Lessons from a new bank

25 Jan 2016 | Richard Kemmish

The Novo Banco / Banco Espirito Santo situation is destined to run for many months, possibly longer. At the time of writing there is still huge uncertainty, but that shouldn’t stop us trying to make some tentative conclusions about the implications for covered bonds, or for that matter financial regulation in general.
Let us start on a positive note: the bank resolution and recovery directive explicitly protects covered bonds from being bailed in in precisely this sort of scenario. This is the basis of covered bond ratings in many jurisdictions and has been respected fully by the Portuguese government, specifically the Bank of Portugal and (presumably) the ECB.

I could go further, the decision to take some senior unsecured bonds back into the resolution shows the determination of the authorities to ensure that the Novo Banco really will come out of the restructuring as a strong bank. This, in itself should be a significant source of comfort for covered bond holders.

But, the situation underlines some of the biggest concerns that investors have about the new rule book, in particular uncertainty and political interference.
Lets start with uncertainty. Insolvency law and the relative status of creditors used to be a lot simpler. You knew where you were, you could attempt to quantify losses and encumbrance levels and arrive at an estimated recovery value.

Now that the losses to be imposed are based on the judgement of a regulator. And that judgement is based on the amount of capital that will be needed going forward (ie, for the next ECB defined stress test), the calculations are all obfuscated. As the Novo Banco case shows, not even the regulators knew how much had to be written down when they made the initial split.  

The potentially more damaging uncertainty is time. Not only do we not know how much write down is needed, also we don’t know when the decision is final. For how much longer do the administrators of Banco Espirito Santo have recourse to Novo Banco’s bondholders? And how does Novo Banco fund itself with that uncertainty?

The second major concern is that the resolution process may be politically influenced. Which senior bonds were transferred to the resolution and which remain intact seems to have been made on the basis of governing law and end investors. Doesn’t sound like the objective rule of law to me.

More and more investors are concerned about the arbitrary application of political decisions to the banking sector in general, and – as Novo Banco shows us – to the resolution process in particular. I could be trite and say that, therefore you should invest more in bonds that are favoured as an asset class, and indeed owned in bulk by the ECB. But any politically motivated influence on the decisions of the single resolution authority and any arbitrary changes to the normal inter-creditor rules of a bank in insolvency are a problem for all bank creditors, no matter where they sit in the hierarchy.

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