Banking

How to Fix Failed Banks, and How Not To

A tale of three bank rescues shows good supervision and transparency matter more than resolution rules.

How not to rescue a bank.

Photographer: SERGEI SUPINSKY/AFP/Getty Images

Three recent bank rescues in Europe could form the backbone of a textbook on how to deal with large, failing banks -- and how not to. 

These are the uncompromising bail-in of Banco Popular in Spain, the controversial rescue of Monte dei Paschi di Siena in Italy and the much-praised but in fact horribly botched nationalization of Ukraine's largest bank, Privatbank. 

The Banco Popular purchase for 1 euro ($1.12) by Santander, Spain's biggest bank, is an example of how such operations should work. Popular, Spain's seventh biggest bank, tried to solve its balance sheet problems caused by the burst real estate bubble of the 2000s by repeatedly raising capital. But it couldn't plug the hole created by its 2016 loss of 3.7 billion euros, close to the bank's market cap at the time it was announced. On June 6, the ECB determined that Banco Popular was "failing or likely to fail" -- the first time such a determination was made to trigger a rescue. The following day, Europe's Single Resolution Board approved the bank's sale to Santander.

The scheme involves no taxpayer funding. Popular's shareholders and convertible bond holders have been wiped out (the bonds were converted to shares prior to the 1 euro sale).  It's a straightforward, easy to explain, fair deal. If a venture fails, the shareholders should absorb the loss, and clients and taxpayers should be safe.

The Monte dei Paschi rescue, permitted by the EU on June 1, doesn't work like that; it's a painful compromise involving 6.6 billion euros of taxpayer funding (the headline number is 8.8 billion euros, but 2.2 billion of that comes from converting some of the bank's bonds to equity). The Single Resolution Board should have acted as in Banco Popular's case. But the Italian government put a lot of effort into negotiating the "precautionary recapitalization" under European resolution rules, arguing that a by-the-book bail-in would have posed a shock to the financial system. Some 2 billion euros of the rescue package is earmarked for compensation to small private investors, to whom the bank had missold convertible bonds; they now stand to receive more reliable debt instruments in place of their paper. 

The government, of course, could have compensated the investors directly, without also recapitalizing Monte dei Paschi. But European regulators decided against pushing for such a clean solution -- perhaps because no private rescuer of Santander's stature showed up and there was no guarantee that anyone would be there to pick up the pieces. Instead, Monte dei Paschi had reached a preliminary agreement with private investors to sell off 29 billion euros of bad debt, and the European approval of the rescue is conditional on that sale taking place. 

If the regulators made a mistake, they erred on the side of caution. The Italian banking system isn't transparent enough to figure out if the failure of a bank with just 4.5 percent of the system's total assets might indeed trigger an avalanche.[note] European institutions generally prefer excessive caution to tough decisions, and that can be both a curse and a blessing -- but only with hindsight.

EU regulators can be praised for Santander and criticized for Monte dei Paschi; it's a matter of opinion whether Europe is ready to deal with failing banks if another crisis comes along. But it's worth remembering how far along Europe's resolution mechanisms are compared with what's happening on the EU's immediate borders. 

On Dec. 18, 2016, Ukraine nationalized its biggest lender, Privatbank, which held some 40 percent of all private deposits. Technically, it bailed in its shareholders: The bank was purchased for 1 hryvnia ($0.04). But without a private entity to take over the bank the government was on the hook to recapitalize it, with the maximum necessary amount estimated at $5.5 billion at the time -- serious money for Italy or Spain but an astronomical amount for Ukraine. 

The government knew most of Privatbank's loan portfolio had been to related parties. Yet it dallied for months as rumors of nationalization circulated, allowing the shareholders -- including powerful oligarch Ihor Kolomoisky -- to take every last penny they could out of the bank. A recently published investigation by the Organized Crime and Corruption Reporting Project found that shortly prior to the government takeover of Privatbank, it handed out some $1 billion in unsecured loans to fly-by-night firms set up by Kolomoisky's friends and subordinates. Many of the firms have been closed since, and the money is gone. 

Instead of keeping a close eye on troubled Privatbank's transactions in the months prior to nationalization, Ukraine's National Bank allowed them. Valeria Hontareva, the central bank's manager at the time, told Kolomoisky he had until the end of June, 2017, to restructure his companies' debts to Privatbank, but Ukrainian officials acknowledge that this is not happening. Instead of moving to recover the money, the Ukrainian government has refused to pay Privatbank's bondholders, claiming they were linked to Kolomoisky and converting their bonds to equity. Bondholders have sued in Ukrainian and international courts, and some Ukrainian investors have already won against Privatbank's new owners. On May 10, Hontareva resigned; she is unlikely to bear any responsibility for the mess.

So are double standards applied to banks in developed nations and in those merely striving to become part of Europe? Not necessarily. 

To regulators and international rule-setters, the stability of a banking system always comes first. They'll do everything by the book when a convenient private savior like Santander happens along, but they'll accept flawed deals like Monte dei Paschi's and even Privatbank's when no such luck is in sight and they perceive a high systemic risk.

For  textbook solutions like in the Banco Popular case to become the norm, it's important to go beyond stress-testing individual banks. Regulators must have a better understanding of the system-wide effects of winding down every large bank. Perhaps if the Italian banking system were more transparent, winding down Monte dei Paschi would have been a better solution. And if Ukrainian regulators had paid more attention to Privatbank's importance to the national banking system, they would have supervised it far more rigorously.

Whether a bank is actually too big to fail, and if it is, how to make sure it never needs a rescue, is at least as important as who ends up footing the bill when the worst actually happens.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

    To contact the author of this story:
    Leonid Bershidsky at lbershidsky@bloomberg.net

    To contact the editor responsible for this story:
    Therese Raphael at traphael4@bloomberg.net

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