To no one’s surprise, the private sector effort to rescue Italy’s third largest bank, Monte dei Paschi, officially failed yesterday. Recognizing an end game was nigh, the Italian government announced that it would raise its debt levels by up to €20 billion to shore up failing banks.1
It does not take much in the way of mathematical skills to see that €20 billion will not go very far in plugging a hole of €360 billion in bad loans, particularly given that the total equity of Italian banks is only €225 billion. In fairness, not all of the loans are total losers; many would be viable if restructured. However, €200 billion are non-performing. So it’s probably generous (to the Italian government) to assume that writedowns would be at least half the total amount, or €180 billion.
So why were some sites, like Business Insider, saying that an Italian rescue might cost “as much as” €52 billion? That’s a lot lower than the hole in the banks’ balance sheets. That is because the bail in rules require 80% of the losses come out of the hides of equity holders and subordinated creditors; the state provides the rest. However, the bail-in rules also stipulate that a bank not be failing.2 Keep in mind that Monte dei Paschi (and no doubt some other Italian banks) are so far gone that they should be resolved, as in nationalized, as the 5 Star Movement is demanding. But the Italian government can’t begin to pretend it can borrow enough under Eurozone rules to provide that level of funding, and the Germans have been incredibly hard-nosed about cutting Italy any slack with respect to its banking mess.
As the very thin press details of the Monte dei Paschi bailout make clear, it’s going to be done at least to some degree in conformity with the new bank bailout rules, which are actually “bail-in” rules. Equity holders, and then creditors are to be wiped out.
The wee problem is that depositors are also creditors, and in the first application of a bail-in, in Cyprus, deposits over a certain size took haircuts.
While no one yet expects depositors to take losses, the wee problem in Italy is that wobbly banks took advantage of often unsophisticated borrowers and sold them subordinated debt products, telling them they were similar to deposits. The Bank of Italy chose to ignore this deception, which started while Mario Draghi was governor.
Some have argued that over 80% of the investors in these debt products were well off, so they can afford to take losses. But that still means a meaningful proportion weren’t affluent. And someone who had a good personal balance sheet could have moved enough of his funds into these products that the losses would strip him of a lot of his wealth.
So while details of how the Monte dei Paschi rescue are scare, a few things seem clear:
The Italian government is leaning towards a less punitive bail in. As took place in Spain, where banks similarly misrepresented subordinated debt instruments as being as good as deposits, retail investors are likely to get some compensation. But the higher the level of recovery, the faster the already-inadequate rescue pot is depleted.
Any “wronged depositor reimbursement program” may nevertheless leave many in distress. Given the urgency of needing to clean up Monte dei Paschi versus the lack of any program (or likely even draft legislation for such a scheme), the subordinated debt investments will probably be haircut quickly, while there will be considerable delay before those investors get any recovery. It’s hard to think it could happen any time before late 2017 and 2018 is more probable (you need to devise procedures, particularly anti-fraud, set up systems and personnel, create application forms, and verify and process them). Those who needed access to those funds will be in quite a pickle.
The Germans and other sticklers may regard any breaks given to creditors, even if by a separate program as a violation of bail-in rules. Note that the payouts to similarly-situated Spanish creditors took place before the new rules became effective in January 2016. However, there has been a fair bit of noise in the press (and one has to assume in official circles) about alleviating the pain inflicted on naive depositors. I may have missed it, but I would have expected to see a smackdown from someone in the officialdom if this was perceived to be crossing a red line, and I haven’t come across anything like that.
The slow motion bank run in Italy will only get worse. Wealthy Italians and Italian businesses have been shifting funds out of Italian banks. Perhaps some who haven’t yet rearranged their affairs believed the government PR that Monte dei Paschi could be salvaged without using government monies. Now that the officialdom is moving on Monte dei Paschi, it’s clear that other banks will be in line, meaning other investors and even depositors may be at risk.
If more retail deposit funding makes its way for the exits, Italy could impose capital controls.
The €20 billion to help with rescues is yet another kick-the-can-down-the-road non-remedy. As we said, it won’t go far enough. The only open question is how long Mr. Market plays along.
1 Although the Italian government will formally sell bonds, and historically Italians have been heavy investors in government debt, a big chunk of recent Italian bond issues have been purchased by the ECB. So while Italians will finance some of this rescue, the ECB will also wind up providing a large portion.
2 Here is how the Italian government has been hoist on its need to please the Confidence Fairy. Monte dei Paschi, implausibly, shows positive equity. So did Lehman before its collapse. In both cases, the assets were marked to unrealistic levels. But that still means that under the new EU banking rules (the Bank Recovery and Resolution Directive, usually referred to as “BBRD”), Monte dei Paschi isn’t eligible for nationalization.