** Bending but Not Breaking the European Central Bank

By Xander Snyder

The Italian government has bailed out its banks again, and in doing so it has unwittingly shown just how ineffective the European Central Bank may be. On June 26, Rome finalized a deal, agreed to in principle earlier in the month, to save Monte dei Paschi di Siena, one of the country’s largest and most important commercial banks. In another deal made June 25, Intesa Sanpaolo, a much more stable bank, will bail out Veneto Banca and Banca Popolare di Vicenza. Both agreements involve Italian government funds and prevent senior creditors from incurring losses, a politically contentious issue for a country in which many retail investors hold bank debt. Both deals also skirt the European Union’s strictest banking regulations, which allow Brussels to impose losses on senior bondholders.

But the ECB hasn’t actually had to enforce these measures yet. In fact, it didn’t even enforce them on Italy – there’s a chance the measures would have failed, and their failure would only have validated concerns of the ECB’s fecklessness.

Three Processes

There are three ways a bank can be bailed out under ECB guidelines. The first is a resolution process managed by the Single Resolution Board, an organization established by the European Union to prevent taxpayers from bearing the financial burden of bailouts as they did after the 2008-09 financial crisis. When the ECB determines that a bank has failed or is about to fail, it refers the case to the SRB, which, according to the EU banking framework, can but is not required to impose losses on shareholders, junior bondholders, senior bondholders and unsecured depositors – in that order. When 8 percent of the bank’s liabilities are accounted for in this “bail-in,” capital from the Single Resolution Mechanism fund can then be accessed, and the member state’s national government can also provide funding.

This process was used for the first time earlier this month when Spanish bank Santander acquired its competitor, Banco Popular, for just 1 euro (that’s not a typo) after the SRB had determined that Banco Popular was “failing or likely to fail.” Santander was able to raise 7 billion euros ($7.9 billion) in private funds to support the transaction, however, allowing it to acquire Banco Popular without unduly weakening its balance sheet. As a result, the process avoided a taxpayer-funded bailout by forcing shareholders and junior bondholders in Banco Popular to incur a loss, though it let the bank’s senior creditors remain whole. The SRB managed the sales process, but it didn’t have to punish anyone since a private buyer provided additional funds.

The second process is called a precautionary recapitalization. This occurs when a bank is struggling but is not, according to the SRB, likely to fail. In this case, the SRB reviews a restructuring plan provided by the bank, and if it determines that the bank has a realistic path back to profitability, the SRB will allow the member country’s government to provide the bank with state funds. These funds must be temporary – the state “should be able to recover the aid in the short to medium term” – and they cannot be used to offset “losses that the institution has incurred or is likely to incur in the future.” Banks perceived as “failing or likely to fail by the ECB [are] not eligible for a precautionary recapitalization.”

This was the path that Monte dei Paschi took. The SRB approved a deal whereby the bank will receive funds from the Italian government and will force shareholders and some junior bondholders to take losses. Not all junior bondholders will lose their funds – there was some controversy that the risk these bonds entailed was misrepresented to retail investors. Here again, no senior bondholders will lose their money.

The headquarters of the Monte dei Paschi di Siena bank is located in Siena, in the Italian region of Tuscany. GIUSEPPE CACACE/AFP/Getty Images

The third process proceeds according to EU State Aid rules. If a bank is recognized as failing by the ECB, it is referred to the SRB. If the SRB determines the bank is failing but is not systemically important to the European financial system, it can forgo the resolution process (the first process described above) and refer it back to the member state’s government, which would then manage the situation based on its own national insolvency laws. In this case, however, EU State Aid rules still require that shareholders and junior bondholders incur a loss in a distressed bank sale. Once again, senior bondholders are spared and are not required under EU State Aid rules to take a loss.

This is what happened in the case of Veneto Banca and Banca Popolare di Vicenza. The SRB claimed that the banks are failing or likely to fail but are not likely to pose a risk to the entire European financial system. The Italian government believed, however, that the banks do pose a systemic risk to Italy, and its insolvency laws allowed Rome to provide state aid in a deal that would avoid financial risk from spreading. The result was an acquisition by Intesa Sanpaolo. The Italian government subsidized the purchase, providing Intesa with enough funds to acquire the two banks’ nonperforming loan portfolios without hurting its own balance sheets. Shareholders and junior bondholders took losses.

Before their acquisition, Veneto Banca and Banca Popolare had applied for precautionary recapitalization in March 2017 but were denied by the SRB, which said their proposed restructuring plans were unrealistic and unlikely to succeed.

Fallout

In each scenario, EU member states are trying to make the best of a bad situation. And in each scenario, the SRB is trying to accommodate EU members, but there’s only so far it can bend without breaking. Though Veneto Banca was relatively small, Banco Popolare was the fourth-largest Italian bank by assets. The EU felt it had enough leverage to turn down their request for a precautionary recapitalization but, despite Banco Popolare’s size, was uncomfortable forcing the SRB resolution process on the Italian banking system and risking losses for senior bondholders. It either didn’t know how Italy would react, or it knew that Italy would reject the harsher measures and therefore couldn’t risk the potential political fallout.

Perhaps the SRB’s decision to forgo the stricter resolution process was made without political considerations. Still, it’s hard to imagine that the ECB did not also contemplate the political consequences of imposing a harsher settlement on Italian banks – only to have the Italian government ignore it. Were that to happen, it would call into question the credibility of the entire SRB resolution mechanism. The vague explanation that the ECB offered detailing its decision – three bullet points with boilerplate language that did not describe the details of the financial positions of each bank – suggests the bank was fully aware of the consequences.

In geopolitics, power trumps multilateral regulatory frameworks. While it is within the ECB’s legal rights to impose certain resolutions upon its larger member states, by choosing a softer solution it has shown that it would prefer to let the measures go untested. Its reluctance is as much a sign of its willingness to compromise as it is an indictment of its own power.