So Who Gets to Pay for Italy’s Banking Crisis?

By Don Quijones, of Spain and Mexico, editor at Wolf Street. Originally published at Wolf Street

“There is not and there will not be a banking crisis in Italy, nor will there be a European financial crisis coming from Italy.” Those were the emphatic words of EU Economics Commissioner Pierre Moscovici over the weekend. “We have the capacity to deal with the situation and it will be dealt with from both Italy and at the European level” he told France Info radio.

Clearly, quixotic delusions are as rampant as ever at the loftiest heights of Brussels’ ivory towers. Either that, or things are now so serious that lying is the only tactic left available.

The markets also appear to be in a state of eerie complacence. Since rumors of yet another publicly funded bailout emerged early last week, bank shares have taken off, not only in Italy but across most European markets. Shares of Unicredit, Italy’s only “systemically important financial institution,” has surged 20%, while Italy’s second largest bank, Intesa Sanpaolo, is up 10%.

Once again, just the slightest hint of future government and/or central bank intervention is enough to steady the nerves of today’s welfare-addled investors. For now.

Monte dei Paschi di Siena (MPS), which has already raised capital twice, will have one last chance this week to raise the capital it needs (min: $5 billion) from private investors. Given its abject failure to raise more than €1 billion of new capital over the last six months, despite the assistance of one of the world’s biggest, best connected mega-banks, JP Morgan Chase, it’s a mighty big call. If it does fall short, it will have one last lifeline at its disposal, Plan Z: a full-blown taxpayer-funded bailout, potentially including a bail-in of subordinated bondholders.

The idea of bailing in subordinated bondholders is a touchy subject in Italy, since they include thousands of retail investors to whom the banks “mis-sold” complex financial instruments as safe investments during the lean years of Europe’s sovereign debt crisis. The last time subordinated bondholders were bailed in at a handful of regional banks at the tail end of last year, one retired investor took his own life after losing all his life savings. However, as Reuters’ financial editor, George Hay, points out, the political impact may be overstated:

Over 85% of Italian bail-in instruments are held by the wealthiest 10% of domestic households, according to the Centre for European Policy Studies. If bonds were mis-sold, compensation could be added as needed – as happened in the case of Spanish lender Bankia.

Alas, since Bankia’s taxpayer funded rescue in 2012, the Spanish government, with the funds of Spanish taxpayers, has refunded not only the bank’s retail bondholders but also many of its duped shareholders.

There’s also the prospect of a much broader bailout of Italy’s banking system, which according to “official sources” could total €15 billion. Given that as many as seven mid-sized Italian banks are as, if not more insolvent, as MPS, according to Italy’s Finance Minister, Pier Carlo Padoan, this is the more likely outcome.

However, €15 billion may not be enough. According to Philippe Bodereau, global head of financial research at PIMCO, as much as €40 billion may be needed. It’s an amount that Bodereau believes is both perfectly “manageable” and “not a large number in the context of Italy’s economy.”

It’s worth pointing out he is hardly an impartial bystander in all this. PIMCO almost certainly has some level of exposure to Italian bonds, which would lose a lot of value in the event of a full-blown Italian banking crisis. And it just took control of a fund holding close to €10 billion of impaired assets belonging to Italy’s biggest bank, Unicredit, which today announced plans to raise €13 billion of new capital by the end of March next year.

If successful, it would be one of the biggest capital expansions in Italian history. As CEO Jean-Paul Mustier admits, Unicredit’s ambitious plan would not be helped by a disorderly resolution of MPS. “We are highly confident that the Monte dei Paschi situation will be solved by the end of the year and will not impact our plans,” he said.

PIMCO’s Bordereau points out that the €40 billion bailout he envisions would represent a mere 2% of Italy’s GDP. By contrast, Spain needed a bailout of close to 10% of its GDP to rescue its banks. What Bodereau conveniently fails to mention is that Italy is Europe’s second most indebted government, after Greece. When Spain’s still beleaguered financial sector was “comprehensively” bailed out in 2011-12, the government had total public debt equivalent to 69% of GDP. In the five years since, that figure has mushroomed to just over 100% of GDP.

In Italy, the debt-to-GDP ratio is already 132%, among the highest on the planet. Yet thanks to the reality-distorting effects of the European Central Bank’s monetary alchemy, that same government is still able to pay historically low yields on the debt it issues.

But the pressure is rising. Italy’s debt is already near the bottom of investment grade, according to the three big US rating agencies, Moody’s, Fitch’s and S&P and Canadian-based DBRS. If Italy’s credit rating falls into “junk” territory with the four ratings agencies, the ECB would be barred from buying its bonds. This would drive up Italy’s borrowing costs.

In other words, a government that is buckling under the sheer weight of its own debt exposure and whose 2017 budget is already at risk of breaching EU fiscal rules due to excessive spending could be on the verge of bailing out banks that, according to some estimates, have more than €350 billion of toxic debt festering on their balance sheets. And the cost of funding for those banks could be about to explode, begging the ultimate question: How is Italy’s government going to save its banks without pushing itself over the edge?

Turns out, as Reuters reported in an article titled “European Commission Hints at Leeway for Aid on Italy Banks,” European Commission Vice President Valdis Dombrovskis is alleged to have said that any state support for banks was likely to be treated as a “one-off expense”, which would not affect Italy’s official structural deficit measures. In other words, no problem.

Banks cannot be allowed, at any cost, to suffer the consequences of their own chronic mismanagement, or worse. Read…  The Fix Is Already In, as Italy’s Moment of Truth Beckons

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  1. JTMcPhee

    “How will sick banks be salvaged?” “Salvaged?” Assumes there’s cargo value to somehow be protected. In maritime law, the “salvor” is COMPENSATED for the risks he or she assumes, and the benefits bestowed: While “bailout” is mostly taken as a boating term, keeping the ship from sinking by removing inrushing water, as opposed to what pilots and other people do to escape a crashing or burning airplane, maybe it is fair to stick with the maritime lexicon? The lede should maybe read “How will the Great Mope Robbery be completed?” As if the answer is not obvious… “There’s class warfare, all right, but it’s my class, the rich class, that’s making war, and we’re winning.”

    1. cnchal

      “How will the Great Mope Robbery be completed?”

      Like it’s always been done.

      . . .a touchy subject in Italy, since they include thousands of retail investors to whom the banks “mis-sold” complex financial instruments as safe investments . . .

      With fake “complex financial instruments”.

    2. LA Mike

      Well said.

      Even worse than robbery, it’s blackmail. Why don’t forget, if we don’t bail out these banks… something really really bad would happen! Like, end of the world bad!

      Or not, of course.

  2. Synoia

    Clever: State support for banks was likely to be treated as a “one-off expense”

    Because it is not an annual budget expense, the “one off expense” could be repeated periodically, every time the banks need to be rescued.

    However, providing this relied to the Greeks and Cypriots was not acceptable. How does this work if the Greeks and Cypriots were stamped upon, and the Italians are relieved of the pressure?

    One set of rule for the Greeks and Cypriots and a different set for the Italians and Spanish? How egalitarian.

    This I must see – pass the popcorn.

    I do see a great future for a “sovereign country software banking package.”

    1. JustAnObserver

      Yeah. Non-GAAP financial manipulation, a favorite of US Corporate EPS gaming, arrives in the Eurozone.

  3. BecauseTradition

    Banks cannot be allowed, at any cost, to suffer the consequences of their own chronic mismanagement, or worse.

    Because the payment system must work through the banks and thus the banks must be kept running?

    We should fix that. An additional payment system, not dependent on banks and their failures, would form by allowing everyone, their businesses, etc. to have inherently risk-free accounts at the cb itself or in a strictly limited ( lending, hence no credit risk) Postal Checking Service and by eliminating government provided deposit insurance and other privileges for the banks.

    We would then have two payment systems, an at-risk, not necessarily liquid payment system that works through the banks and a risk-free, always liquid payment system that does not. Thus bank failures would only affect 100% volunteer depositors and other creditors of the banks while the rest of us could go about our business unhindered.

    1. MisterMr

      “a risk-free, always liquid payment system that does not.”

      But someone’s savings are, by definition, someone else’s debts.

      Who is going to be able to borrow for 0 interest? Or are “risk free” savings going to pay interest?

      1. BecauseTradition

        Risk-free deposits should not pay positive interest lest we have welfare proportional to wealth, not need.

        As for lending, that would be at the discretion of the account owners, not the PCS (if we go that route), for whatever interest they might obtain. Of course individual lenders would have credit risk but their loss would affect no one but themselves, unlike a bank.

        1. MisterMr

          I think you misunderstand my point.

          Suppose that the country of A has a yearly production of 1000 potatoes, each potato costs 1$, so the NDP of A is 1000$.

          Some inhabitants of A wants to save something for old age, so what do they do? They consume less potatoes than what they produce, for example is a saver produces 10 potatoes yearly but consumes only 9, he saves a potato a year.

          But said saver can’t just stockpile potatoes, because potatoes, like all consumption goods, are not very durable. So he sells 10 potatoes, gets 10$, spends 9$ to buy potatoes to eat and keeps 1$ in his saving account as “savings”.
          But this implies that, while he consumed less potatoes than he produced, someone else consumed one potato more than he produced and got into “debt”.

          So the 1$ of savings of the saver do not correspond to an actual non consumed potato, but just to the -1$ of debt of the spender. No “real” saving can happen in the world, because “real” means “acual stockpile of consumption goods”, which is something really stupid that no one really does, as consumption goods deteriorate in time.

          Even if we take “debt” out of the equation, and we think of a “coin only, no debt” economy, “savers” would just stockpile coins, perhaps causing deflation, but “real” goods, that is consumption goods, cannot be saved.

          In other words all savings are “fictitious wealth”, that in case of debt is balanced by someone else’s debt. Since my savings are just the obverse of someone’s debt, they can’t be “risk free” as this someone might be unable to repay me.

          1. Downunderer

            But if I understand BecauseTradition’s proposal, that 1$ of debt would not be the responsibility of either the government or any of its secured depositors, as that govt savings/payment mechanism would neither a borrower nor a lender be. It would simply hold and pass along government-issued value tokens, as a service to the taxpayer who supports the whole system.

            Whatever debt there might be would involve interest-paying accounts at private bank/lenders, where the interest paid would (assuming transparency and a free market) be proportional to the risk assumed by the bank & its depositors.

            1. BecauseTradition

              It would simply hold and pass along government-issued value tokens, as a service to the taxpayer who supports the whole system. Downunderer

              Yes. Just as it does for depository institutions, ignoring that the cb should not create* fiat except for its monetary sovereign (e.g. US Treasury). From there the new fiat would be spent or distributed as desired.

              The injustice of the current system will be very stark indeed if physical fiat is ever totally abolished since then citizens will not be able to use their nation’s fiat AT ALL(!) but instead be forced to lend (a deposit is legally a loan) all of their money to depository institutions.

              Thanks for your comment. It’s refreshing to see someone understand what should be but apparently isn’t a simple concept – equal protection under the law wrt to fiat creation and usage.

              *e.g. interest on reserves (IOR), asset purchases from the private sector, loans** to the private sector.
              ** Grants are not ruled out though if based on merit, not wealth or equally disrtributed to all citizens.

  4. MisterMr

    It’s true that nominal yelds for italian bonds are at an historical low, but it’s also true that inflation is now 0 or perhaps even negative, so in real terms yelds aren’t really low for Italy.

    Plus the italian government is still paying the older higer yelds on older bonds, but with the present low inflation.

    I’m remarking this because sometimes people come up with the idea that, because of the access to the EU, Italy could take advantage of very low yelds and ramped up debt, but in reality what happened is that Italy had to curb inflation substantially (anti-stimulus) and the real yeld didn’t really fall (because of the change in inflation), and for this reason, even if the italian government is running a primary surplus since the ’90s and currently Italy is a net exporter, the debt to income ratio keeps balooning up thanks to the magic of compound interest. Also the primary surplus likely depresses the “real” GDP.

    I think that many people see a problem in the “real” italian economy, whereas the problem is mostly monetary.

  5. Sound of the Suburbs

    Earlier this year Mario Draghi commented on how the European banking sector needed thinning out.

    It is probably safe to assume they are not going to save the bad banks and close down the good ones.

    Unconditional bailouts for bankers and austerity for the people has not gone down well and is a factor behind the populist uprisings, this is why the EU came up with bail-ins.

    The people in Italy are undergoing austerity and a public bailout of Italian banks would ensure Five Star surges to power.

    Central Bankers and mainstream politicians are not known for their intelligence we will have to see how it plays out.

    Austerity left people with less money to pay off their loans leading to rising NPLs – a fail for the ECB.
    It is probably the mainstream politicians turn to mess up this time.

    1. Sound of the Suburbs

      For future reference ….

      Mario, this is why you should do fiscal stimulus, a balance sheet recession and austerity just make the money supply contract faster leaving people with less money to pay off their debts.

      Ben Bernanke had read a book by Richard Koo and ensured the US didn’t go over the fiscal cliff by cutting Government spending by imposing austerity.

      You are following Christina Romer, who made a mistake analysing data from the Great Depression leading her to think FED monetary policy got the US out of the Great Depression.

      She was wrong it was the fiscal stimulus of the New Deal.

      Richard Koo (the man that saved Ben Bernanke’s bacon) explains:

      First 12 mins. of the video explains the mistake she made.

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