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The Early BRRD

Anthony Smouha and Gregoire Mivelaz, who co-manage a number of GAM’s credit strategies, draw considerable encouragement from the practical application of new regulatory mechanisms, which have been designed to curb contagion in the financials sector and thus prevent idiosyncratic issues from morphing into systemic events.

11 July 2017

The EU Bank Recovery and Resolution Directive (BRRD) has been created as a means of consigning the phrase ‘too big to fail’ to the financial history books. It can reasonably be argued that the unprecedented level of state support for banks seen during the global financial crisis was necessary in order to prevent the systemic contamination of the financial sector, a complete meltdown in capital markets and an economic depression. However, it is also clearly an unsustainable proposition for taxpayer money to be used to bail out the private sector at the expense of more holistic public projects.

In this context, the mechanism defines ‘resolution’ as the point when the regulatory authorities determine that a bank is likely to fail or is in the process of failing. Where it is clear that it would not be possible for conventional processes, such as a rights issue or other forms of capital raising, to restore the institution to a viable footing without causing financial instability, a ‘resolution authority’ will step in to ensure that order is maintained.

We saw a live example of this in early June when European authorities, applying the new BRRD mechanism, intervened in order to arrange a sale of the failing Spanish bank Banco Popular to its rival Santander for the symbolic price of one euro. This epitomised the spirit of the regulatory developments, which assert that no bank is too big to fail, remedial measures will be swiftly carried out – ideally without any government funding – and that there should be no wider contamination.

We subsequently witnessed similar developments in Italy, involving the acquisition of Veneto Banca e Banca Popolare di Vicenza by Intesa Sanpaolo. Although the directive did not have the same impact in Italy, where the government had to step in to take over some non-performing loans, as in Spain, where no government funding was involved, this reflects the subtle differences in the scenarios. The case of Vicenza and Veneto involved liquidation because the SRB deemed these two Italian banks to be too small to apply a resolution action.

Conversely, Popular was large in size but in a weak position, having suffered for some time from the poor asset quality and insufficient provisioning of their non-performing loans. These accounted, on a gross basis, for almost one-quarter of the bank’s balance sheet. Furthermore, the Spanish lender had previously demonstrated a consistent inability to generate organic regulatory capital through equity issuance. As a result of decisive action by the SRB, Banco Popular was effectively restructured overnight and placed under the protective wing of rival Santander.

We believe that the outcome of these ‘test’ cases is positive in the broadest possible sense. Although the specific issues that catalysed these events were entirely particular to the banks concerned, had we witnessed a similar scenario 10 years ago, the outcome is likely to have been much messier. It seems likely that we would have witnessed contagion across the Spanish and Italian banking sector and this could have potentially resulted in systemic crisis. All the hard work that regulators have put in, and the pressure they have applied to the financial sector, in terms of capital build-up and de-risking appears to be paying off. Market participants are now able to view these high-profile issues as purely idiosyncratic events and this bodes well for investors looking to exploit fundamental dislocations in the price of securities.

Unlike its avian counterparts that catch a worm if they are sufficiently early, the BRRD mechanism relies on prompt intervention to prevent idiosyncratic events from contaminating the broader financials sector. Such anti-contagion measures should go a long way towards preventing the type of systemic collapse that engulfed markets during the 2008 Global Financial Crisis. This also reinforces our own observation that there are some very attractive yields to be garnered from the bonds of financial institutions. Nevertheless, these recent developments emphasise the importance of measured, bottom-up issuer selection, in addition to choosing the most appropriate risk / reward trade-offs at the security level.


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