And Yet it Moves: Understanding Why Italy’s Threat is Exaggerated

new businessToward the end of 2015, Portugal bailed in some senior creditors in addressing a failed bank.  Many observers were aghast.  This was thought to be horrific and uncivilized by some of the very same people who are critical of the EU and Italy’s decision not to bail in senior creditors in the two failed regional banks in Italy.    

They were wrong about Portugal.  It was not a watershed event that spurred capital flight from Europe.  And they are wrong about Italy.  This does not end banking union, and if Europe moves to two-speed, as some proposal for EU reform post-Brexit suggested, it will not be because of Italy and the EU’s decisions regarding Veneto Banca and Banca Popolare di Vicenza.

The critics are like someone watching a basketball game.  One player fouls another who had an easy shot.  Fouling the player to force them to ostensibly take a more difficult shot is not cheating.  It is not a loophole.  It is part of the rules of the game, and part of the strategy of the game.

Some argue that by not bailing in senior creditors, Italy violated the “spirit, if not the letter, of the European banking resolution rules.”  It is certainly not the case that Italy violated the letter of the law.  Indeed the EU approved the actions, making them legal.  The spirit of the law is a different story, but arguably, the spirit was upheld by Italy and would be violated by the overly rigid ruling by the critics.

The procedures and processes were followed to the letter.  The Single Resolution Board, the pertinent entity, ruled that the BRRD (the directive that governs the resolution process) did not apply because the failure of the two regional banks was not expected to have a “significant adverse impact on financial stability.”  This is important because this transferred the back to Italian authorities and the national insolvency laws and procedures.

The two regional Italian banks accounted for around 2% of the Italian banking system.  The EU regulators could fairly and honestly expect little systemic financial risk.  However, Italian officials argued that there were still important regional economic risks that the failures posed.

It is not unreasonable to be concerned about the fallout on other banks if the two regional banks were forced into resolution.  The EU rules, which the Financial Times points out, would have required Italian banking system to fund a 12 bln euro deposit insurance program.  This would have to come from the Italian banks, such as Unicredit, Intesa, UBI Banca, and the troubled Monte Paschi.

All these banks have either recently raised capital themselves or are going to the market shortly.  Moreover, all the loans from the two banks would have to be called immediately, which would also be potentially disruptive and could spur a run on other Italian financial institutions.

Also, there was obviously political and economic concern about the impact of bailing in senior creditors.  Many years ago, as the banks were marketing these bonds, a significant tranche was sold to retail investors as a secure investment.  They were when they were sold, but the quality deteriorated, and the rules changed.  The bonds that were part of the “misselling scandal will mostly mature in the next few years, and this will resolve this issue.

Italian officials hoped to minimize a recurrence of what happened in late 2015 when liquidated four small popolari banks (mutually owned rather than publicly traded) and losses on retail investors that made for the particularly poor press.  The bank failure meant job losses for some local households, and they were penalized by losing some of the funds invested in the same bank.

While fans at the basketball game may try goading the referee into making a call, the referee judges what a foul is.  In these matters, the European Commission is the only referee that matters, and it agreed with Italian officials.  Much the critics’ chagrin, the EC concluded that the Italian actions are consistent with the EU rules on state aid.

There is no need to “mourn the banking union,” as one critic put it because the BRRD “has been trampled to death,” wrote another critic.  Europe’s slowly coagulating banking union is still in its early stages, and it is still moving forward.   That senior creditors and depositors were not “bailed in”  non-systemic banks will not prevent the continued movement toward the banking union, which was much more about the systemically important banks.    It is an extreme exaggeration to say that “Senior creditors need never again to fear losses due to failing bank.”  It is simply not true, and the polemical zeal asphyxiates reasonable and dispassionate discourse.

Rest assured these are not the last banks in Europe to have problems.  Pity the next Italian bank to have problems.  Given the criticism of the way Italy handled these two banks, the risk is that it will come down harder on the next.  However, the critics call to punish Italy for its efforts (they think) to circumvent the rules, has fallen on deaf ears.  Italian bank shares are up nearly 3.75% since the weekend announcement.  European bank shares in the Dow Jones Stoxx 600 are up 1.5% over the past two sessions.   Italy’s five year credit default swap (the price for insurance) is  at its lowest level since last October.

Banking union and European integration remain a work still very much in progress.  The critics are prone to hyperbole.  The key to European integration going forward it not to be found in Rome or Venice., but in Paris and Berlin.  Macron, now with his substantial parliament majority, must bring France back into compliance with the Stability and Growth Pact and boost its competitiveness (e.g., exports as a share of world exports).  That may prove more important that forcing haircuts on senior creditors and depositors at two non-systemically important banks.