Italian Bank Risk Surges as Capital Needs Fuel Bail-In Concerns

  • Monte Paschi junior CDS signal 63% chance of default
  • UniCredit, Intesa Sanpaolo subordinated bonds decline

Measures of debt risk for Italian banks surged amid concern that government plans to shore up capital ahead of regulatory stress tests may require losses for junior creditors.

The cost of insuring Italy’s biggest lenders soared and bonds fell. Credit-default swaps on subordinated bonds of Banca Monte dei Paschi di Siena SpA surged to a record and now signal a 63 percent probability of default within five years.

Italy is talking with European Union authorities to get approval to provide capital to Monte Paschi, its third largest bank, a person with knowledge of the plan said on Tuesday. Failing unanimous approval by EU member states to waive rules designed to protect taxpayers, any injection of public funds would require shareholders and junior creditors to take losses.

“If Italy wants to do a state-sponsored cash injection, then from a creditor perspective the first question is will they use the bail-in rules?” said Alexander Plenk, the head of investment research at Bayerische Landesbank in Munich. “A bailout technically requires a bail-in, but they’ll do everything to avoid it.”

Default Swaps

The upfront cost of credit-default swaps insuring 10 million euros ($11 million) of Monte Paschi’s junior debt for five years jumped to 3.6 million euros from 3 million euros, according to CMA. That’s in addition to 500,000 euros annually and assumes that investors would recover 20 percent of face value in the event of default.

Monte Paschi’s 379 million euros of subordinated bonds due September 2020 dropped 9 cents on the euro to 76 cents, the lowest since February, according to data compiled by Bloomberg. The riskiest securities of UniCredit SpA and Intesa Sanpaolo SpA, Italy’s two biggest lenders, also fell.

Concerns about Italy’s banking system and the U.K.’s decision to quit the European Union fueled an increase in broader measures of credit risk. The Markit iTraxx Europe Subordinated Financial Index of credit-default swaps on the junior debt of 30 banks and insurers jumped 20 basis points to 250 basis points, according to data compiled by Bloomberg.

Stress Tests

Italy is looking to invoke an EU rule allowing temporary state aid if European Central Bank and European Banking Authority stress tests due on July 29 reveal a shortfall, said the person familiar with the matter, who isn’t authorized to talk about the plan and asked not to be identified. Monte Paschi said that the ECB increased its targets for disposing of bad loans.

A European Commission official reiterated that the EU executive body is in contact with Italian authorities and said a number of solutions can be put in place. The commission gave Italy permission last week to guarantee as much as 150 billion euros in liquidity for its struggling banks until the end of the year.

Italy could try to avoid bailing in creditors by claiming extraordinary public support is needed to avoid a crisis, said Mario Todino, a lawyer at Jones Day in Brussels. Exceptions to EU state-aid rules include “exceptional circumstances” such as when enforcing them would “endanger financial stability.”

The EU may be also sympathetic to easing the rules because a bail-in of creditors at big banks could damage prime minister Matteo Renzi’s chances in an October referendum on constitutional reform that he said he needs to win to stay in power, according to Francesco Castelli, a London-based money manager at Banor Capital, which oversees more than 4.5 billion euros.

Italy may want to avoid bailing in creditors after its experience last year, he said. Losses at four small Italian lenders led to protests by savers, a nationwide selloff of bank debt and one suicide. Almost 200 billion euros of Italian bank bonds are held by retail investors, according to Bank of Italy data through December.

“The collapse of a big Italian bank would be a financial disaster for everyone and could threaten the EU itself,” Castelli said.

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