Photographer: Alessia Pierdomenico/Bloomberg

Germany Sees Monte Paschi Bailout Eroding Bank-Failure Rules

  • Lawmakers urge EU to uphold its new rules for bank failures
  • Losses caused by bad loans or mis-selling mustn’t be covered

German officials and lawmakers are concerned the state rescue of Banca Monte dei Paschi di Siena SpA is stretching the credibility of the European Union’s new regime for too-big-to-fail banks.

Wolfgang Schaeuble’s Finance Ministry remains skeptical about Italy’s plan to protect individual investors and would prefer them to seek individual compensation through the courts rather than en masse as Italy plans, according to officials familiar with internal discussions, who asked not to be identified because the talks are private. Lawmakers from the ruling coalition urged the European Commission to fully enforce the rules for failing banks. 

“Italy’s plans are a provocation,” said Carsten Schneider, the deputy head of the Social Democrat caucus in the Bundestag, Germany’s lower house of parliament. “For the European Commission and the European Central Bank, this is the litmus test for whether the new European rules for bank resolution are enforced.” The Social Democrats are the junior partners in Chancellor Angela Merkel’s governing coalition.

The EU laid down new rules for how to deal with failing banks in 2014, after member states used almost 2 trillion euros to prop up banks during the financial crisis. The Bank Recovery and Resolution Directive foresees small banks going insolvent like non-financial companies. Big ones that could cause mayhem would be restructured and recapitalized under a separate procedure called “resolution,” in which losses are borne by owners and creditors.

State Support

In a bailout that is slated to cost 8.8 billion euros ($9.5 billion), Italy is using a provision that allows state support for solvent banks in exceptional circumstances. To avoid misuse of that clause for old-style bail-outs, the law states that such support mustn’t cover “losses that the institution has incurred or is likely to incur in the near future” and instead seeks to protect a sound bank against a shock from external influences out of its control.

Read more about Monte Paschi’s State Bailout

A key element that irks the Germans is Italy’s plan for 40,000 individual investors who own Monte Paschi’s Tier 2 subordinated bonds to receive 2 billion euros of senior notes in a transaction effectively funded by the Italian government, the officials said. Italy justifies the deal by claiming that Monte Paschi mis-sold the securities, understating their risk. Other subordinated creditors will be forced to convert into equity.

No one was immediately available for comment at Germany’s finance ministry. An Italian Treasury official declined to comment.

Closed Meeting

In a closed meeting with lawmakers last week Schaeuble acknowledged that there is an option for state aid in the BRRD, saying that it was up to the commission to make sure the rules governing aid are observed, according to participants, who asked not to be named because the meeting was private. While Schaeuble stopped short of explicitly questioning the legality of Rome’s plan, he said retail investors should seek redress individually.

Read more about global efforts to end ‘too big to fail’

“The owners and the creditors must be the ones who cover the bank’s losses,” said Klaus Peter Willsch, a lawmaker for Schaeuble’s and Chancellor Angela Merkel’s Christian Democratic Union. “The bail-in regime mustn’t be hollowed out. You can’t create one exception after the other to limit the bail-in principle.”

The Germans’ concern centers on the likelihood that the Monte Paschi bailout will set a bad example, opening a door for other nations to pass through. Analysts at Commerzbank AG said in a note to clients that bond investors should start to consider Monte Paschi’s rescue a blueprint for bigger banks.

‘Built-in Flexibility’

“Arguably, it is a stretch to assert that all conditions have been met but it is not possible to prove the opposite beyond doubt” in the Monte Paschi case, Christoph Rieger and Nigel Myer write in the note. “Considering the deliberate built-in flexibility of this framework and the political interests involved, we assume that precautionary recapitalization will typically be considered when a systemically important bank runs into trouble.”

“The finance ministry must make clear on the European level that the bail-in principle is upheld,” said Lothar Binding, a Social Democrat lawmaker. “Otherwise, this would create a precedent to soften the liability of shareholders and creditors.”

A second element of the Monte Paschi bailout that Germany dislikes comes from the fact that the bank’s main problem is the towering pile of bad debt that accounts for about a third of its loan book, according to one of the officials familiar with the discussions. The ECB has told the Italian lender to shrink the stack of soured loans by selling them, crystallizing further losses. 

Germany argues those losses have already been incurred, making them exactly the kind that’s ineligible for state aid, according to the official. The same could be said about the program to compensate individual bondholders, which Berlin also considers a legacy loss that can’t be offset using government cash.

If taxpayer bailouts become the norm again, the link between sovereigns and banks that the EU has sought to sever would be reinforced, which goes against the idea behind the creation of a banking union, the official said.

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