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Op-Ed: Italy Seeks to Support Troubled Banks While Meeting EU Rules on State Aid

Summary:
Public guarantee scheme risks being too little and too late Since their troubled start of the year, Italy’s banks have come under pressure again after the recent UK referendum. The current market concern about Italian banks is not surprising. Though they were resilient to the early phases of the global financial crisis, the banks have accumulated non-performing loans (NPLs) ever since, with no forceful countermeasure being taken. The solution adopted in 2016 foresees a public guarantee scheme for NPLs together with a bank-funded reserve that will buy junior NPL tranches and support banks’ capital raises, but it runs the serious risk of being too little and too late. The European Banking Association stress tests due to be published at the end of July may renew the focus on Italian banks, revealing the need for further recapitalizations. The European Commission authorized Italy to issue public guarantees worth €150bn to banks raising liquidity from the market but there is much less clarity about how potential capital shortfalls should be tackled. The point of contention is about the use of public funds, and it is especially relevant and delicate because it risks opening two Pandora’s boxes, one in Italy and one in Europe. Under EU state-aid rules, additional capital requirements should in the first place be covered from the market and other private sources.

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Public guarantee scheme risks being too little and too late

Since their troubled start of the year, Italy’s banks have come under pressure again after the recent UK referendum.

The current market concern about Italian banks is not surprising. Though they were resilient to the early phases of the global financial crisis, the banks have accumulated non-performing loans (NPLs) ever since, with no forceful countermeasure being taken. The solution adopted in 2016 foresees a public guarantee scheme for NPLs together with a bank-funded reserve that will buy junior NPL tranches and support banks’ capital raises, but it runs the serious risk of being too little and too late.

The European Banking Association stress tests due to be published at the end of July may renew the focus on Italian banks, revealing the need for further recapitalizations. The European Commission authorized Italy to issue public guarantees worth €150bn to banks raising liquidity from the market but there is much less clarity about how potential capital shortfalls should be tackled.

The point of contention is about the use of public funds, and it is especially relevant and delicate because it risks opening two Pandora’s boxes, one in Italy and one in Europe.

Under EU state-aid rules, additional capital requirements should in the first place be covered from the market and other private sources. If private funding is not sufficient, and additional state aid is needed in the form of a capital injection, that must be approved under EU state aid rules before it is granted and on the basis of a restructuring plan. Moreover, the Bank Resolution and Recovery Directive (BRRD) foresees that a bank in need of state aid normally has to be put in resolution, which triggers a mandatory preliminary bail-in of 8% of total liabilities.

This is an unpleasant perspective for Italy, where about a third of bank bonds are held by retail investors. The last IMF Article IV consultation estimates that a bail-in of 8% of total liabilities would imply a hit on junior debt, and for a majority of banks also part of senior debt. Retail clients are estimated by the Fund to hold 46% of all subordinated debt (€31bn out of €67bn), and €200bn of senior debt.

The troubled Monte dei Paschi di Siena (MPS) is a striking example: data reported by La Repubblica suggests that the outstanding subordinated debt of MPS amounts to €5bn, of which almost 65% was sold to retail savers. One bond, coming due in May 2018, amounts to €2.1bn and it was sold directly in the bank’s branches to anyone willing to invest at least €1,000.

There is only one exception - stated in BRRD Article 32 - which allows for state aid outside resolution, as "precautionary recapitalisation" in exceptional circumstances (which in this case would be Brexit). The exemption can be used to remedy a serious disturbance in the economy and preserve financial stability, but it is meant for solvent institutions and it still requires the bail-in of equity and junior debt. That means public funds could be injected after a reduced bail-in, but the retail junior debt holders would still be hit.

Prominent calls against the current bail-in requirements have come from the Bank of Italy, and the head of the Italian banking association (ABI) has recently gone on record saying that BRRD is against the Italian constitution, whose article 47 states that the Republic "encourages and protects" saving in all its forms.

This argument is frequently read in the media and referred to as a “constitutional right to savings”. However, this interpretation neglects the fact that there is a difference between savings and investment such as the investment of savings in banks’ junior bonds. The constitution does not and should not grant a right to be always and unconditionally bailed out of bad investment decisions.

What people should be granted is the right of having proper financial information and not being misled into investments whose risk they are not aware of or are not prepared to take. In a country that scores so poorly in terms of financial literacy, this is obviously not easy to ensure, but it was the role of those who are now raising the constitutionality argument to prevent mis-selling.

The Italian government thus faces a very thorny political conundrum. The stress test and the current market pressure would warrant strengthening banks’ capital position to reassure investors. But the use of public funds is subject to at least the minimum bail-in of junior debt, which is bound to hit a large proportion of retail savers. For a government that has received worrying signals from the recent local elections and that faces a crucial referendum in October, wiping out retail investors is a dreadful option.

At the same time, the solution to the Italian bank problem bears important implications at the EU level, as this is the first time that the BRRD rules would be tested in real life after their implementation in January 2016. Ensuring a coherent application is crucial for establishing the credibility of the new regime.

The solution to this delicate puzzle will need to strike a balance between these conflicting needs. Some will most likely be hurt, as even in case the BRRD exception can be used, junior debt would still have to be bailed in before injecting public money.

If mis-selling is determined, reimbursing retail junior holders may be possible along the lines of  two bank resolutions last year, but the political backlash is likely to be relevant. What is certain, is that this will be a hard way to learn the lesson that a solution to banking problems should never be delayed, and that an effective solution requires a good balance between rules and flexibility.

Silvia Merler is affiliate fellow at Bruegel, an economic policy think-tank, and a former economic analyst at the European Commission. 

MNI Euro Insight
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