European Economy

Europe's Addiction to Bailing Out Banks

Effective regulation means letting some banks fail.

It's seen better days.

Photographer: Alessia Pierdomenico/Bloomberg via Getty Images

Like repentant smokers, Europe's politicians have promised to quit bailing out banks. They're finding the habit hard to break.

The Italian government wants to rescue three banks which are struggling under the weight of non-performing loans. The trade-offs, as always, are complicated: financial stability now against financial stability later; shielding taxpayers from the costs of a rescue against protecting small investors from heavy losses. Yet the right balance can't mean saving every struggling bank every time.

Last December, Monte dei Paschi di Siena, Italy’s fourth largest bank by assets, applied for an injection of public money -- a so-called precautionary recapitalization -- and the European Central Bank and the European Commission are examining its request. Two smaller regional lenders, Veneto Banca and Banca Popolare di Vicenza, have followed suit, as a first step towards a possible merger.

Note that Italy is playing by the rules. The EU's directive governing bank failures allows governments to inject fresh capital into a bank so long as it is solvent under normal circumstances and support is needed to prevent wider economic and financial disturbances. Precautionary recapitalization requires junior bondholders to face losses but, unlike a full-blown resolution, spares investors holding senior debt.

This procedure, in other words, allows exceptions to the EU's strictures against bail-outs. Regulators should be cautious in overseeing this loophole. Some governments will seek to exploit it to keep "zombie banks" alive. This temptation is particularly strong in Italy, where many retail investors were mis-sold bank bonds. The government is keen to rescue as many of them as possible to avoid a political backlash.

Keeping all banks alive would be very costly in the end. Aside from the effect on banks' incentive to manage themselves prudently, the financial system is going through an era of momentous change, as lenders face competition from nimbler fintech companies. Technological change means that the number of profitable banks in Europe is likely to shrink dramatically. Saving a lender today is no guarantee that you won’t have to do the same tomorrow.

Balancing legitimate concerns over financial stability with the need to let more banks fail will be tricky. The answer lies in a stricter application of the rules. The regulators should be stringent in ensuring that bailed-out banks are viable. It's questionable that Banca Popolare di Vicenza and Veneto Banca, both short of capital, pass this test -- though the banks say the ECB regards them as eligible for precautionary recapitalization. In general, regulators should be more cautious about bigger, interconnected banks, and more relaxed about the smaller ones. In the case of Italy, this could mean rescuing MPS while letting the smaller banks be resolved.

The main objection to this approach is that it ingrains the problem of "too big to fail", which was exposed during the financial crisis. For this reason, banks should be made to speed up their work on drafting plans ("living wills") that allow regulators to wind them down without a significant impact on the rest of the system. Lenders that don't comply should be required to downsize. Until this process is completed, however, there's a good case for differential treatment.

By the way, letting a bank fail doesn't mean "hands off" -- the state still has to be involved. Guaranteed deposits would need to be protected. Where retail investors were truly mis-sold securities such as subordinated bonds without knowing the risks involved, the government should step in and compensate them. Bank workers who lose their jobs should be helped to retrain.

The main thing is that Europe's governments should get ready to accommodate the changes occurring in the banking industry, instead of blindly opposing them. The alternative is to see billions of euros go up in smoke, merely to delay the inevitable.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

    To contact the author of this story:
    Ferdinando Giugliano at fgiugliano@bloomberg.net

    To contact the editor responsible for this story:
    Clive Crook at ccrook5@bloomberg.net

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