Creditor Participation in European Bank Restructurings

A Corner Turned ?A Corner Turned ?

Münchener SeminareNovember 2013

Hans-Joachim DübelFinpolconsult, Berlin

Discussion TopicsDiscussion Topics

• Bank liquidity and capital policies during crisis

• Creditor participation before and during

restructuring/resolution

• Lessons: policies and institutions for Europe

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Bank Liquidity PoliciesBank Liquidity PoliciesTemporary Fix for Low Bank CapitalTemporary Fix for Low Bank Capital

Euro crisis• High EUR demand by banks hit by real

estate and sovereign crisis, pullout of banks / institutions,

• Note that country ranks have changed over time (Italy!).

• ECB has been slow on bank capital o It took ECB until 2013 to call for

comprehensive recapitalizations ( ‘Asset Quality Review’),

o Resistance against bail-in Draghi letter of July 2013,

o Lots of unintended consequences...

4Source: Osnabrück University.

Eurosystem Net Lending / Borrowing of Selected Countries, 2007-2009

Bank Liquidity PoliciesBank Liquidity PoliciesYour Central Bank as an ATM Machine..Your Central Bank as an ATM Machine..

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Source: Central Bank of Cyprus, Finpolconsult computations.

ELA – Emergency Liquidity Assistance,IBU – International Business Unit.

Laiki Bank

Large ECB ELA borrower, at peak EUR 9.8 billion (33% of assets),

Some 50% can be estimated to have used to pay out mostly large deposits (IBU), senior and subordinated bond holders,

Asmussen: ‘did not reach 2/3 majority in Gov Council to block Laiki ELA’,

some tightening of ELA rules Oct 2013 (reporting on borrower/collateral, GC must take decision if >EUR 2 billion).

Discredits Walter Bagehot’s Lender of Last Resort rule?- lend without limits, at penalty rate.

Not quite: bank capital !!

Laiki Bank Deposits by Source 2010-2012

Bank Liquidity PoliciesBank Liquidity PoliciesTemporary Fix for Low Bank CapitalTemporary Fix for Low Bank Capital

USD crisis (of European banks..)•2008 SIV/ABCP after pullout of US MMFs,

•Ongoing: European banks’ role in the global China/Petrodollar recycling,

•The Fed shoots fast !!

o After 2008 Steinbrueck interview closed window for HRE/Depfa,

o After the 2011 US MMF run on French banks, the Fed passed on credit risk to the ECB (EUR-USD swap agreement).

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NY Fed Term Auction Facility Lending to German Banks, 2007-2010

Source: Federal Reserve Bank of New York, Finpolconsult computations. Cumulative lending.

SIV – Structured Investment Vehicles,ABCP – Asset-backed Commercial Paper,MMF – Money Market Funds.

USD Target DebateUSD Target Debate

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Bank Capital PoliciesBank Capital PoliciesEarly Bailout Cases: Hypo Real Estate/GermanyEarly Bailout Cases: Hypo Real Estate/Germany

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• Public recapitalization 2009

o Private deposit insurance fund de-facto insolvency by late 2008 (“17 billion in potential losses”),

o Early public capital injection and squeeze-out of shareholders by June 2009,

o Followed by second recap in same year,

o And creation of ‘Bad Bank’ in 2010.

Source: Bank reporting, Finpolconsult.

HRE Total Liability Structure

Bank Capital PoliciesBank Capital PoliciesBad Bank Is Often Stealth Public RecapBad Bank Is Often Stealth Public Recap

Bad banks systematically untie the fate of junior (and senior unsecured) debt from the fate of assets,Transfer pricing chosen may be right or wrong,Why expose government to such risk?

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Bad Bank Model (Asset Swap Model)

Bank Capital PoliciesBank Capital PoliciesFMS WertmanagementFMS Wertmanagement

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Bad Bank oBy October 2010 with entire Greek exposure !!oand with full public ownership, no transfer of junior debt (despite law): = de-fact third – and most expensive - public recapitalization.

Bank Capital PoliciesBank Capital PoliciesClassic Bailout: CitibankClassic Bailout: Citibank

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“Indeed, I was surprised when Tim started reaching out to me directly on the possibility of doing a good bank/bad bank structure for Citi.

Initially, he raised the idea of the FDIC setting up and funding a bad bank, without imposing any loss absorption on shareholders and bondholders. I was flabbergasted.

Why in the world would FDIC take all of the losses and let Citi’s private stakeholders take all the upside with the good bank?

During the second meeting, we discussed a proposal to have the common equity and some of the preferred shareholders help absorb losses. Our view was that all of the private preferred shareholders should convert and that the bondholders should take some losses as well.

..That was a nonstarter for Tim. He wanted FDIC to take a hit.

Sheila Bair ‘Bull by the Horns’

Bank Capital PoliciesBank Capital PoliciesClassic Bailout: Hypo Real Estate/GermanyClassic Bailout: Hypo Real Estate/Germany

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• Financial resulto Shareholders received cash,o Junior creditors were almost

entirely protected, except hybrid coupons (EU rules) and UT2 haircuts (held by retail),

o Ca 18 billion in public capital investment with perhaps 10% recovery expectation, reduced by almost EUR 4 billion outstanding junior debt.

• Landesbankeno WestLB last minute junior bail-in did

not use the bail-in legislation.

• Germany estimate:• EUR 50 (hybrid) + 60 (sub) billion

investors lost a fraction only, • Total loss for taxpayer could be ca

EUR 100 billion.

Source: bank reporting, Finpolconsult.

HRE Junior Debt Structure

Bank Capital PoliciesBank Capital PoliciesBasel III Transition In the Middle of CrisisBasel III Transition In the Middle of Crisis

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Basel III (Dec 2010)o Fights failure of Basel II to bail in junior

debt,o New core capital definition: no revaluation,

all capital is permanent, hybrid is limited. o Strongly rising capital demands while second

leg of financial crisis unfolds,o Incentivizes buybacks, early calls of Tier 2

and non-eligible Tier 1 instruments.

The PROBLEM: o This is all fine for going concern banks ..o .. while it somehow ignores progress in bank

restructuring / resolution law (UK, DE), which has widened the bail-in definition.

o But what happens, when a bank in difficulties starts “buying” core capital by selling extended capital?

Source: FitchRatings (2010)

Discussion TopicsDiscussion Topics

• Bank capital and liquidity policies during crisis

• Creditor participation before and during

restructuring/resolution

• Lessons: policies and institutions for Europe

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When Gone Concerns Buy Core Tier 1 When Gone Concerns Buy Core Tier 1 Liability Management Exercises in GreeceLiability Management Exercises in Greece

Sources: Alpha Bank, Finpolconsult LME deal analysis.

Alpha: ‘Rationale for the Offers’, May 2013:•Eurogroup announcement of Nov 2012: “liability management exercises should be conducted in respect of remaining subordinated debt holders so as to ensure a fair burden sharing”•“The Offers are made in order to provide investors with an opportunity to monetise their investments at the relevant Purchase Price on a voluntary basis.”

Alpha Bank Liability Structure

When Gone Concerns Buy Core Tier 1 When Gone Concerns Buy Core Tier 1 Liability Management Exercises in GreeceLiability Management Exercises in Greece

Sources: bank reporting, Finpolconsult LME deal analysis.

• Is offering between 40 and 60% in cash on subs and hybrids in entirely voluntary LME ‘fair burden sharing’?

• Greek government recap effectively replaces some 70% of GGB losses (four large banks),

• Once government is invested in shares, subordinated debt investors can expect to be paid par moderate acceptance,

• Financial result: Junior bank debt investors are largely exempt from GGB losses, ca EUR 2 out of 3.5 billion per Q IV 2011 = cash payment.

Greek Bank Junior Debt RepurchasesCash offer conditions to investors 2012, 2013

1: National Bank of Greece, 2: Alpha Bank, 3: EFG Eurobank, 4: Piraeus Bank. EFG Eurobank DES – debt equity swap.

When Gone Concerns Buy Core Tier 1 When Gone Concerns Buy Core Tier 1 Liability Management Exercises in CyprusLiability Management Exercises in Cyprus

Laiki Bank

June 2012, first restructuring

Cypriot government invests EUR 1.8 billion (>10% GDP) into shares, before hybrids and subs are haircut/converted,

Financial result:

Hybrid capital investors in are offered a voluntary equity swap, which only by December 2012 becomes mandatory (still far too high number of shares).

Subordinated bond investors enjoy a highly concessionary deal (EUR 450 million subordinated bond)•Bond offer: 72.5% exchange into senior bond with twice the interest level of deposits (MTM~85), accepted by EUR 132 million,•Cash offer: 55% cash offer, accepted by EUR 182 million.

Laiki Bank Subordinated Bond LME Laiki Bank Subordinated Bond LME

SLE Capital Loss EUR 150 mln = 1/3SLE Capital Loss EUR 150 mln = 1/3

18Source: Laiki Bank Reporting, Finpolconsult.

SLE – Subordinated Liability Exercise.

When Gone Concerns Buy Core Tier 1 When Gone Concerns Buy Core Tier 1 Liability Management Exercises in CyprusLiability Management Exercises in Cyprus

Laiki Bank (other)

In September 2012, EUR 330 million in senior bonds matured days before the PIMCO due diligence exercise started,

The June 2012 subordinated bond deal was partially ‘clawed back’ in March 2013 through the mandatory debt-equity swap of senior unsecured.

Bank of Cyprus

In May 2011 called a subordinated bond of EUR 200 million at par, at the first possible date,

Note: Deutsche Bank had broken with this policy in 2008.

When Gone Concerns Buy Core Tier 1When Gone Concerns Buy Core Tier 1Creditor Rotation Through LMECreditor Rotation Through LME

Sources: bank reporting, Finpolconsult computations.

Bankia Funding Structure

Bankia•Large volumes of senior unsecured and covered bonds sold to foreign investors, these investors rotated with the ECB,•2006/7 subordinated debt issued mainly to professional investors.

When Gone Concerns Buy Core Tier 1When Gone Concerns Buy Core Tier 1Creditor Rotation Through LMECreditor Rotation Through LME

Sources: bank reporting, Finpolconsult computations.

Bankia Funding Structure, Expanded

Bankia•Since 2010, covered bonds were issued into ECB repo (i.e. disappear from balance sheet and ECB claims appear),•Foreign bank investors recycle proceeds into ECB surplus reserves.

When Gone Concerns Buy Core Tier 1When Gone Concerns Buy Core Tier 1Creditor Rotation Through LMECreditor Rotation Through LME

Sources: bank reporting, Finpolconsult computations.

Bankia•Cash payments to (largely professional) subordinated investors in 2010 and 2011 of ca. EUR 2 billion,•In parallel new subordinated debt and equity was issued, at this time mostly to retail investors/households,•2012 cash paid had to be reinvested in equity (LME).

Bankia Cash Flow

Share Buyback as a Costly Policy to Share Buyback as a Costly Policy to Support Equity LMESupport Equity LME

Sources: http://ftalphaville.ft.com/2012/06/26/1056401/the-spanish-bank-buy-back-riddle/Onvista.de.

Stabilizing LTRO-effect in Q I 2012 for share prices was used by Spanish banks for share buybacks.

Bankia:

-Offered hybrid investors shares at high exercise prices into collapsing share price trajectory, benefiting insiders who sold immediately.

-Bank may have lost EUR three-digit millions in cash (Core Tier 1)

-Reports for total year 2012 75 million loss from own share dealing operations.

When Gone Concerns Buy Core Tier 1When Gone Concerns Buy Core Tier 1Creditor Rotation Through LMECreditor Rotation Through LME

Sources: bank reporting, Finpolconsult computations.

SNS Reaal•2008 public (senior) hybrid capital injection.•In 2009 the profit situation was still seen as healthy enough for SNS to buy back EUR 250 million of the hybrids, most of which from government, and retire other junior debt, •In 2010, SNS Bank placed a EUR 500 million subordinated bond with a 10-year maturity,•2011 large cash LME over EUR 420 million of old subordinated debt,•2012 first possible call of 2003 issued hybrid capital securities exercised.

SNS Reaal Cash Flow

Restructuring – Restructuring – Debt Equity Swap or Haircuts?Debt Equity Swap or Haircuts?

Source: FinpolconsultSLE – Subordinated Liability ExerciseCoco – Contingent ConvertiblesCDS – Credit Default Swaps.

Spain (Bankia)- Haircut & DES

• Group 1 – mandatory SLE,• Group 2 – first voluntary,

then mandatory SLE.- Pricing approach:

• “market price” (first law draft permitted 10% over) vs.

• liquidation value,• Ultimately ‘negotiated’.

Netherlands (SNS Reaal) – Expropriation

• 100% haircut,• liquidation value.

Both approaches lead to same desired Core Tier 1 effect.

Bankia: Haircut & Debt Equity Swap Combined

Debt equity swap leaves possible economic upside on the table for investors, tied to asset performance.

Parallel to Coco debate:•0-1 (insurance) instruments carry significant legal risk, esp. if triggers are regulatory.

Alternatives?• CDS written by bond investors

on initial bank portfolio,• Example: KfW credit-linked

notes program.

Restructuring – Restructuring – Comprehensive Debt Equity SwapComprehensive Debt Equity Swap

Bank of Cyprus = extension of Spanish junior debt bail-in to senior unsecured-No initial haircuts of debt !! swap.-Allocation of sub, senior unsec, large deposits to thin equity classes, -Full voting rights for these classes, -High interest rates for preferred shares if bank performs,-Current main shareholder is Laiki Bank unwinding vehicle (18%),-Issue: ad-hoc seniority given to Cyprus public sector and ECB. 26

Bank of Cyprus – Debt Equity Swap

Source: Finpolconsult.

Restructuring – Restructuring – Good Bank Model (FDIC Standard)Good Bank Model (FDIC Standard)

Cases•Laiki Bank, Good Bank & P&A combined with super-seniority of insured deposits.

o Denmark (Amagerbanken), Greece (ATE, Hellenic Postbank).•Problem as with all P&A is determination of sales price during stress. The larger the bank, the greater valuation risk (e.g. U.S. Washington Mutual). •Response: Iceland - bridge banks to be sold later. •Would have required public funding in the case of Laiki. •Did Greek subsidiary P&A to Piraeus cut losses or profit?

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Laiki - Good Bank, Purchase and Assumption (P&A)

Source: Finpolconsult.*

Fiscal ExpenditureFiscal ExpenditurePrivate Sector Involvement, 3 CountriesPrivate Sector Involvement, 3 Countries

28Source: Central banks, Analistas Financieras Institucionales, Finpolconsult. Gap based on target CT1, ‘internal includes proceeds from sales, accounting issues (DTA)’ *pre-Sareb, **without impact of Good Bank-Bad Bank splits on non-core banks, ***assumes some OSI in debt-equity swaps.

2012/13 summary: three countries = three approaches.•Complete individual path-dependency, only MoU changed was Cyprus,•Greek OSI ratios >> Spain,•Cyprus outlier (but not for smaller banks).

Greek Banking Program**Spanish Banking Program, Group 1*

Cyprus Banking Program***

Fiscal ExpenditureFiscal ExpenditureExpanded Country SampleExpanded Country Sample

29Source: Finpolconsult.

Creditor participation ratios increasing over time , however with outliers:•Amagerbanken an early case (fall 2010) with senior unsecured creditor participation,

o Note: In fall 2010, Ireland was not permitted to bail-in senior debt at Anglo Irish Bank, while Denmark did so,

•Dexia a late case (second recap 2012), even after Spain, with large junior bondholder bailout, junior debt investors will receive in total some EUR 2 billion.

Estimated Private Sector Involvement in Capital Gap Financing

Fiscal ExpenditureFiscal ExpenditureExpanded Country SampleExpanded Country Sample

30Source: Finpolconsult.

Deterrents to bail-in: • First government recap often followed by second rather

than bail-in –> avoids stigma of wasting taxpayer money (HRE, Dexia),

• Fiscal capacity, program vs. non-program country (currently MPS Italy),

• Restructuring delay, may hit the wrong creditorsBankia, but did not deter SNS Reaal.

Dexia S.A. Junior Debt Structure

Fiscal Expenditure vs. CostFiscal Expenditure vs. CostLoss Expectation of RecapsLoss Expectation of Recaps

31Source: Bank reporting, national central banks, Finpolconsult.

Question: -What share value does government acquire with a given expenditure?-Chart assumes 100% price/book ratio of acquired bank stock, i.e. full capital gap has been detected and adequately provisioned for. Result: •7 sample bank aggregate fiscal loss would have eaten up 30%-35% of ESM capital.

Fiscal Loss Based on 2012 Book Value

Fiscal Expenditure vs. CostFiscal Expenditure vs. CostLoss Expectation, Extended Country Loss Expectation, Extended Country

SampleSample

32Source: Bank reporting, national central banks, Finpolconsult.

Additional result: •SNS Reaal with small fiscal profit, based on (possibly heroic) assumption of no additional losses,•Deep bail-in cases (Laiki, Amagerbanken) show high loss for government as government ‘gives up’ initial recapitalization,•Median expected loss ratio for government is 75%.

Fiscal Loss Based on 2012 CT1 Book Value

Fiscal Cost of Bank ResolutionFiscal Cost of Bank ResolutionMethodology Example, SpainMethodology Example, Spain

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Source: FROB, Bank of Spain, Autonomous Research, Finpolconsult assumptions and computations.

DES – Debt Equity Swap

Recovery expectation matters !!•ECB repo is both super-senior and collateralized,•ECB ELA at least super-senior (Cyprus),•Hybrid capital safer than shares,•Share injection after bail-in safer than before bail-in, •DESs share economic value with investors, haircuts don’t.

Spain-Historic expenditure inflated by large guarantees.-Very large ECB/ELA exposure, e.g. Bankia alone EUR 74.5 bln,-Potential bad bank (Sareb) fiscal cost are not properly accounted for (guarantees).

Spain, Banking Program Accounting under Author’s Subjective Expected Loss Assumptions

Discussion TopicsDiscussion Topics

• Bank capital and liquidity policies during crisis

• Creditor participation before and during

restructuring/resolution

• Lessons: policies and institutions for Europe

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Bank Restructuring & Resolution Bank Restructuring & Resolution LawLaw

What did take Europe so long?What did take Europe so long?

In the U.S, the 1991 FDIC Improvement Act marked the turning point – a full 9 years after Garn St Germain:•Abolition of ‘Open Bank Assistance (‘direct recapitalization’),•Least Cost Resolution Approach (from taxpayer perspective),•ALL deposits became super-senior (separate act), •FDIC became only required to transfer insured deposits in a P&A bail-in of large deposits.

Europe: IKB to Cyprus is 5.5 years.. (but there was a template!)

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FDIC Least Cost Resolution Game Changer 1991

Lessons LearnedLessons LearnedResolution and RestructuringResolution and Restructuring

• A European Directive by 2018 is too late !o 10 years after Lehman – exempts all likely current crisis cases,o EU KOM rule (Aug 1, 2013) disallowing state aid without prior junior

bond bail-in less effective without the Directive (MPS case).

• Exceptions should be avoidedo At least junior bond bail-in,o Include Covered Bonds overcollateralization,o ‘Systemic risk’ backdoor should be closed main risk is fiscal collapse, o ECB ‘precautionary recapitalizations’?

• Complete Banking Union architecture o Build the European version of U.S. FDIC, to create vested interest in

shorter time to restructuring and deeper creditor participation,o ECB has conflicts of interest as de-facto bank investor and cannot be a

monopoly bank regulator from a fiscal perspective shared supervision.

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21/04/2337

Internal Market

Single Resolution Fund

National Resolution Authorities

manages

puts under resolution /

sets resolution frameworkcontribute

provides funding

instructs

resolve

All banks

Failed bank

supervise

notify

ECB

National Supervisors

COM

Single ResolutionBoard

EU ‘FDIC’ ConceptEU ‘FDIC’ Concept(Source DG Markt)(Source DG Markt)

Lessons LearnedLessons LearnedJunior Bond Capital AvailabilityJunior Bond Capital Availability

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Reconcile Basel and fiscal definitions of bank capital !!

Challenges AheadChallenges Ahead

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Irish Mortgage Portfolio Funding, Stylized

Source: above - Osnabrück University, below - Finpolconsult.

• Securities portfolioso Self-inflicted ‘sovereign-bank’ doom-loop by

banks rejecting diversification, o ECB has not enforced diversification, LTRO

without conditionality,o Whichever-is-lower ratings are accepted -

usually Canadian DBRS,o Arbitrary repo policies (e.g. Cyprus sov).

• Loan portfolioso ‘Kick-the-can’ corporate loans (EBIT<interest;

40-50% in ES, IT, PT),o Insufficient mortgage profitability related to

indexed loans (Euribor, ECB refi),o Underperformance and market risk are NOT

generally covered by Asset Quality Review.

Slow bank recapitalization due to rejection of bail-in means that Eurosystem imbalances could remain high.

USD Target DebateUSD Target Debate

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