1. The ECB can act quickly when considering if a bank has reached the point of non-viability (PONV), and enacting a resolution plan. The speed with which regulators acted clearly took the market by surprise. At the same time, how the regulator determines a bank to be non-viable is still a grey area (considering the situation around some of the weaker Italian banks).
2. EU stress tests are not a very good assessment of banks’ medium-term viability. This isn’t new information, but Popular should serve as a reminder of the fact given it had a low but passing adverse-scenario CET1 of 7.0% in the 2016 tests. Similarly, a high liquidity coverage ratio (LCR) may be little comfort in the face of a run on deposits (Popular’s LCR of 146% was well above the 100% regulatory minimum).
3. When it comes to AT1 (Additional Tier 1) conversion triggers, the point of non-viability trigger is the more likely to result in conversion/write-down rather than the breach of capital ratio – making the difference in high trigger to low trigger coco’s less relevant.
4. Valuations of a bank’s assets tends to fall sharply once the bank is deemed non-viable. Whether from signalling effects or regulator incentives to be conservative, losses imposed on investors have historically been considerably larger than market expectations leading up to a resolution or bail-out (Portugal’s Novo Banco is another example).
5. In a stress situation, Tier 2 losses may not be very different from those of AT1s. The swift and full T2 write-down highlights the potentially unenviable position of T2 investors. We’re not suggesting they pose exactly the same risks (unlike T2, AT1s share many features with equity such as discretionary distributions and the possibility to extend into perpetuity), but in a point-of-non-viability case, T2 may not offer much more protection to investors.
6. There is a fine line between PONV and resolution – non-preferred senior bonds are also designed to take losses. While non-preferred senior debt is a resolution instrument, not a PONV instrument, there is a good chance that when a bank reaches PONV it will be put into resolution and trigger the non-preferred senior. There are scenarios where conversion of sub-debt may be sufficient to prevent a bank from being put into resolution, however this depends on the size of the loss at the individual institution. Given the point above re valuations, we think the probability of resolution following PONV is fairly high. There was no non-preferred senior debt outstanding in this case, but if there had been there is a good chance it would have also taken losses.
7. Despite the fact that seniors were spared in this instance, we do not believe this means that regulators will bend over backwards to avoid losses on other bail-in-able seniors in future cases. Regulators are more likely to attempt to protect seniors which are pari-passu with deposits or other senior liabilities, in the name of a “clean” resolution and financial stability, but it is more straightforward for them to bail in liabilities that sit below deposits (e.g. German seniors, HoldCo seniors, non-preferred seniors) and we should not expect these to be protected.
8. Questions remain about the “no creditor worse-off than in liquidation” (NCWO) principle, as it remains unclear how Popular’s subordinated debt holders might have been treated in a liquidation scenario. They may believe the provisions Santander is taking on Popular’s NPLs are too conservative (they result in considerably higher coverage ratios than the average Spanish bank – though the average may not be a reasonable benchmark) and may therefore litigate. The ECB/SRB (Single Resolution Board) made no mention of the NCWO principle in their communications regarding Popular, which raises questions on how they handled this requirement.