Let Europe Pay for Italy’s Bank Bailout

Matteo Renzi’s plan to inject money from the Italian government would destabilize the economy.

By Harald Benink

    Photo: Getty Images/iStockphoto

During his press conference last week, Mario Draghi, the president of the European Central Bank, said that the European Union’s rules of state aid for problem banks contain all the flexibility needed to cope with “exceptional circumstances.” He also said that a public backstop is a measure that would be “very useful” to help banks deal with their nonperforming loans.

In Italy, nonperforming loans on the balance sheets of Italian banks currently amount to €360 billion, according to the International Monetary Fund’s latest Global Financial Stability Report. At some point, these banks will have to start recognizing losses on these loans and find new equity capital to compensate for them. Investors are concerned, as demonstrated by falling share prices at some of Italy’s leading banks.

To help bolster these problem banks, Matteo Renzi, Italy’s prime minister, has proposed a capital injection of €40 billion, financed by government debt. This amount is likely to be insufficient as compensation for the losses on the nonperforming loans.

More importantly, such a bail-out would violate the EU’s rules, which require that losses first be borne by shareholders, then the holders of subordinated debt, bond holders and holders of large deposits, all before resorting to taxpayer money. In order to get around these rules, Mr. Renzi would make use of an exemption clause in the EU’s Bank Recovery and Resolution Directive, which applies to cases where the stability of the financial system is at stake. As evidence, Mr. Renzi points to the widespread fall in bank-stock prices across Europe following the Brexit referendum last month.

But allowing the Italian government to bail out its banks would imply an increase in government debt. At more than €2 trillion, and with a debt-to-GDP ratio of approximately 135%, government debt is already irresponsibly high. A potential destabilization of Italian government finance and of the euro system associated with even lower debt sustainability would be unwise.
Moreover, allowing shareholders and creditors to avoid having to write off at least part of their debt, thus suspending the EU rules only six months after they entered into force, would undermine the credibility of Europe’s single resolution mechanism. The SRM is supposed to provide an orderly means to manage failures at systemically important institutions, and is meant to put an end to the old “too big to fail” regime under which a bank’s bondholders did not have the incentives to monitor bank risk and undertake disciplinary action. Under SRM, unsecured creditors can no longer expect governments to bail them out. Circumventing the EU’s rules would thus seriously damage the credibility of SRM and significantly increase the probability of a future banking crisis.

As Jeroen Dijsselbloem, the chair of Eurogroup, has said, in order to address the problems of Italy’s banking sector, the focus must be on their unsecured creditors being the first to bear the burden.

Where appropriate, small retail investors who have been misled into believing that the bank debt they purchased is riskless may be compensated for losses associated with the write-offs.

Furthermore, a public recapitalization involving a residual amount of new capital after the unsecured creditors have taken a haircut may be necessary to restore confidence.

If destabilization is to be avoided, this capital injection shouldn’t be provided by the Italian government. It should come instead from Europe’s permanent rescue fund, the European stability mechanism. When the ESM was created in 2012, it was agreed that part of the fund, for an amount up to €60 billion, may be used for the direct recapitalization of banks after write-offs by private investors have taken place.

Mr. Draghi is right when he states that a public backstop may be very useful. But such a public backstop should only be allowed after private investors have taken a haircut. And it should be provided not by Italian taxpayers, but by European taxpayers only.

Mr. Benink is professor of banking & finance at Tilburg University in the Netherlands.

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