A couple of weeks ago, a grossly mismanaged major bank in a Western country collapsed, its senior employees and board members were summarily replaced, the losses associated with its collapse were properly allocated, and a new “good bank” was created that provided uninterrupted services to its customers. All of this took place in the course of a weekend, not dissimilar to the weekend it took not to accomplish any of this with Lehman Brothers, and required only a small raid on the public purse that will probably be entirely paid back. And almost nobody noticed.
Who accomplished this miracle of modern finance? How did they do it? And can they teach the US government to do the same?
The answer to the first question is Portugal, that well-known center of advanced financial thinking. The answer to the second question is that they had insolvency laws and bank regulations that actually made sense for large, systematically important financial institutions. The answer to the third question is: Your guess is as good as mine.
The bank is question is, appropriately enough for this tale of reincarnation, Bank Espirito Santo (“BES”). Prior to its demise, BES was the second largest bank in Portugal. Although all the details are not out yet, it came apart largely because the broader Espirito Santo Group used it like a private piggy bank, financing everything from hospitals to cattle ranches. It also engaged in some pretty dicey lending through its subsidiary in Angola, proving once again the curse of being a colonist.
Faced with this problem, the Portuguese government took a number of pretty simple steps. First they took inspiration from Sergio Leone and divided the assets of the bank into “the good, the bad and the ugly” – well, probably just the “good” and the “bad”. The first group was put into a new bank – cleverly named “Novo Banco” – along with all of the senior debt and deposits, and most of the employees and operations, of the bank. Since the senior debt and deposits were greater in value than the “good”, the Portuguese government injected €4.9 billion into Novo Banco in order to balance the books and recapitalize it. They expect to get this money back when they sell the shares of Novo Banco in the future.
Come Monday morning, Novo Banco hit the ground running, providing the usual services. Customers who spent the weekend drinking port wine and eating bacalhau, instead of watching the television news, probably did not even notice that they suddenly had a new bank.
The “bad”, conversely, were left in old BES, along with all the subordinated debt of this bank and its equity. These assets will be liquidated and the holders of the subordinated debt and the shareholders will get the results, but only after the government has recovered any part of its €4.9 billion left unpaid after the sale of the shares of Novo Banco. Judging by the prices at which the subordinated bonds traded after the restructuring, the market does not expect them to get much. And as for the shareholders, I am sure their stock certificates will make lovely mementoes.
Notice that many good things have happened here. First, the management that got the bank into trouble has been removed; Novo Banco has new leadership. Second, the previous shareholders and subordinated lenders, who did such a poor job of policing the management of BES, have been duly chastised; no “moral hazard” here and no public money used to bail out feckless investors. Finally, no contagion and no interruption of essential banking services, the great “boogeymen” used by the financial services industry to extract large sums of money from the public.
But the Portuguese could have done an even better job. In fact, there was no need to inject any public money into Novo Banco; they could have accomplished the recapitalization simply by leaving enough of the senior bonds, although probably not the small deposits, in BES to produce a solid net equity figure for Novo Banco.
There is no economic law that says that holders of senior liabilities have to be fully paid off if they have been foolish enough to lend to poorly managed banks. Any senior liabilities left in BES would have maintained their priority over the subordinated lenders and shareholders, and would have been paid off first from the sale of the remaining assets in BES. One of these remaining assets would have been the shares of Novo Banco, which would have remained with BES since there would have been no government money involved. To use the lingo, the “good bank” would have become a “hived down” subsidiary of the “bad bank”, fully independent of the difficulties of its parent.
There is very little that is new here. The idea of dealing with a banking crisis through the creation of “good banks” and “bad banks” goes back, at least, to the Swedish experience in the mid-1990s; in fact, when I was a young pup at Goldman Sachs, I recommended exactly this structure to the management of SBAB, the Swedish equivalent of Fannie Mae and Freddie Mac. Careful readers of Too Big to Fail, the story of the demise of Lehman and its consequences, will recognize that this solution was exactly what the private sector bankers were struggling to achieve with Lehman, but they lacked the legal power to impose loses on the creditors and make the numbers work.
Certainly, I have simplified matters here. There are complicated issues, particularly for big “universal” banks that engage in lending, trading and derivatives across multiple legal jurisdictions; these can be simplified, although probably not totally eliminated, through required structures and the preparation of “living wills” that will facilitate the separation of the “good bank” from the “bad bank”. But the overall lesson here is that “bail ins”, as this form of recapitalization is called, are a much better solution for troubled financial institutions than the “bail outs” that were so popular in the financial crisis. This should be the target of the regulators and legislators when they are considering modifications to the banking and insolvency laws.
Roger Barris, London
I wish that I had said that…
“Governing Italy is not impossible; it is pointless”, former Italian Prime Minister Giovanni Giolitti (also attributed to Mussolini)
“The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities … will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands”, Warren Buffett, who requires no introduction
“With or without religion, good people can behave well and bad people can do evil; but for good people to do evil – that takes religion,” Steve Weinberg, an American winner of the Nobel Prize in Physics