Why Italy’s Bank Problem Challenges the Rule Book: QuickTake Q&A

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What Comes Next for Monte Paschi?

Italy’s banks are a basket case. Helping them has divided policy makers and called into question Europe’s attempts to end taxpayer bailouts. The shares and riskiest securities of European banks plunged this year even before Italy’s Dec. 4 referendum on constitutional reform led to the resignation of Prime Minister Matteo Renzi. If the country’s banking crisis isn’t solved soon, there are worries it could spread to the rest of Europe.

1. What’s wrong with Italy’s banks?

They’re saddled with about $400 billion of bad loans and lack the financial reserves to sell them off. The combined stock market value of UniCredit SpA and Banca Monte dei Paschi di Siena SpA, Italy’s biggest and third-biggest banks respectively, has tumbled by more than half this year to just $13 billion. By comparison, Snap Inc., the photo-sharing app, is targeting a valuation twice that much.

2. How did we get here?

During the 2008 global financial crisis, banks in the U.S., U.K., Spain, Ireland and elsewhere were bailed out with taxpayer funds. Italy, not facing an immediate need to recapitalize its lenders, waited for an economic recovery that never came. The government this year sponsored attempts to recapitalize troubled banks and buy bad loans. Investors were underwhelmed. Skittishness about banks intensified and stocks slid after Europe woke up to the reality of Brexit.

3. What’s the issue?

It all comes down to who pays for the mess. Renzi considered injecting public funds. But state-aid and banking rules normally require that shareholders and junior creditors share in the losses before public money can flow. That was meant to end the "too big to fail" problem.

4. So why not let private investors share the pain?

Trouble is, lots of them are middle-class individuals who put their savings in bank bonds. Bondholder losses at four small banks in November sparked protests by savers, a nationwide selloff of bank debt and one suicide. A so-called bail-in -- which would force bondholders and other creditors to take losses -- could spark an economic crisis.

5. Has anybody proposed a bail-in?

Monte Paschi, the world’s oldest bank, warned that that’s an option if it fails in its bid to raise 5 billion euros from investors. That’s increasingly likely now that the European Central Bank has rejected the bank’s request for an extension of its Dec. 31 deadline to raise the funds.

6. Did Renzi get any support in proposing to use public money?

He got some backing outside Italy, but German Chancellor Angela Merkel has resisted attempts to bend EU rules. (Germany, with Deutsche Bank, has a bail-in dilemma of its own.) National elections across Europe in 2017, including in Germany, complicate matters. “No one running for election wants to be seen as giving banks or giving Italy a break” from the rules, Carmignac Gestion SA analyst Matthew Williams said.

7. What are financial markets saying?

Monte Paschi has survived more than five centuries. But it’s lost 99 percent of its value since the collapse of Lehman Brothers Holdings Inc. in 2008, and Fitch Ratings Ltd said on Nov. 22 that its offer to junior creditors to swap their bonds for shares “signals the failure of a bank." Investors in under-capitalized banks like Banca Carige SpA and UniCredit, which is planning its own massive cash call next year, are getting nervous.

8. What’s likely to happen?

A smooth, successful capital raise wrapped up in time for Christmas was what Monte Paschi was aiming for, but investors will be surprised if they get it. As for government aid, Italy may have some room to help its banks, thanks to a quirk in the rules allowing for "precautionary" aid, an EU official said. But European bureaucrats have sweated away for thousands of hours devising complex regulations for how to deal with failing lenders, and they may not be prepared to throw out the rule book just yet.

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