14 July 2016

Bruegel: Italy’s banking problem is serious but can be fixed

Italy’s weak banking sector is the largest remaining pocket of financial fragility from the long sequence of banking system problems that has blighted Europe since 2007. [...]

The Brexit vote of June 23 was followed by a decrease in share prices of listed banks in Italy as elsewhere in Europe, which makes it comparatively harder for them to raise fresh capital from private investors if needed. Even if the UK had chosen to remain in the European Union, however, Italy’s banking problem, and most immediately MPS’s weak balance sheet, would certainly have become the next focus of attention of market participants in Europe once the all-consuming British referendum campaign was over.

The situation of MPS has crystallized a debate about burden sharing, or in other terms, whether losses should be imposed on some creditors, especially junior ones, as part of the bank’s capital strengthening. Such imposition of losses, also referred to as “bail-in,” may be justified on several grounds. Public guarantees of bank creditors, and their “bail-out” when a bank fails, distort competition among banks from different European member states. They are a controversial use of public funds, create questionable incentives for banks, and they also contribute to the bank-sovereign vicious circle which threatened the very integrity of the euro area in 2011-12. The European Commission’s competition policy arm (known as DG COMP) has a mandate to keep such state aid in check. Furthermore, the European Union in May 2014 adopted a Bank Recovery and Resolution Directive (BRRD), which attempts to make bail-in the default option when a bank fails. This echoes a global reform effort to mitigate moral hazard in banking systems, labelled “Ending Too-Big-To-Fail” by the Financial Stability Board (FSB), and similar policies adopted in other jurisdictions.

[...] In the case of Italy, however, a complicating factor is that much (though far from all) of the banks’ junior and senior debt, together with equity, was sold by the banks to their retail customers, with no objection (and until a few years ago, even encouragement in the form of tax incentives) from the public authorities, including the securities regulator CONSOB and the Bank of Italy. This can be viewed as massive misselling, since these instruments, and particularly equity and junior debt, are intrinsically risky and should not have been placed as a safe retail investment product, even before the European Union started consulting on the BRRD legislation in the early 2010s. Such dubious practices have also occurred in other European countries, but have been uniquely pervasive in Italy. [...]

Everyone agrees that holders of equity shares are not entitled to compensation, even though their losses can be painful as well. As a consequence, the discussion on MPS is centred on those junior debt holders who cannot be viewed as innocent victims of misselling, namely well-to-do families, professional investors and other banks. The Italian government appears to be adamantly opposed to any bail-in of these. But its stance is hard to justify by considerations of financial stability. Banks issue much less junior debt now, and one hopes they sell it only to knowledgeable investors anyway. Assuming minimally competent public communication, there is no risk whatsoever of a bank run. In sum, a reasonable compromise would involve bailing in junior creditors, presumably in the form of a debt-equity swap; compensating the retail victims of misselling; and sparing all senior creditors and depositors under the BRRD’s exemption for precautionary recapitalizations. [...]

A more comprehensive approach to Italy’s banking fragility is overdue, even though political realities may delay it until after a constitutional referendum due in October 2016. The tried-and-tested way to resolve Italy’s banking problem would be a system-wide exercise of “triage,” with an ad hoc balance sheet assessment of banks representing the vast majority of the system’s total assets, and thus including a number of the smaller banks that currently escape direct ECB supervision. To be credible, the assessment should be directly conducted by the ECB, possibly also involving evaluators from the private sector as was done in several EU countries including Ireland, Greece, Spain and Cyprus. Those banks that would be found unviable should then be resolved using the procedures set out by BRRD, again with adequate compensation of retail victims of misselling. In the unlikely case that EU authorities would opine that this may lead to systemic instability, then the option might be considered of reactivating the possibility of direct bank recapitalization by the European Stability Mechanism, the euro-area fund based in Luxembourg, with conditionality for the Italian authorities in a spirit comparable to that of the Spanish program of July 2012. Also, the governance of many Italian banks should be further reformed to prevent them being captured by local political interests. In parallel, echoing recent recommendations by the International Monetary Fund in two recent papers, the Italian governments should pursue reforms and allocate resources to facilitate out-of-court settlements and court judgments in order to facilitate the seizing of collateral on bad debt, and thus increase the currently depressed value of Italian banks’ vast portfolios of non-performing loans.

Assuming a modicum of cooperation by all public authorities involved, Italy’s banking problem could thus be solved in the first half of 2017 if not earlier. By then, it is to be hoped that the euro area will have almost entirely addressed its legacy of financial fragility from the past years of crisis. This should in turn allow leaders to move towards making the banking union more consistent and resilient, with more risk-sharing and sounder incentives for public authorities and banks. The agenda should include a European deposit insurance scheme, as the European Commission proposed last November; limits on banks’ exposures to individual euro-area sovereigns, with a lengthy transition period to avoid disruption in sovereign debt markets; harmonizing bank insolvency law across the euro area, an indispensable complement to BRRD; and perhaps also amending BRRD itself in the light of lessons learned from the Italian experience.

Moreover, that same experience suggests that a sustainable banking union will require additional arrangements for the protection of customers of financial services. The fact that banks were allowed to sell their own risky debt to retail households as a savings product for so long is disturbing, as is the fact that no one in Italy appears to have taken any accountability yet for this policy failure. EU authorities should draw the right lessons so that similar fiascos do not happen again.

Full article on Bruegel

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