Italian Dilemma: To Bend the Rules or Break the Banks

For Europe’s banks, it is now all about the politics

By Paul J. Davies

The headquarters of Monte dei Paschi at the Piazza Salimbeni in Siena, Italy. Photo: Agence France-Presse/Getty Images 
       

For Europe’s banks, it is now all about the politics. Italy voted “No” in a referendum that became a protest against the government and the restrictions of European Union membership.

To stop this drama turning into a crisis, eurozone politicians may have to allow Italy to use taxpayers’ money to shore up its sickest bank, Banca Monte dei Paschi di Siena.

This will be deeply uncomfortable because it lays bare the lack of trust in economic competence between eurozone countries and risks reviving fears about government exposure to local banking systems.

Those fears dogged the single currency five years ago. This time it is less a matter of survival—although many eurozone banks need more capital—than one of getting over the final hurdle of higher post-crisis capital requirements.

European banks’ very weak valuations illustrate how difficult and expensive it will be for some of the bloc’s largest lenders, like UniCredit and Deutsche Bank, to get the equity they need.

The first test is Monte dei Paschi. Italy’s “No” vote looks likely to derail its €5 billion ($5.3 billion)-capital raising plan because the uncertainty created by the resignation of Prime Minister Matteo Renzi will stop investors backing the deal—unless Italy can rapidly form a new, stable government.

On Monday, MPS’s bankers are trying to decide whether the deal will work.

If the bank fails to get funds from private investors, it will have to impose losses on bondholders to cover the capital it needs. That will mean some public money is used, because about half of MPS’s bonds are held by retail investors whose losses would be politically and economically painful.

Retail investors could be protected by a compensation scheme, or by Italy putting money straight into MPS in a precautionary recapitalization. This latter move is allowed under stiffer new European rules on bank bailouts, but only under certain conditions. The key one is that the money mustn’t cover known recent or likely losses, which is a problem at MPS because much of the money it needs is to fund provisions on bad loans that European regulators have demanded it takes.

There is however a financial-stability get-out clause behind most new European banking rules. That lets politicians get around the letter of the law when it threatens severe banking or economic turmoil.

This is where the politics counts. Turmoil for Italy would further provoke the anti-Europe feeling that has foiled Mr. Renzi. But allowing a bailout of the bank risks opening the door to public money being used elsewhere while eurozone governments are struggling to get their economies firing, keep voters happy and meet the bloc’s strict financing rules.

Italy’s largest lender, UniCredit, is waiting to launch a €13 billion-capital raising program and it isn’t alone among European banks in needing fresh equity.

A calming, technocratic administration in Italy could yet see MPS’s plan go ahead. If not, eurozone leaders will need to make some hard political choices—and quickly.

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