Italian recapitalisation undermines banking union

Legacy problems threaten single resolution mechanism

The planned recapitalisation of Banca Monte dei Paschi di Siena, Italy’s third largest and the world’s oldest surviving bank, illustrates how national legacy problems threaten the credibility of the single resolution mechanism, and thereby the European banking union.

Governments and central banks ought to specify the conditions for the ‘systemic risk exception’ to avoid its being used to protect specific actors from bail-ins. The European Stability Mechanism, rather than national authorities, should play a more prominent role as the fiscal backstop in resolution and recapitalisation. This would reduce political influences on resolution decisions.

Monte dei Paschi qualified for resolution at the end of 2016 under the SRM. The bank required extraordinary public support to survive. Its non-performing loans were approximately 45% of its assets on a gross basis. The Italian government favoured a public sector recapitalisation to protect the unsecured debt holders, which to a large extent are households. Such a recapitalisation violates, in principle, the European Union’s state aid rules.

Last December the European Commission and the European Central Bank approved a recapitalisation of €8.8bn with limited bail-ins of creditors. The total value of the bail-in amounts to around €600m.

There is little doubt that the bail-in would have been substantially larger if the SRM had been applied. Thus, the ECB and Commission practiced forbearance when permitting recapitalisation with such a small part funded by the bank’s creditors.

The fear of systemic consequences of more widespread losses is understandable. A large portion of the Italian banking system is under pressure from €350bn worth of non-performing loans and a large share of subordinated debt held by households.

However, the systemic risk exception must not be used as an excuse to protect particular groups from losses. The Commission and the ECB appear jointly to have undermined the SRM’s credibility by creating the perception that the bail-in rules will not be applied fully. Recapitalisations with mild bail-ins may become the rule rather than the exception for distressed banks. If so, the objectives of the SRM to eliminate the implicit subsidisation of bank debt and to strengthen market discipline on risk-taking will suffer.

The existence of a systemic risk exception from the application of bail-ins is unavoidable. However, policy-makers must more clearly define the conditions that justify the injection of government funds. This is to avoid the exception being abused.

The Italian banking sector shows how legacy problems in some countries threaten to undermine the credibility of the SRM and, therefore, the harmonised rules for banking supervision and resolution. Factors such as Italy’s non-performing loans may not have been taken sufficiently into consideration when the rules were designed.

Two reforms may reduce the tendency to use the systemic risk exception for political purposes. First, the criteria for systemic risk to be a valid justification must be defined with greater clarity. Second, the ESM, rather than national authorities, should be empowered to provide funds to support bank recapitalisations under strict conditions.

In the Monte dei Paschi case, the Italian government provides the fiscal backstop. If an EU authority such as the ESM were to provide the backstop, it would be likely to offer less forbearance than the Italian government. The ESM would be free from national influence in its determination of the need for public funding. It would be able to provide a backstop based on concern for systemic risk alone.

Legacy problems can be symptoms of deeper institutional and structural weaknesses. It is possible that Italy’s non-performing loan problem will appear again unless governance structures and competitive conditions in its banking system are improved. In this case, it would be a mistake from both a European and a national perspective to focus exclusively on the short-term solution to the problem. Institutional and structural reforms nationally are required to facilitate harmonised rules for resolution of banks.

Harald Benink is Professor of Banking and Finance at Tilburg University and Chairman of the European Shadow Financial Regulatory Committee.

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