(This story originally appeared in IFR, a Thomson Reuters publication)
By Christopher Spink
LONDON, Aug 11 (IFR) - There was some surprise in the market when holders of senior bonds escaped a bail-in in the rescue of Banco Espirito Santo, but perhaps there shouldn't have been given that the European Central Bank was a major creditor of the Portuguese bank.
Forcing a contribution from seniors in addition to subordinated bondholders would have posed a dilemma about what to do with the ECB's claims, which amounted to a net 7.4bn at the end of June.
Imposing losses on ECB claims would in effect have meant eurozone taxpayers helping to pay for the recapitalisation, something that bank regulators and politicians have pledged to avoid under new bank resolution legislation shortly to take effect across Europe.
The ECB's claims stem from assets parked at the central bank. These include senior unsecured floating-rate notes issued by BES, and guaranteed by the Portuguese state, paying Libor plus 12 percentage points. These were pledged as collateral to the ECB in return for funding.
These senior notes are some of the largest outstandings of BES senior bonds. For instance, three such notes cumulatively with a face value of 3.5bn come due this December, January and February. All were issued at the height of the eurozone crisis in late 2011 or early 2012, in effect to extract liquidity from the ECB.
BES has been relying on such emergency funding for some time. At its peak in 2009 the bank's loan to deposit ratio stood at 192%. That has since reduced to 126% but wholesale funding remains a key element of the bank's liabilities. ECB funding to BES increased 37% in the first half of this year.
Portugal was able to act quickly to rescue the majority of BES's loans, as well as its deposits and senior claims, by creating a bridge institution, Novo Banco, backed by a 4.9bn government loan because Europe's new bank recovery and resolution directive is not yet in place.
"Portugal like many other countries hasn't yet put the legislation in place, so that gave authorities the freedom to choose whether or not these creditors would be bailed in," said one senior banker at a European bank. "Two years from now, there would have been no choice but to bail in senior bondholders."
BRAVE NEW WORLD
The new pan-European rules must be applied from the end of 2015. That will create a strict hierarchy of creditor seniority that must be followed to decide which claims should be bailed in to recapitalise financial institutions in trouble.
That situation may place the ECB in peril, since it is a major creditor of many eurozone banks. It could also leave it wide open to accusations that it has a conflict of interest when it takes direct control of bank supervision across Europe from this November.
"There is potential for a conflict of interest in that the ECB is going to be both regulator and creditor to many banks," said the banker.
Under the new rules, senior bondholders will rank alongside uninsured depositors and other unsecured creditors. If there is insufficient equity or subordinated debt then these instruments will also have to take a haircut to recapitalise a bank sufficiently.
"This shows how carefully the ECB must tread if it doesn't want to test the collateral of these government bonds parked with it," said a lawyer. "You could imagine that when the ECB becomes the main regulator that it will not risk ECB exposures at all costs. It would not choose to hit senior bondholders if that meant hitting itself."
Another lawyer specialising in bank resolutions confirmed that under the new rules the ECB's claims would "almost certainly" rank with other senior bondholders, making it likely that it would be "seriously conflicted" if such a situation had arisen after 2015.
The lawyer added that under the new regime a full asset valuation would have had to have been carried out before a bridge institution would have been set up, making it less likely that seniors would have escaped.
Overall as of August 1, the ECB had 533.5bn outstanding with eurozone credit institutions, principally through its LTRO schemes. An additional 74.2bn of "other claims" to such bodies were also outstanding. These are understood to include these emergency liquidity arrangements.
The ECB declined to comment specifically on BES's rescue. However, a spokesperson said risk control measures, such as applying appropriate haircuts to instruments pledged as collateral, were in place to confront these situations.
This "ensures that the Eurosystem is protected against the risk of financial loss in case the underlying assets have to be realised owing to the default of a counterparty," said the ECB spokesperson.
IFR reported in June that Greece's four major banks still had 40bn of such funding outstanding. In May Alpha Bank, for instance, issued to itself a 2.82bn state-guaranteed FRN at three-month Euribor plus 12 percentage points explicitly for use as collateral at the ECB.
The immediate need to recapitalise BES came on August 1 after the ECB indicated it might not be able to continue to provide further liquidity facilities, a decision that would have sparked a run on the bank's deposits.
The Novo Banco solution also suits another official sector creditor, the China Development Bank, which lent BES 300m for three years in September 2011. That facility is due to be repaid next month. (Reporting by Christopher Spink; Editing by Matthew Davies)