What the ECB Didn’t Say About Monte Paschi’s Bailout

Photo showing the statue of Sallustio Bandini, an economist and politician, in front of the Monte dei Paschi di Siena bank headquarters in Siena, Italy
Photo: Alessia Pierdomenico

Two years ago, Italian taxpayers bailed out the world’s oldest bank. Banca Monte dei Paschi di Siena SpA, reeling from huge losses and an accounting scandal, needed 5.4 billion euros ($6.1 billion) to avoid imploding.

Regulators granted the lender its third helping of state aid in less than a decade because they worried its collapse could trigger a broader crisis across the country’s banking industry.

So the European Central Bank publicly backed the handout. Privately, the region’s top banking supervisor harbored deep misgivings about the firm’s viability. In minimizing Monte Paschi’s myriad problems, the ECB looks to have run afoul of its own requirements to put broken lenders on a path that can end in liquidation.

How do we know? A previously undisclosed, 85-page report prepared by a team of ECB inspectors in 2017 put the Italian bank’s solvency in doubt as early as 2015—calling into question whether the lender should have remained open for business, let alone been eligible for a bailout under European Union rules. The ECB considered Monte Paschi to be in such dire condition that it worried a rescue effort might not succeed.

The manner in which the ECB tackled the Italian lender’s problems, its first big test as a banking regulator, threatens to undermine its credibility. ECB President Mario Draghi has yet to win over the many analysts, politicians and others who remain skeptical of the authority’s ability to act as a strong, strict and independent supervisor. To restore investor faith in Europe’s banks, the regulator needs to be more accountable and transparent. This bailout suggests that the ECB may not be up to the task.

Medieval Roots

Founded in 1472, Monte Paschi traces its roots to a pawnshop that catered to Siena’s poor. During the 16th century, it began to fund local farmers, and in 1783 combined with Monte dei Paschi, a local agricultural and commercial lender. With Italy’s unification in 1861, it began to expand beyond its hometown in Tuscany.

After Benito Mussolini nationalized the banking industry in the 1930s, the bank was owned by the government until 1995. That year, ownership was transferred to a nonprofit foundation in Siena. Over time, the charity sought to diversify its investments, and so Monte Paschi held an initial public offering almost exactly 20 years ago.

Monte Paschi’s Lost Decade

The Italian lender’s earnings have been hobbled by hidden losses and bad loans

Net income

€2B

Record profit

0

2004

2007

2019

Est.

–2

–4

–6

2007

Monte Paschi agrees to buy Antonveneta.

2008

Monte Paschi uses derivatives to counter losses from the Antonveneta deal and other transactions.

2009

Monte Paschi gets €1.9 billion in government aid to boost capital as bad loans build up.

2010

Jan. Bloomberg News reports that Monte Paschi used a derivative from Deutsche Bank to obscure losses and a similar deal with Nomura emerges.

Feb. The bank receives a €4.1 billion government bailout.

2013

Jan. Bloomberg News reports that Monte Paschi used a derivative from Deutsche Bank to obscure losses and a similar deal with Nomura emerges.

Feb. The bank receives a €4.1 billion government bailout.

2014

June Monte Paschi raises €5 billion from investors.

Oct. The bank fails European European stress tests.

2015

Monte Paschi raises €3 billion from investors.

2016

May ECB sends inspectors in to Monte Paschi.

July ECB asks Monte Paschi to dispose of €14 billion of non-performing loans. Later that month, stress tests show the bank’s capital would be wiped out in a severe economic downturn.

Dec. Monte Paschi fails to raise funds privately and seeks a taxpayer rescue.

2017

June ECB inspectors complete their report, showing Monte Paschi’s CET1 was 0.58% at the end of 2015, below the regulatory minimum of 4.5%.

July The European Commission approves Monte Paschi’s state aid request.

2018

The bank completes the sale of €24 billion of loans.

Net income

€2B

Record profit

0

2004

2007

2019

Estimated

–2

–4

–6

2007

Monte Paschi agrees to buy Antonveneta.

2008

Monte Paschi uses derivatives to counter losses from the Antonveneta deal and other transactions.

2009

Monte Paschi gets €1.9 billion in government aid to boost capital as bad loans build up.

2010

Monte Paschi gets €1.9 billion in government aid.

2013

Jan. Bloomberg News reports that Monte Paschi used a derivative from Deutsche Bank to obscure losses and a similar deal with Nomura emerges.

Feb. The bank receives a €4.1 billion government bailout.

2014

June Monte Paschi raises €5 billion from investors.

Oct. The bank fails European European stress tests.

2015

Monte Paschi raises €3 billion from investors.

2016

May ECB sends inspectors in to Monte Paschi.

July ECB asks Monte Paschi to dispose of €14 billion of non-performing loans. Later that month, stress tests show the bank’s capital would be wiped out in a severe economic downturn.

Dec. Monte Paschi fails to raise funds privately and seeks a taxpayer rescue.

2017

June ECB inspectors complete their report, showing Monte Paschi’s CET1 was 0.58% at the end of 2015, below the regulatory minimum of 4.5%.

July The European Commission approves Monte Paschi’s state aid request.

2018

The bank completes the sale of €24 billion of loans.

Net income

€2B

Record profit

0

2004

2007

2019

Estimated

–2

–4

–6

2007

Monte Paschi agrees to buy Antonveneta.

2008

Monte Paschi uses derivatives to counter losses from the Antonveneta deal and other transactions.

2009

Monte Paschi gets €1.9 billion in government aid.

2010

Mario Draghi, then governor of the Bank of Italy, calls on the nation’s banks to bolster their finances.

2013

Jan. Bloomberg News reports that Monte Paschi used a derivative from Deutsche Bank to obscure losses and a similar deal with Nomura emerges.

Feb. The bank receives a €4.1 billion government bailout.

2014

June Monte Paschi raises €5 billion from investors.

Oct. The bank fails European European stress tests.

2015

Monte Paschi raises €3 billion from investors.

2016

May ECB sends inspectors in to Monte Paschi.

July ECB asks Monte Paschi to dispose of €14 billion of non-performing loans. Later that month, stress tests show the bank’s capital would be wiped out in a severe economic downturn.

Dec. Monte Paschi fails to raise funds privately and seeks a taxpayer rescue.

2017

June ECB inspectors complete their report, showing Monte Paschi’s CET1 was 0.58% at the end of 2015, below the regulatory minimum of 4.5%.

July The European Commission approves Monte Paschi’s state aid request.

2018

The bank completes the sale of €24 billion of loans.

Net income

€2B

Record profit

0

2004

2007

2019

Estimated

–2

–4

–6

2007

Monte Paschi agrees to buy Antonveneta.

2008

Monte Paschi uses derivatives to counter losses from the Antonveneta deal and other transactions.

2009

Monte Paschi gets €1.9 billion in government aid.

2010

Mario Draghi, then governor of the Bank of Italy, calls on the nation’s banks to bolster their finances.

2013

Jan. Bloomberg News reports that Monte Paschi used a derivative from Deutsche Bank to obscure losses and a similar deal with Nomura emerges.

Feb. The bank receives a €4.1 billion government bailout.

2014

June Monte Paschi raises €5 billion from investors.

Oct. The bank fails European European stress tests.

2015

Monte Paschi raises €3 billion from investors.

2016

May ECB sends inspectors in to Monte Paschi.

July ECB asks Monte Paschi to dispose of €14 billion of non-performing loans. Later that month, stress tests show the bank’s capital would be wiped out in a severe economic downturn.

Dec. Monte Paschi fails to raise funds privately and seeks a taxpayer rescue.

2017

June ECB inspectors complete their report, showing Monte Paschi’s CET1 was 0.58% at the end of 2015, below the regulatory minimum of 4.5%.

July The European Commission approves Monte Paschi’s state aid request.

2018

The bank completes the sale of €24 billion of loans.

Sources: Bloomberg; company reports

State and nonprofit ownership had made the bank vulnerable to local political interference. It frequently lent money to court power. In doing so, it tended to overlook credit risk.

The bank’s major misstep took place in November 2007, when it made a 9 billion-euro bid for rival Banca Antonveneta SpA, draining its cash reserves just as markets were peaking. The deal, which should have raised alarms among regulators, was approved by the Bank of Italy, overseen by Draghi at the time.

The financial shockwaves set off by the collapse of Lehman Brothers Holdings Inc. in September 2008 placed added pressure on Monte Paschi. The bank took to masking its burgeoning losses with a series of complex derivatives deals. Those transactions were hidden from public view until I later reported on them. Once they were disclosed, Monte Paschi had to restate its accounts twice.

In response, Italian prosecutors filed criminal charges against the bank, alleging market manipulation and regulatory obstruction, and two trials are ongoing. Prosecutors are seeking jail sentences for a group of former employees, including the ex-chairman and general manager. The lender itself reached a plea bargain.

Unfortunately, the climate was less than ideal for recovery. As Italy’s economy sputtered during the European sovereign debt crisis, Monte Paschi saw bad loans pile up and was forced to tap state funds in 2009 and again in 2013. In 2014 and 2015, shareholders injected 8 billion euros to help replenish its capital buffers and to repay taxpayers for the earlier bailouts. This funding soon turned out to be insufficient.

The ECB, which had replaced the Bank of Italy as Monte Paschi’s chief regulator in late 2014, made a push in early 2016 to get Italy’s banks to clean up their balance sheets and placed them under heightened scrutiny.

Capital Squeeze

Public disclosures show Monte Paschi’s capital ratio was below those of its peers in 2016

Common equity Tier 1 ratio

Monte Paschi

Average of top European peers

15%

10

5

0

2014

2015

2016

2017

2018

Common equity Tier 1 ratio

Monte Paschi

Average of top European peers

15%

10

5

0

2014

2015

2016

2017

2018

Common equity Tier 1 ratio

Monte Paschi

Average of top European peers

15%

10

5

0

2014

2015

2016

2017

2018

Common equity Tier 1 ratio

Monte Paschi

Average of top European peers

15%

10

5

0

2014

2015

2016

2017

2018

Sources: Bloomberg; Bloomberg Intelligence

The ECB’s supervisory division, which officially oversees banks, sent a team of inspectors to Siena in May 2016 to take a closer look at Monte Paschi. Two months later, the ECB ordered the lender to offload 40% of its existing bad loans. A stress test that month showed that the bank’s equity would have been worthless in a hypothetical scenario involving a sharp economic downturn.

Disposing of the loans would have produced a huge loss, and Monte Paschi began asking investors for yet more money to stanch the bleeding. Although the bank disclosed the ECB’s request to investors, neither it nor the ECB revealed the full scope of the firm’s challenges.

According to the ECB report, the inspection team reviewed a sample of about 1,700 debtors and discovered many more loans had soured by the end of 2015 than the bank had accounted for. The lender had also failed to set aside sufficient funds to cover loans that had already deteriorated. Combined, the additional provisions needed would have overwhelmed Monte Paschi.

Based on an estimate the company submitted to the ECB on Dec. 13, 2016—while it was still trying to raise money from investors—the bank’s 2015 common equity Tier 1 ratio would have been 0.58%. That measure of core capital relative to risk-weighted assets is a widely accepted gauge of a lender’s viability. To pass muster with regulators, firms need a ratio of at least 4.5%—or more than seven times what the report estimated Monte Paschi had at the time.

In short, the ECB knew in 2016 that the Italian lender appeared to be insolvent. Neither party disclosed this critical assessment, even as the bank’s bonds and shares were trading publicly. Investors ultimately declined to step up, and the bank formally abandoned plans to raise funds from the markets on Dec. 22, 2016, forcing it to turn to the government for a bailout.

On a public holiday four days later, Monte Paschi delivered another surprise for taxpayers: It warned that the ECB had required it to raise even more capital than it had been seeking privately. At the time, neither entity provided an explanation for the last-minute change. The bank said the ECB still considered it to be solvent and in line with minimum capital requirements.

Bad Bet

Pouring taxpayer funds into a lender private investors had already shunned was a bad bet based on Monte Paschi’s financial metrics alone. Yet an even bleaker picture emerged from the ECB assessment of the firm’s corporate governance and financial controls. In the final report dated June 2, 2017, Monte Paschi’s failings included:

  • Accounting for collateral twice, or even multiple times, with different values;
  • Failing to identify loans at risk of souring and underestimating the probability of default in its accounts;
  • Not giving high-level managers enough information about the deterioration in the loan book.

Under EU regulations, the European Commission has to approve taxpayer-funded bailouts. It relies on the ECB for guidance. The commission approved Monte Paschi’s rescue a month after the investigators’ report was circulated internally at the ECB and the Bank of Italy.

It’s not clear whether the commission had seen the ECB’s entire report or was fully briefed on Monte Paschi’s condition when it approved the bailout. But as it announced its decision, the commission cited a June 28, 2017, letter from the ECB confirming that, as of that day, the bank was solvent and fulfilling the 4.5% capital requirement.

“Based on the available information, there are no elements which would give rise to serious doubts as to the ECB’s underlying analysis of the solvency criterion,” the commission wrote.

I asked officials at the ECB and the commission for an explanation for why Monte Paschi was seen as a viable recipient of a taxpayer bailout, but they declined to comment, as did officials at the Bank of Italy, the Italian Treasury and Monte Paschi itself.

There is no question that regulators have to manage perceptions when trying to rescue an institution. Public disclosures can create devastating bank runs that might undermine those efforts. Supervisors also have to exercise delicate judgments based on a holistic picture of a financial firm’s strength, which may not be fully reflected in one or two isolated metrics.

The commission also might have been confident that public funds would have helped the bank overcome its problems, though the severity of the lender’s financial difficulties make that view hard to fathom.

Patchy Disclosures

It looks like Monte Paschi had a severe capital shortfall around the time of its bailout. EU rules should have disqualified it from getting the so-called precautionary recapitalization it received.

“State aid in this context can only be granted as a precaution (to prepare for possible capital needs of a bank that would materialize if economic conditions were to worsen),” the commission said on July 4, 2017, when it approved the package.

In other words, the bailout was meant to steel Monte Paschi against tough times ahead rather than cover past or probable losses. In its statement, the commission said the bank’s likely losses of 4.4 billion euros could be covered through private means, giving it comfort that state aid would not be used to offset previous or anticipated losses.

This reasoning overlooks the fact that money is fungible. It is impossible to prove exactly what the funds were used for.

For its part, Monte Paschi continued to put a rosy spin on its public disclosures. In its 2017 annual report, the company said it had made additional capital provisions stemming from the ECB’s inspection, without offering investors and analysts specific figures. It said it had suffered losses resulting from the sale of a portfolio of bad loans in 2017, which had overlapped with the “additional valuation differences.”

This hardly passes as full disclosure, given that regulators were worried about the bank’s solvency and a bailout had been granted, inflicting losses on shareholders and some bondholders.

Value Destroyed

Monte Paschi shares are down by almost 80% since they resumed trading after the bailout

€5 a share

4

3

2

1

0

2018

2019

June

€5 a share

4

3

2

1

0

Oct.

2018

2019

June

€5 a share

4

3

2

1

0

Oct. 2017

2018

2019

June

€5 a share

4

3

2

1

0

Oct. 2017

2018

2019

June

Source: Bloomberg

Over the past year, Monte Paschi has become profitable again. But 17% of its loans are still classified as nonperforming, a figure that is almost twice as large as the average for Italy’s top nine banks, according to Bloomberg data. And the cleanup continues. The firm is in final talks to sell a package of bad loans with a face value of about 1.1 billion euros to Cerberus Capital Management and Bank of America Corp.

So Monte Paschi is surviving, but investors remain none the wiser about how it was faring at the time of the bailout. The ECB’s decision to plug holes in the bank’s finances so it wouldn’t sink will be of little comfort to those who entrust the regulator to hold financial institutions accountable and to keep the public informed.

The ECB, the commission and the Bank of Italy all need to explain clearly to investors, the public, global regulators and the rest of the international banking community exactly how the rescue was engineered. Otherwise, the vision of the ECB as a financial supervisor immune from national interests and political meddling, one with the ability to end decades of mismanagement at some of Europe’s lenders, will remain in doubt.