreclosed assets. It is expected that each bank receiving bailout money will be required to adopt specific reforms.
The weak banks resulting from the review’s conclusions will then be allocated recapitalisation funds. However, the very weakest could be wound down. As part of this process, burden-sharing is likely to be required.
After losses to equity investors, bondholders may be required to get involved in the reduction of the country’s burden by taking haircuts on their holdings. This involvement could be voluntary, or if required, through mandatory Subordinated Liability Exercises. The Spanish government is expected to introduce the adequate legislation for these transactions by the end of summer.
It is relevant to note that burden-sharing is likely to affect only investors in subordinated debt.
Senior bonds are currently expected to be excluded from these measures, with authorities keen to avoid contagion to the wider bank financing market.
From an investor perspective, this could potentially result in sub/senior ‘decompression': subordinated bonds (which may be included in burden-sharing) drop in price relative to senior bonds.
There is a plan for the creation of a single specialised financial institution, a “bad bank”, into which the banking system’s distressed assets will be placed. The objective will be to park toxic assets of weak lenders, particularly related to property, with the aim of selling them off at a later stage. It is envisaged that this will be similar to the approach adopted in Ireland.
Markets are hoping to obtain further clarity by the end of this week on how the bailout will work. However, a number of questions remain unanswered in relation to the objectives set out in the draft memorandum. While a single banking supervisor is viewed as fundamental to enable the direct recapitalisation of banks, there is uncertainty on the nature and extent of the mandate this institution will have. The actual process of establishing a single supervisory framework is likely to take several months, and is not expected to be complete before the first half of 2013. In turn, this would mean that state guarantees may still be required before the new framework is in place.
With respect to burden-sharing, while the introduction of adequate legislation will facilitate this process, the imposition of coercive burden-sharing could be politically challenging. Analysts have noted that a considerable portion of subordinated debt is held by retail investors – a consequence of the previous selling of sub debt through banks’ extensive branch networks. According to the International Financing Review, retail investors hold an estimated €30 billion of sub debt. The creation of the “bad bank” in Spain will also be a particularly lengthy and complex process, with the Bank of Spain governor noting that this cannot be resolved “in a few months or in a few years”.
On balance, the summit and the further meetings that followed are encouraging. However, a more detailed and a clearly defined work path are required to reassure financial markets.
Curmi & Partners Ltd are members of the Malta Stock Exchange and licensed by the MFSA to conduct investment services business. This article is the author’s objective and independent opinion. It is based on public information and should not be viewed as investment advice in any manner. The value of investments may fall as well as rise and past performance is no guarantee of future performance.
Mr Falzon is a credit analyst at Curmi and Partners Ltd.