Marcus Ashworth is a Bloomberg Gadfly columnist covering European markets. He spent three decades in the banking industry, most recently as chief markets strategist at Haitong Securities in London.

Banca Monte dei Paschi di Siena SpA is going to try one last time with a 5 billion euro ($5.3 billion) capital increase to avoid a state-backed rescue. Mom and pop, and the regulator, need to join in. 

Before a push to raise equity before the end of the year can take place, the bank must reopen a debt-to-equity swap for 40,000 retail investors holding about 2.1 billion euros of subordinated bonds. Only then would a big stock investor be willing to dive in. 

Some 29 percent of Italian bank bonds are held by households, compared with barely 1 percent in Spain, according to Bruegel. This is largely as a result of preferential tax treatment of income interest on bonds which actually expired in 2011, but there has been little incentive to move out of fixed income. Most private investors regard bank bonds as a higher-yielding alternative to a normal deposit.

The trick for rescuing Monte Paschi, and perhaps the entire Italian banking system, will be to persuade its retail investors that switching into equity won't destroy their savings. This will involve both carrot and stick.

Monte Paschi's Subordinated Mess
Its Lower Tier II debt, a favorite of retail investors, fell as the prospects of a private rescue faded
Source: Bloomberg

First, the carrot. On the assumption that the terms will be the same as offered last month to institutional investors, these should be enough to get the deal done, as Gadfly has argued. 

But this isn't entirely the point. The one unbroken rule the European Union has stuck to throughout the crisis has been to protect up to 100,000 euros in individual bank deposits. This shield has in most cases been extended for retail bondholders. It's fair for Monte Paschi's retail creditors to ask now why they should give that benefit up in exchange for the unlimited downside of equity.

This is where the stick comes in. The only other alternative is a state bail-in, which would almost certainly involve harsher terms. To avoid a lengthy legal process these could perhaps be sweetened with some additional compensation, but that's not necessarily ready money -- some smaller Italian banks that were bailed in under EU rules last year have yet to resolve their bondholder compensation issues.

So retail investors should hopefully see the light and vote "yes" for the swap. But first, they'll need the Italian market regulator, Consob, to clear their path.

Consob, whose job is to protect households on financial matters, had blocked them from some parts of last month's swap, according to Il Sole 24. This time around, it's waiting for a signal from the European Central Bank before deciding whether to change its approach, according to Il Messaggero.

And the Month's Not Half Over
Tough times for Monte Paschi as government changes and ECB denies extension for capital increase
Source: Bloomberg

Keeping the retail investors out of the swap would kill this last gasp effort for Monte Paschi stone dead. But if they're in, this can pave the way for a cornerstone investor, such as Qatar, to stump up for the capital raise. And then, perhaps, Monte Paschi can step back from the cliff.

There seems to have been a turn in sentiment today in favor of a private deal. The bank's share price is up 6.4 percent from Friday, and the riskiest Tier 1 bonds are 5 cents higher. The bulk of retail money is in Lower Tier II subordinated bonds and they have firmed modestly firmly in little trading. 

Everyone has to hold hands and jump over the cliff together -- otherwise the state will push them over, under the watchful eye of the ECB.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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