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Banco Popular: First European AT1 Hybrid (CoCo) Triggered

In July 2016, a stress-test conducted by the European Central Bank (ECB) highlighted the “alarming levels of debt” carried by some of Europe’s biggest lenders. Among a few others, Spanish Bank Banco Popular was expected to fall short of capital requirements in a stressed scenario.

Reason for failure
The bank’s inherent weakness was emphasized when it posted a €3.5 billion loss in 2016 on the back of an unsustainable mortgage portfolio. The bank had €37 billion in foreclosures and other non-performing assets accumulated during Spain’s housing downturn (in 2012). With the crisis deepening, there was significant concerns around the bank’s inability to sell assets, raise capital and/or facilitate a takeover.

Consequently, the ECB deemed Banco Popular as “failing or likely to fail” and sold the bank to its rival Banco Santander for €1 in an overnight auction conducted by the Single Resolution Board (SRB).

Figure 1. Performance of Banco Popular Instruments across the Capital Structure

Source: Bloomberg

Implications

Like many other European lenders, Banco Popular used contingent convertible debt (CoCos) as a source to raise a significant proportion of its regulatory capital. European CoCos are the equivalent of post-transitional Australian Bank Additional Tier 1 (AT1) Hybrids which carry Capital and Non-Viability Triggers. They pay discretionary coupons and carry the potential (Capital and Non-Viability Triggers) to be converted into shares if the bank’s capital ratios fall below a certain threshold, making them the first capital holders (behind equity investors) to be wiped out in a bank failure.

Figure 2. Key Features of Instruments across Capital Structure


Source: FIIG Securities, BondAdviser

In theory, how far write offs progress up the capital structure in the event of a bank’s non viability will depend on the size of the problem. Typically, a country’s resolution authority will consider each distressed bank on a case by case basis and will reflect the difficulties faced.

ECB’s action stemmed from Popular’s lack of liquidity (i.e. inability to meet short term obligations) and hence, the Point Of Non-Viability (PONV) was triggered. As a result, all existing shares (Common Equity Tier 1) and Additional Tier 1 (AT1) instruments were cancelled. In addition, the Tier 2 instruments were converted into equity and sold to Santander for €1. The only investors left untouched were the bank’s senior debtholders along with non-capital instrument liabilities (including deposits).

Figure 3. Implications for Banco Popular


Source: BondAdviser

This resolution decision by the ECB comes less than a week after the European Commission gave preliminary approval for government rescue of troubled Italian bank Monte dei Paschi di Siena, which fared significantly worse than Banco Popular in the ECB stress test conducted last year. By requesting approval to provide capital to Monte dei Paschi, the Italian government were able to avoid the ECB triggering the PONV.

This is the first time the Central Bank along with the EU Single Resolution Board, the European body charged with ensuring taxpayer money doesn’t go to bailing out failing lenders, has concluded that a lender was “failing or likely to fail.”

Figure 4. Market Reaction

Source: Bloomberg

The timely and decisive intervention by the new bail-in regime (instated under Basel III) in this case has helped contain the spillover damage across sensitive European markets, which has experienced fierce sell-offs recently (Deutsche Bank Announcement in February 2016). Notably, this lack of flow on to other banks across capital structures demonstrates the success of the new banking policy framework and is a fitting example of how different parts of the capital structure are awarded protection – or lack thereof.