The EU bends the rules for Italy's banks, again

Ever since Greece's exit from the eu­ro­zone was averted in 2015, Italy has been the big­gest threat to European unity. It's the Con­ti­nent's most in­debted econ­omy, with public debt of 132 per­cent of GDP.

Financial Nigeria Magazine - - Contents -

Over the week­end (of June 25), two of Italy's most trou­bled banks were wound up: The good as­sets of Veneto Banca and Banca Popo­lare di Vi­cenza were taken on by In­tesa San­paolo, a larger peer, while the bad as­sets were moved to an un­der­per­form­ing bank to be fi­nanced by state funds. Over­all, the cost to con­sol­i­date the in­sti­tu­tions could come out to around 17 bil­lion eu­ros (roughly $19.3 bil­lion) for the Ital­ian gov­ern­ment, con­sid­er­ably higher than ear­lier es­ti­mates. More prob­lem­atic for the European Union, it was the sec­ond time that its new Bank­ing Union rules have been tested in Italy in the space of six months. It was also the sec­ond time those rules have been bent for po­lit­i­cal ex­pe­di­ency. The European Union, buoyed by good eco­nomic growth and the re­cent elec­toral vic­to­ries of mod­er­ate po­lit­i­cal forces, has turned dis­cus­sions back to­ward in­te­gra­tion. But if this episode demon­strates any­thing, it was that Italy will still sti­fle such am­bi­tions.

The bailouts were not un­ex­pected. In a coun­try suf­fer­ing from a gen­er­ally weak bank­ing sys­tem, the two banks were the next on ev­ery­one's list fol­low­ing the bailout of the world's old­est bank, Monte Dei Paschi, in De­cem­ber. More sur­pris­ing, though, was the man­ner in which they were re­solved, which di­rectly sub­verted the Bank­ing Union rules.

Af­ter the 2011-12 eu­ro­zone cri­sis, pol­i­cy­mak­ers re­al­ized a large source of risk was the fact that when a European bank ran into fi­nan­cial trou­ble, its na­tional gov­ern­ment was in­vari­ably forced to bail it out. The sys­tem cre­ated not only a moral haz­ard by en­abling banks to run up huge debts but also sys­temic risk from the most highly in­debted gov­ern­ments, which could lead to a debt spi­ral as bank and sovereign debt min­gled and dragged each other down.

The solution: Cre­ate a European Union­wide Bank­ing Union that would share fi­nan­cial risks hor­i­zon­tally across the bank­ing sys­tem rather than ver­ti­cally in na­tional si­los. These rules, which came into ef­fect in 2016, meant that if banks ran into trou­ble, the first pain would be felt not by na­tional tax­pay­ers, but by the banks' in­vestors, who would have their funds used, or "bailed-in," to save the banks. The threat of putting up in­vestors' own money was also meant to dis­cour­age the banks from ex­ces­sive risk-tak­ing dur­ing good eco­nomic times.

Fi­nan­cial pain would ex­tend to the banks' share­hold­ers as well as their debthold­ers, in­clud­ing ju­nior and se­nior bond­hold­ers. (Se­nior bonds pay less yield – or in­ter­est – than ju­nior bonds, but are meant to be pro­tected and a safer in­vest­ment as a re­sult.) The threat to de­pos­i­tors was then sup­posed to be pro­tected by a blocwide de­posit in­sur­ance scheme, in which European banks would pay into a fund to help pro­tect each other. Un­for­tu­nately for this new sys­tem, the de­posit in­sur­ance scheme has yet to be agreed on, blocked pri­mar­ily by Germany, which is un­able to over­come its wari­ness of mu­tu­al­iz­ing risk with what it per­ceives as fi­nan­cially undis­ci­plined south­ern peers. With­out the scheme, the bail-in rules alone have had a patchy record.

Still, there have been some suc­cesses. The strug­gles of Spain's Banco Pop­u­lar ended in early June in a pro­ce­dure that broadly demon­strated how the Bank­ing Union was de­signed to work. Af­ter European reg­u­la­tors de­clared the bank's debt was un­sus­tain­able, Santander, a larger bank, swiftly bought its as­sets for a nom­i­nal fee. Santander then im­me­di­ately went about rais­ing cap­i­tal to cover the costs of Banco Pop­u­lar's bad loans. The in­vest­ments that had been made by Banco Pop­u­lar's ju­nior bond­hold­ers were used to cover those losses, but the cap­i­tal raised by Santander was enough to spare se­nior bond­hold­ers from pay­ing. In this way, pri­vate cap­i­tal was used to res­cue the bank, avert­ing dis­as­ter with­out us­ing tax­payer funds.

But then there are the Ital­ian ex­am­ples. At the end of 2015, four small banks were wound up us­ing the new rules, re­sult­ing in huge po­lit­i­cal fall­out. In Italy, mom-and­pop in­vestors are large hold­ers of bank­ing debt, and the re­sult­ing losses when they were bailed-in led one pen­sioner to com­mit a high-pro­file sui­cide and drew wide­spread con­dem­na­tion, in­spir­ing fear of the new rules among Italy's po­lit­i­cal class. So when Monte Dei Paschi, a large bank, ran into trou­ble in late 2016, Ital­ian and EU reg­u­la­tors de­cided to avoid im­pos­ing a bailin, wish­ing to avoid fur­ther po­lit­i­cal fall­out, es­pe­cially at a time when the Euroskep­tic Five Star Move­ment was within strik­ing dis­tance of at­tain­ing po­lit­i­cal power. Along with some pri­vate cap­i­tal from other banks, a "pre­cau­tion­ary re­cap­i­tal­iza­tion" rule al­low­ing the use of state money was em­ployed to skirt the bail-in reg­u­la­tions. Monte Dei Paschi's po­lit­i­cally sen­si­tive pri­vate in­vestors were largely spared and even re­im­bursed in the process.

The Monte Dei Paschi res­cue may have bent the Bank­ing Union rules, but the lat­est Ital­ian bank sit­u­a­tion warped them even fur­ther. Any at­tempt to use pre­cau­tion­ary re­cap­i­tal­iza­tion in their cases was com­pli­cated by other banks' un­will­ing­ness to pro­vide pri­vate cap­i­tal to take on some of the risk. In­stead, only In­tesa San­paolo made a clear of­fer, and it pro­posed buy­ing only the least risky as­sets at a cheap price, on the ex­press con­di­tion that its own eco­nomic health was not harmed by the trans­ac­tion. It got the two banks' good as­sets for a nom­i­nal fee, plus 5 bil­lion eu­ros from the Ital­ian Trea­sury to guard against any of the loans go­ing bad.

An­other 12 bil­lion eu­ros was also made avail­able to pro­tect against fur­ther losses. Ju­nior bond­hold­ers have been bailed in as part of the trans­ac­tion (they will prob­a­bly be re­im­bursed), while se­nior bond­hold­ers were spared again. Con­sid­er­ing that most of the money spent in this trans­ac­tion be­longs to Ital­ian tax­pay­ers, the bail-in, in fact, looks more like a state bailout sim­i­lar to the ones that pre­dated the Bank­ing Union.

These bailouts are not nec­es­sar­ily a sign of fu­ture Ital­ian bank­ing prob­lems, at least not im­me­di­ately. The mar­kets re­acted fairly well to the lat­est news, be­cause it re­moves Italy's riski­est banks from the pic­ture, and there are no ob­vi­ous sources for the next threat of sys­temic risk. Italy's bank­ing sys­tem has tough­ened over the last six months as well, with large bank Unicredit no­tably man­ag­ing to raise 13 bil­lion eu­ros in new cap­i­tal in Jan­uary. All the while, European eco­nomic growth has taken some pres­sure off Italy's large pile of non­per­form­ing loans.

In­stead, these bailouts un­der­mine the European Union's prospects for fu­ture in­te­gra­tion. Eco­nomic growth has been matched by the elec­tion of mod­er­ate po­lit­i­cal fac­tions in the Nether­lands and France, her­alded by the rise of Em­manuel Macron to the French pres­i­dency. Talk has thus turned to how the European project might be able to move for­ward af­ter the Ger­man elec­tions, in which mod­er­ate forces are again ex­pected to win. Ger­man Chan­cel­lor An­gela Merkel has even shown a will­ing­ness to con­sider new de­vel­op­ments.

But if Europe is re­ally go­ing to in­te­grate fur­ther, the next ef­fec­tive step would most likely be to com­plete the Bank­ing Union, po­ten­tially putting the European Union's econ­omy on a more solid foot­ing. For that to hap­pen, Germany needs to change its mind and agree to the bloc-wide de­posit in­sur­ance scheme. Af­ter all, the re­peated bailouts are ev­i­dence of the kinds of part­ners with which Germany would be mu­tu­al­iz­ing its risks.

Ever since Greece's exit from the eu­ro­zone was averted in 2015, Italy has been the big­gest threat to European unity. It's the Con­ti­nent's most in­debted econ­omy, with public debt of 132 per­cent of GDP. It's also due to hold elec­tions within the next year, with sev­eral lead­ing par­ties ques­tion­ing Italy's con­tin­ued pres­ence in the eu­ro­zone. The risk on its bal­ance sheet, and its pen­chant for bend­ing bank­ing rules rather than ad­her­ing to them, make it hard to imag­ine Germany sign­ing up to any scheme that ties the fate of its cit­i­zens' wealth to Ital­ian de­ci­sions.

“The EU Bends the Rules for Italy's Banks, Again” is re­pub­lished with the per­mis­sion of Strat­for, un­der con­tent con­fed­er­a­tion be­tween Fi­nan­cial Nige­ria and Strat­for.

Ital­ian bank In­tesa San­paolo

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