February 16, 2017

Italy’s Bank Fudge Takes EU Rules To The Limit

by Breakingviews

Italy’s bank fudge takes European rules to the limit. The government wants to put 5 billion euros into two small banks – as much as their common equity. It’s hard to square with European rules that only allow governments to help stable banks.

The rescue of Banca Popolare di Vicenza and Veneto Banca is just the latest rescue to use the so-called “precautionary recapitalization” escape clause introduced in European bank-resolution rules. Italy also wants to use this technique with its 8.8 billion-euro rescue of Banca Monte dei Paschi di Siena.

The main requirement for a precautionary recapitalization can be ticked: both banks currently meet their minimum common-equity Tier 1 requirements. But then there’s the 5 billion euro capital hole. If that were needed to cover losses, the banks would have little equity left.

European rules are more subtle than that. They distinguish between losses that are probable, and those that would happen in a severe scenario, as determined in a stress test. So long as state capital only covers the latter, and the bank is still solvent in the real world, state capital is allowed. The caveat is that subordinated creditors still have to take losses under state aid rules.

Yet the European Commission and European Central Bank could instead tip the banks into a full resolution by winding them down. That might be reasonable: Vicenza and Veneto are in a pretty dire state. With bad loans equivalent to twice their equity after deducting provisions, and very low profitability, they would struggle to earn their way out of any downturn, or cut bad debt portfolios without taking big losses.

Such a stance would save state money as it would allow burden sharing on senior creditors. But it would be pretty damaging too. In the current plan, at least some capital will come from the private-sector bank-bailout fund Atlante. The government might feel obliged to compensate some senior creditors for mis-selling – as they have done with MPS.

The Italian recapitalizations show how a literal interpretation of European rules can justify rescuing all but the most desperate banks. That’s a problem. One option would be to apply a more subjective test for viability. The other would be for the European Commission to always insist on a higher standard of burden sharing, including senior creditors.

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