Death in Venice for banking union
Misguided market cheers for rescues
by Danae Kyriakopoulou in London
Wed 28 Jun 2017
Italy's use of taxpayers' money to manage the liquidation of regional lenders Veneto Banca and Banca Popolare di Vicenza was a suboptimal response to a difficult situation. The alternative – bailing in senior bondholders – would present its own problems. In terms of confidence, market turmoil and damage to economic activity, a bail-in might have even been worse. Regardless, the outcome undermines the credibility of financial regulation in the euro area and may damage prospects for European banking union.
The need for a common banking regulation and resolution framework in Europe became acute after Greece's experience in the early years of its debt crisis. The 'private sector involvement' approach implemented in February 2012 as part of the second Greek bail-out involved 83.5% private sector participation in the world's largest sovereign debt restructuring deal. In return, €40bn from the taxpayer-funded bail-out was set aside for the banking system: €26bn for the recapitalisation of the four systemic banks, and €14bn to manage the liquidations of the Agricultural Bank of Greece, the Hellenic Postbank and some smaller banks in 2012-13. The adoption of the Bank Recovery and Resolution Directive followed in 2014 (becoming effective from January 2016) with a view to breaking the link between banks and the state.
The first serious test of the new rules – the resolution of Banco Popular Español in early June – was a success. Banco Santander absorbed Popular's good and bad assets and went to the market to source the necessary support capital. The rescue cost Santander an estimated €7bn. In contrast Intesa Sanpaolo, Italy's second largest bank, bought only the good assets of the two Veneto banks for the symbolic price of €1. Intesa was given a further €5.2bn to maintain its capital ratios, while the bad assets were put into a 'bad bank' backed by a €12bn state guarantee. Senior debt holders and depositors came out with no losses, which will instead be felt by the taxpayer.
The rescues did not technically break the European Union's rules about the resolution of troubled banks as set out in the BRRD. Italy exploited a loophole, and the European Commission approved the action. On 23 June the European Central Bank determined the banks were 'failing or likely to fail'. The Single Resolution Board – which was opened to ensure the orderly resolution of failing banks – determined that resolution was not in the public interest, stating that 'neither of these banks provides critical functions, and their failure is not expected to have significant adverse impact on financial stability.'
This retreat by the SRB meant the issue became subject to domestic rather than European regulation. Italy's bankruptcy rules do not require senior creditors to be bailed-in in the same way that the BRRD does. The latter would have required at least 8% of the two banks' liabilities to be erased before state funds were deployed. But Italian officials argued state aid was necessary to avoid economic disturbances in Veneto. The presence of a eurosceptic movement in the region probably strengthened this incentive, as did the separate political motive to prevent losses for retail investors. The Commission finally accepted the state aid as lawful, given that it will lessen damage to the regional economy.
Despite its legality, the deal clearly contradicts the spirit of banking union and the BRRD. In this context, the exuberant reaction of the markets was extraordinary, if unsurprising. Over the course of Monday FTSE MIB, Italy's benchmark stock index, rose 0.8%. Intensa shares rose 3.5%. This was to be expected: two banks were saved and the private sector did not have to bear any of the losses.
But markets may regret the cheers. Italy's approach highlights that the dangerous link between banks and the state remains extant in the euro area's third largest economy, and may apply in future cases of greater magnitude. Monte dei Paschi di Siena, the world's oldest lender, will soon follow. Italy's financial institutions had set aside €3.5bn for rescuing the two Veneto lenders via the Atlante private equity fund: Sunday's rescue opens the possibility for these funds to be used to rescue Monte dei Paschi instead.
Most importantly, the Veneto rescues risk damaging the prospects for banking and fiscal union in the euro area. German policy-makers have rushed to interpret the salvage action as breaking the promise that taxpayers' money will not be used for saving banks. While the reality is more nuanced given the uncomfortable alternative of bail-ins in this case, Germany's view will matter a great deal in the next steps for establishing the common deposit guarantee scheme needed to complete banking union.
Danae Kyriakopoulou is Chief Economist and Head of Research at OMFIF.
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