Italy Clears Hurdle in Monte Paschi Rescue Without Even Trying

  • European Commission has to approve application for state aid
  • Government in Rome is planning 8.8 billion-euro bailout

Italy’s bailout of Banca Monte dei Paschi di Siena SpA cleared a first legal hurdle even before the plan was drawn up.

European Union law assumes that if a bank needs “extraordinary public financial support,” it’s failing and should be wound down. An exception is allowed when the aid is required to “remedy a serious disturbance” in a country’s economy, but Italy won’t have to make that case.

That’s because the European Commission, which rules on state-aid applications, found in mid-2013 that a “crisis situation persists” in the EU, justifying state aid for banks. The commission hasn’t revised that assessment in the three and a half years since, meaning Italy has one less thing to worry about as it prepares an 8.8 billion-euro ($9.3 billion) rescue of the world’s oldest lender.

The government in Rome is planning a so-called precautionary recapitalization of Monte Paschi, the procedure for funneling state aid to a solvent bank without triggering resolution. This will involve imposing losses on junior creditors, in line with the EU’s push since the crisis to make investors, not taxpayers, bear the cost when lenders struggle or fail.

Critics of the plan say it risks short-circuiting a system EU lawmakers spent years building to break the link between governments and banks. This isn’t Monte Paschi’s first bailout, after all. Italy rescued the bank twice after the crisis when it failed stress tests, posted billions of euros of losses and creaked under a mountain of bad loans. The bank’s track record has convinced some observers that it should be wound down, not propped up.

‘Verge of Collapse’

“This is an institution that has been on the verge of collapse for years,” said Philippe Lamberts, a Belgian lawmaker in the European Parliament. “And therefore in the spirit of the legislators, and I was one of them for BRRD, this is precisely a case for resolution,” he said, referring to the Bank Recovery and Resolution Directive, the EU’s bank-failure law.

The commission’s finding of a “persistent risk of a serious disturbance” in the economies of EU member states, which underpins its approach to state aid for banks, was never intended to be permanent. It last made this judgment in August 2013, not long after a 10 billion-euro bailout of Cyprus that involved closing the country’s second-largest bank. Applying the decision is possible “only as long as the crisis situation persists, creating genuinely exceptional circumstances where financial stability at large is at risk,” the commission said at the time.

EU Competition Commissioner Margrethe Vestager, who’ll make the call on Italy’s Monte Paschi plan, said during her confirmation process that “we have to come back to the usual application of state-aid control in the banking sector,” and she was “ready to do so as soon as the market conditions permit.” That was in 2014.

Even with the “serious disturbance” check off the table, Italy still has to convince Vestager that the bailout meets a number of other conditions in talks expected to take two to three months. The commission said last week that it would work with the Italian authorities to “assess the compatibility of the planned intervention by the Italian authorities with EU rules.”

1. Solvency

To receive state aid outside of resolution, a bank must be declared solvent. The European Central Bank, which oversees euro-area lenders, checked that box last month. This determination has been questioned by EU lawmakers including Lamberts and Germany’s Sven Giegold.

2. Stress Test

Public money for viable banks can only be used to cover a capital shortfall identified in a stress test. Monte Paschi was the worst performer in last year’s test, with a common equity Tier 1 ratio of minus 2.4 percent of risk-weighted assets in the adverse scenario, far below the legal minimum of 4.5 percent. The ECB told Monte Paschi it needed enough capital to push its CET1 ratio to 8 percent and total capital to 11.5 percent, which translates to a shortfall of 8.8 billion euros, according to the Bank of Italy.

3. Losses

As the name suggests, a precautionary recapitalization isn’t intended to clear up a bank’s existing problems, such as Monte Paschi’s mountain of soured loans. It addresses a capital gap indicated by the adverse portion of a stress test, which is based on an extreme and hypothetical scenario. The law explicitly rules out the use of these funds to “offset losses that the institution has incurred or is likely to incur in the near future.”

Given the “deep problems” at Monte Paschi, “it is doubtful that a precautionary recapitalization is appropriate,” said Isabel Schnabel, a member of German Chancellor Angela Merkel’s independent council of economic advisers. “Part of the capital injection is needed to cover losses from non-performing loans; hence public funds are likely to be used at least partly to cover past losses, which would contradict BRRD.”

4. Temporary and Proportionate

The law, BRRD, states that precautionary aid must be temporary, meaning the state is supposed to sell its shares in the bank or be reimbursed for its aid to limit taxpayers’ exposure to losses. That runs counter to the commission’s own thinking laid out in the 2013 Banking Communication, which states that public support to cover capital shortfalls identified in stress tests “is normally of a permanent nature and cannot be easily undone.”

The recapitalization must also be “proportionate to remedy the consequences of the serious disturbance.”

5. Burden Sharing

If Italy wins approval of its Monte Paschi plan, the rescue will still be subject to state-aid rules, which include a new restructuring plan showing how the bank will return to long-term viability. To limit the burden on taxpayers, the rules also require shareholders and junior creditors to contribute to the “maximum extent.”

In the plan laid out by the Bank of Italy, about 4.2 billion euros of the CET1 increase are covered by burden sharing on subordinated bonds. An additional 2.5 billion euros are needed to reach the total capital ratio of 11.5 percent to “compensate for the elimination” of bailed-in subordinated bonds previously included in total capital. Thus the “immediate cost” to the state is about 4.6 billion euros, the central bank said.

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