26 June 2017

Financial Times: Italy shows EU banking union still has far to go

[...] The justification for common European bank regulation and resolution framework is twofold: to help free banks across the continent from the overhang of crisis-era bad loans, and to cut the dangerous link between banks and sovereign states. The liquidation moves the good assets of the two banks, along with a €4.8bn slug of taxpayer cash to a larger bank, Intesa Sanpaolo. The bad loans will be put into a “bad bank,” backed by a €12bn state guarantee. Senior debt holders and depositors will absorb no losses. The contrast with the recent liquidation of Spain’s Banco Popular — in which Santander absorbed Popular’s good and bad assets, and went to the market for the cash needed to support them — is damning.

So while bad loans have been quarantined, the Italian state is in up to its neck. The nominal justification for Rome’s involvement under state-aid rules — that because the banks are being wound up, there are no competitive concerns — is wildly unconvincing. The clear message from the deal is that Italian banks, or at least certain favoured Italian banks, carry a state guarantee. The competitive implications are obvious.

Both Italian and European regulators can share the blame. The Italians sat on their hands while their banks issued junior debt and equity to retail investors. The recession made the non-performing loan problem far worse. The banks should have been liquidated or consolidated years ago. And the European authorities could have intervened long before last week, when the Single Supervisory Mechanism declared the two banks likely to fail.

Insufficient vigour over a period of years by both national and supra-national regulators made a solution that respected the letter and spirit of European rules much harder. Such a solution would have required that 8 per cent of the two banks’ liabilities be wiped out before state funds were deployed. In such a case senior bondholders and large depositors (who are on equal footing in the credit hierarchy) would have been hit.

This would have been very difficult amid strong Eurosceptic sentiment, especially in northern Italy. The damage to corporate depositors and retail holders of the senior debt could have hurt the regional economy. A bail-in could also have spooked big depositors at other banks into withdrawals, igniting a bank run. The Italian authorities were simply not going to take that risk.

None of this signals that banking union is a pipe dream. Indeed, resolving the weakest Italian institutions (one way or another) should make union easier. That Italy needed to resort to bending the rules shows that at least two things need to happen. First, banks should be forced to issue adequate quantities of loss-absorbing debt whose eligibility for bail-in is unambiguous — ideally converting automatically when predefined financial thresholds are breached. The ambiguous status of the Veneto banks’ liabilities made a proper bail-in riskier.

Second, to reduce the threat of bank runs, the eurozone needs a common deposit insurance scheme. That would sever the link between banking systems and sovereigns and so end the risk of contagion. Banking union remains a worthy goal. An imperfect bailout in Italy should not derail it.

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