Did the European Court of Justice Just Rescue Italy’s Banks? (Updated)

As readers may recall, Italy has been trying with no success to get the ECB and European banking authorities to allow it to rescue its banks. Unlike banks in most other European countries, Italy’s got sick the old fashioned way: by lending to businesses in its own market, and then having the loans go bad, in large measure to how lousy the post-crisis economy has been.

New Euronzone-wide banking rules took effect in January. They require bank bail-ins as the remedy for sick banks, with only narrow exceptions. “Bail-in” means wiping out shareholders, and then wiping out bondholders and converting bondholders to equity holders to the degree that you now have a bank with a decent equity cushion.

That might sound sensible, except in Italy, many banks defrauded depositors by persuading them to buy bonds that are junior enough to put them first in line in a bail-in, by telling them those bonds were just as good as deposits. So bail-ins would hurt and potentially wipe out a lot of retail savers. That would not only damage the economy in a serious way, but it would also create political havoc. Premier Matteo Renzi is already at risk of losing to Beppe Grillo’s Five Star movement in elections this fall. Bail-ins would seal his fate. Five Star has vowed a referendum on exiting the Eurozone. Given that the currency union has become an economic hairshirt for Italy, a referendum is seen as having good odds of passing

One would think the foregoing would motivate the Eurocrats to cut Italy some slack, and Renzi has made several cases as to why Italy should get a waiver. Commentators at the Financial Times are sympathetic. From an article last week:

Wriggle room was an issue much debated by investors in Europe’s banks this week: can Italy use as much as €40bn of public money to help its banks when the aim, if not the fine print, of EU rules is that it should not?

The question is pressing because Monte dei Paschi di Siena, the world’s oldest bank, may fall short when regulators this month assess its ability to withstand losses. Estimates for how much capital is needed range from €3bn to €6bn, after finding a buyer for perhaps €20bn of loans gone bad..

A cascade of problems could follow from the knock to confidence in the Italian financial system. The prospect of merging strong banks with weaker ones could fade. Retail investors, who the International Monetary Fund estimates own a third of the €600bn of bonds issued by Italy’s banks, may panic at the prospect of losses.

Yet the authorities have ignored Renzi’s pleas. But has the European Court of Justice given Italy a reprieve? From Reuters (hat tip Richard Smith):

European Union member states are not obliged to make shareholders and junior creditors pay before intervening to rescue a bank, the EU top court said on Tuesday.

EU rules imposing losses on bank creditors before a bank bailout were considered legal by the Luxembourg-based European Court of Justice in its ruling over a Slovenian banking rescue.

However, the rules are not binding on member states, the court said in its ruling that slightly limits the European Commission’s antitrust powers amid talks for an Italian banking bailout. The court said that burden-sharing by shareholders and subordinated debt holders was not a precondition for granting state aid to a troubled lender.

I need to turn in and have yet to see commentary elsewhere. Please provide links in comments if you do. Thanks!

Update: It looks at if Reuters, which was out first with the story, got it wrong. From Marc Chandler (hat tip Michael S):

The European Court of Justice upheld the principle of making creditors bear the burden for investment in banks that sour before government funds can be used. Italian banks are particularly sensitive to the ruling, which cannot be appealed because the European Banking Authority and European Central Bank stress tests on July 29 are expected to show that some Italian banks are under-capitalized.

One of my colleagues, an attorney who regularly reads ECJ and similar rulings, says they are much more difficult to parse than US decisions. Not only are they usually written in a more convoluted manner, but the ruling is seldom in English, and the official translations to English are often not very good. So she didn’t find the Reuters muff to be all that surprising.

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  1. ArkansasAngie

    “…except in Italy, many banks defrauded depositors by persuading them to buy bonds ”

    This is cited every time as the reason not to go through with “bankruptcy.” How much? and are the fraudsters in jail?

    1. Yves Smith Post author

      In this case, the fraud appears to have started when ex Goldmanite and now head of the ECB, Mario Draghi, was the head of the Bank of Italy. So he was either asleep at the switch or actually endorsed this practice.

      The good bank/bad bank solution that Renzi wants to pursue is also a type of bankruptcy. It’s not as if the banks get off scot free, as they did in our bailouts. A good bank/bad bank shrinks the institution, leads to firings, and for many of these banks, what is left may be too small to stand alone, so you can expect some consolidation, which means the top brass will lose their jobs. They are sufficiently painful that Dick Fuld rejected an investment that would have saved Lehman but forced a “good bank/bad bank” approach, meaning a bankruptcy for the bad bank.

      The other problem is the Germans are being rigid about requiring bail-ins. Most experts think they are a terrible idea and will lead to bank runs.

      The issue is not recognizing losses. It’s who bears the losses. You are seriously suggesting small savers who were turned into financial human shields take a hit?

      1. visitor

        The other problem is the Germans are being rigid about requiring bail-ins. Most experts think they are a terrible idea and will lead to bank runs.

        Then why did all other EU members accept the “German” bail-in scheme when it was discussed and then passed into EU law if experts were warning against it and if the procedure would be detrimental to their national finances?

        The more I read about EU institutions, the more absurd it all looks.

        1. digi_owl

          Because Germany is the economic engine of EU right now.

          Thanks to a decade or more of stagnant wages and a “beggar thy neighbor” export policy they are the one nation in the whole mess running a surplus (by draining the rest of the EU, but nobody wants to mention that).

          1. Nadia Davila-Pestana

            I wonder why Germany is the only country running a surplus. But nobody wants to mention that. And Germany is not only the economic engine of the EU, it is the EU. But nobody seems to want to mention that either.

      2. Stein

        The bail-in scheme is not German and neither is requiring it. Most financial regulation is international. The person who created bail-ins did so actually with writing an article in English. I can find you his name if you want to, but I think he’s American (not 100% sure).

        Also, it’s false that bail-ins are mostly condemned by experts. Most consider that if we had today’s regulation when we had Lehman, we could have avoided most of the losses. On the contrary, most consider bail-outs illegitimate. At least on the legal side – and I have met with legal experts on the question across the Atlantic. Mind you, I don’t have the expertise to say whether it’s economically sound, but economics cannot dominate all the time. Sometimes, you have to ask yourself if this is the type of business you want to have in society.

        Also, a bail in does not exclude a good bank/ bad bank approach. Actually, that’s one of the ways how it can function. I wonder if the ECB can decide to bail in one type of bonds, but not the retail type of bonds.

        That being said, Italy’s case is special because, as you have said, the bail-in bondholders are retail. And the ECB might do well to be less rigid from time to time. So a bail-in would be similar function as a more direct bail-out than just using taxpayer money.

        1. Stein

          Sorry for the double post, but I can’t edit this one anymore.

          There’s one comment from the FT:
          “While the ruling suggested that such burden-sharing was “not a prerequisite” for lenders prior to the receipt of state aid from governments, it made clear that Brussels would be entitled to enforce rules to limit the granting of aid and impose conditions that protect competition across the single market.”


        2. Betina

          Is there no legal recourse for bail-in fraud in Italy? Wouldn’t that solve the issue Yves pointed out?

      3. repubanon

        Shades of Charles Keating’s savings and loan folks convincing people to trade in their federally-protected deposits for unprotected investments…

        Keating became a national emblem of the fast-buck 1980s, and Lincoln became the poster child of the S&L crisis. In the early 1990s, state and federal juries in Los Angeles convicted Keating of looting Lincoln and swindling thousands of its customers — convictions that were later overturned. Many of them were elderly Southern Californians, who cashed out federally insured deposits to buy $265 million of uninsured American Continental junk bonds pushed by the S&L.

        S&L fraud figure was emblem of ’80s excess LA Times. (emphasis added)

    1. digi_owl

      Bloomberg seems like more and more of a propaganda machine for big finance these days.

    2. Yves Smith Post author

      Yes, it looks like Reuters was out first and got it wrong. I’m told by an attorney who reads ECJ and similar opinions regularly that they are very difficult to parse because the judges write in a less straightforward manner than Americans to begin with, and then that opinion is not in English, but is translated, usually badly, into English. So if you don’t have someone who can read the opinion in the original language, you are at risk.

  2. Bimbo

    The Court put some limits to the Governments actions but didn’t save the Italian banks.

    Bank oligarchs still wait for a miracle.


  3. vidimi

    That might sound sensible, except in Italy, many banks defrauded depositors by persuading them to buy bonds that are junior enough to put them first in line in a bail-in, by telling them those bonds were just as good as deposits. So bail-ins would hurt and potentially wipe out a lot of retail savers.

    i think any bail out should be conditional upon prosecuting those responsible for this heist. is there any chance that would happen? i think Renzi’s government may be complicit in it so i’m guessing no.

    1. sunny 129

      Why Blame just Renzi?

      Look at at DOJ decision on HSBC!

      They all are complicit with ‘Too big to prosecute’ Banks!

  4. sunny 129

    “Burden-sharing by shareholders and subordinated creditors as a prerequisite for the authorization, by the commission, of state aid to a bank with a shortfall is not contrary to EU law,” according to the EU Court of Justice. The Luxembourg-based court’s decision is binding and can’t be appealed. The European Commission, which checks whether state aid violates EU rules, welcomed the ruling, which it said “confirms the commission’s current case practice and application of EU state aid rules to the banking sector.” The ruling also made the case for a bailout as opposed to a bail in more difficult and Italian banks dropped after the decision with Banca Monte dei Paschi declining as much as 7.1%. UniCredit SpA slipped 3.2% in early trading, while Intesa Sanpaolo SpA decreased 2.5%.


    But there is hidden ‘fig leaf with loop hole’, to allow BAILOUT under ‘extenuating’ circumstances! I bet Renzi will use that.

    1. Yves Smith Post author

      I saw that yesterday and am not sure that is much of a help to Italy or its banks, despite the size of the facility.

      First, the ECB made clear they don’t expect it to be used. They want it to be short-term liquidity for banks that are solvent or maybe are being wound down (you need to fund the bad loan book while you are winding it up).

      Second, if Italy is able to use it the way Greece used the ELA to prop up its insolvent banks, it gives the ECB control over the banking system, which means control over the country. The ECB will be able to do what it did to Greece, limit liquidity, which will force a bank holiday and bring the country to its knees.

  5. Bam_Man

    Well, there will have to be “cram downs” then. More senior creditors will have to take greater haircuts than they would have otherwise. Either way, there are going to be a lot of unhappy “investors”.

  6. David Mills

    Magical thinking… If the bonds yielded higher than the deposits they HAD to have more risk. Yet another example of banks eating their customers.

  7. Matt

    Retail bond holders should be penalized by however much cumulative yield they have enjoyed in theirs years of investment. I doubt the majority of them were really unaware of the extra risk, where did they think the extra interest was coming from? But even supposing they were, it would be unfair to other people who chose not to take the extra risk, and consequently have received no yield, to indemnify them fully. No risk on principal fine, but then no return either, so if you’ve received 5% p.a. for the last 6 years, a 30% haircut is appropriate.

    1. Yves Smith Post author

      Sorry, misrepresenting a product is fraud, period. These products were misrepresented. And the overwhelming majority of people, particularly bank depositors, are not sophisticated. They weren’t told these products were bonds, for starters.

      In the US, we have SEC mandated disclosure for securities. That’s not the case in Italy. You are applying US assumptions to a different market.

      1. Matt

        Hi, though I didn’t mention it (perhaps because to me it seems such a given), prosecution and jail terms for the bankers who actually misrepresented the products would be my first priority, in Italy, Spain and anywhere else, starting with much bigger-scale frauds by US and UK banks. It’s interesting, I would tend to imagine your basic US customer as being less sophisticated and requiring much more protection than Spanish or Italian consumers, but that’s probably a misconception on my part…I do think it’s doing them a disservice to assume that most Italian or Spanish moms and pops aren’t savvy enough to perfectly understand the notion of getting something for nothing…but it is true I haven’t see the actual offering documents (looking them up now), if they state on paper things like “These bonds are as safe as deposits” then I’ll concede your point. Otherwise, I stand by the notion that haircutting them by the amount of their cumulative earned interest is not penalizing them, they come out even over the duration — what about their smarter neighbor who didn’t invest in the bonds because he smelled something rotten and has forfeited earning any of that yield over the past few years, who will compensate him if the other retail investors get bailed out? In the real world, if the alternative is collapse of the system and a much worse outcome, said neighbor will accept having been screwed over the previous years of course, but that’s because we’ve let things go much too far yet again, and any agents who keep being made whole whenever they make bad decisions that they either did not understand or pretend they didn’t understand will make them again, that’s true of institutions and individual consumers as well.

    1. Yves Smith Post author

      It took me years to connect the dots, but the bail-in in Cyprus was an economic sanction against Russia. Cyprus was the place reputable companies did in-bound investment into Russia, to get the advantage of English law and English courts in the event of a dispute. But it looks like the officialdom become so enamored of bail-ins that they want to use them elsewhere. Ugh.

      1. P. Petropoulos

        The EU Bank Recovery and Resolution Directive (2014/59), which imposed the bail-in, should apply equally to ALL. Or else it should be repealed, and Cypriot depositors (who were of all nationalities, not only Russians) should be compensated.

  8. Boyce Schwetz

    That task also falls to national courts, in as much as they retain jurisdiction to review the administrative implementation of Union law, for which the authorities of the Member States are essentially responsible; many provisions of the Treaties and of secondary legislation – regulations, directives and decisions – directly confer individual rights on nationals of Member States, which national courts must uphold.

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