The European Court of Justice upheld the
principle of making creditors bear the burden for investment in banks that sour
before government funds can be used.
Italian banks are particularly sensitive to the ruling, which cannot be appealed because the European Banking
Authority and European Central Bank stress tests on July 29 are expected to
show that some Italian banks are under-capitalized.
The problem is that the private sector does
not have much appetite and the government-facilitated Atlas fund does not
appear to have sufficient resources after buying equity in two banks.
The Italian government has been engaged
in what at times seem like acrimonious negotiations with the EU over the
construction of a recapitalization plan.
Italian officials want to tread carefully
around bailing in junior creditors. In Italy, the junior creditors are often retail investors, especially
in the domestically focused banks. Retail
ownership of bonds accounts for 15%-20% of total direct funding for several
banks and nearly 12% for Monte dei Paschi, which is the focus of so much
attention recently. In the more international banks, the
retail share of direct funding is considerably less, like less than 6% for
UniCredit and 7.5% for Intesa.
The Bank of Italy’s July 2016 Economic
Bulletin notes that nearly half of the bank bonds held by households at the end
of last year mature by the end of 2017,
and 90% mature by 2020. This offers
Italy to put into place new rules to educate and protect retail
investors. However, it does little to address the immediate exposure of
junior creditors.
The European Court of Justice was clear:
“Burden-sharing by shareholders and subordinated creditors as a
prerequisite for the authorization, by the commission, of state aid to a bank
with a shortfall is not contrary to EU law.” There is an exception
to the principle, and that is if bailing
in “would endanger financial stability or lead to disproportionate
results.”
Claiming extraordinary circumstances after the
UK referendum seemed to be Italy’s first push, but that was deftly blocked by Germany. Prime Minister Renzi
appeared to have anticipated the court ruling that found the EC did not
overstep its authority in requiring subordinated creditors from being bailed in
before public funds were used in
formulating an alternative plan.
Italian banks shares appeared to extend their
earlier decline when the European Court of Justice decision was announced. From session highs,
the low was 5.5% away. Share prices
stabilized but remain more than 2% lower on the day. It is the
first decline since last Wednesday and the second loss since July 6.
There are different ways that subordinated
creditors can be bailed in to meet the requirement. For example, a case last year that involved
bailing in subordinated creditors in four small banks at the end of last year,
some retail investors could plead hardship (if they met certain financial
criteria) and file for a refund. Some subordinated creditors may be offered an opportunity to swap debt for
equity.
The Bank Recovery and Resolution Directive
(BRRD) requires a preliminary bail-in of 8% of the bank’s total liabilities
before government money can be drawn.
In theory, me cases, it may be possible to meet the threshold and still exclude
a particular instrument, for example, like a bond Monte Paschi marketed to
retail investors for an acquisition (from ABN-Amro). However, if
the stress test on Monte Paschi were to reveal a shortfall in the high end of
market expectations, the 8% bail-in requirement would require all or nearly all
of the junior creditors to be bailed-in.
Italian banks face three challenges:
capitalization, bad loan, and profitability. The government appears
to be moving toward a recapitalization and a way to get the bad loans off the
bank books. The longer-run profitability of the banks may be too much to
push for in this round. If it were to mean higher unemployment, the
government might not find, for example,
that a campaign to reduce the number of bank branches to be particularly
urgent.
Addressing Italy’s bank challenges is
important in it own right, but is also important politically. In
three months, there is a referendum on the reform of the Senate. It
sounds like an idiosyncratic issue, but it is significant if for no other
reason than Renzi has pinned his tenure to its approval. He has indicated
he will resign if the measure is rejected.
Renzi is the third unelected prime minister,
but his resignation would likely spark a
political crisis.
Polls suggest that the Five-Star Movement,
which won the recent mayoral contests in Rome and Turin, is more popular than
Renzi’s center-left coalition (PD). The Five-Star Movement appears
to have softened its criticism of the EU recently, but it continues to blame
EMU for Italy’s poor economic performance and social stress.
How Renzi deals with the banking issues,
this summer may be more important for the outcome of the October referendum
than the specific merits of the issue.