The EU Bends the Rules for Italy's Banks, Again

7 MINS READJun 27, 2017 | 21:53 GMT
Veneto Banca and Banca Popolare di Vicenza's assets were consolidated over the weekend. It's the second time the European Union's new Banking Union rules have been tested in Italy.

Over the weekend, 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's the second time that its new Banking Union rules have been tested in Italy in the space of six months. It's 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's 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 Union-wide 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-and-pop 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 bail-in, 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 blocwide 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.

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