In the seventh ADEMU perspective, Thomas F. Cooley (NYU Stern and Chair of the Advisory Committee of ADEMU) reviews how credible the banking union is in the eurozone, looking at evidence from recent resolutions in Spain and Italy.
One of the crucial elements of the new European banking legislation is the bail-in provision – the requirement that existing stakeholders absorb losses equal to 8% of the bank’s assets before any state aid becomes available. Recent events in the banking sectors of Spain and Italy tested this provision and revealed the defining factors for its application. In particular, faced with failing banks in the two countries, Spain chose to apply the bail-in rule while Italy opted to bail out its banks. Why this stark difference and what do these recent experiences mean for the viability and credibility of the new European banking regulations?
The case of Spain
On June 6th the European Central Bank’s Single Supervisory Mechanism (SSM) declared Spain’s Banco Popular “failing or likely to fail.” This set in motion the EU’s Single Resolution Board (SRB) which, in collaboration with the Spanish regulators, restructured the bank and engineered its takeover by Santander. This was a key test of two of the critical components of the European Banking Union, the SSM and the SRB. In addition, it provided a real life test of Europe’s wide-spread reliance on contingent convertible debt (CoCos). The restructuring involved wiping out the existing equity and some junior debt, triggering the conversion of the contingent debt to equity which was then handed to Santander for 1 euro. Senior debt holders and depositors were not impaired and, most importantly, as prescribed by the regulations, taxpayers’ money was not involved.
In the case of Spain’s Banco Popular, the bail-in provision of the Resolution Mechanism worked as intended and no bail out was necessary. While the Spanish test of the regulatory framework led to some initial euphoria regarding the achievement of an orderly resolution, the enthusiasm was short-lived. A month later the Italian government stepped in to provide state aid to some of its failing banks, with the approval of the ECB, without first applying the bail-in provision.
The case of Italy
Faced with the distress of the Italian lender Monte dei Paschi Di Siena (MPS) and the failing regional banks Banco Popolare di Vicenza and Veneto Banca, the Italian government got permission from the ECB and the European Union to inject at least 20 billion Euros into the Italian banking system.
Monte dei Paschi di Siena has been hovering on the brink of default for several years. Plans for its rescue were finalized a few weeks ago with the arranged sale of a portfolio of bad loans from the bank’s balance sheet for the equivalent of about 20 cents to the dollar. The bad loans are being transferred to a special vehicle. At the same time, a plan was approved to close Banco Popolare di Vicenza and Veneto Banca. The shareholders and junior debt holders of these banks would be wiped out and the healthy remains would be acquired by Intesa Sanpaolo. To incentivize Intesa to assume the healthy assets of those two regional banks, the Italian government would provide billions of euros to Intesa so that after its acquisition of these assets, it would not be worse off than before it acquired them. In addition, the government would bail out investors who bought the senior unsecured debt of the defunct banks. In other words, the Italian government bailed out those banks and avoided applying the bail-in provision of the new European banking regulations.
Why did Spain bail-in and Italy bail-out?
In the case of Spain, it was deemed that applying the bail-in provision would not lead to contagion, and it did not. The Italian authorities reached the opposite assessment, however, in the case of Italy. The specific conditions surrounding the Italian banking sector and those banks in particular, made them susceptible to setting in motion contagion in the Italian banking system. The Italian government has been determined to avoid that.
One of the reasons the Italian government stepped in to rescue its banks is that the banks sold much of their contingent convertible debt to their own retail customers, offering them higher returns without warning them of the risks. A default by some of them could lead investors of contingent convertible debt from other banks to dump them, unleashing contagion across the Italian banking system and impairing the ability of the economy to function. But they got to this point because they were unwilling to acknowledge the weakness of the banking sector earlier. Spain had no choice but to do so.
The health of the economies of the two countries have also played a role. Figure 1 shows that Italy and Spain have diverged in recent years in terms of their economic growth trajectories. While growth has significantly accelerated in Spain since 2014, it remains largely stagnant in Italy. Furthermore, Italy suffered a deeper recession than Spain following the financial and European crises that left scars on its economy. The recent pickup in growth in Italy and across the region, shown in Figure 2, is a positive and welcome development, but it does little to reduce the prolonged economic divergence of the Eurozone economies.FIG1 Cooley
Some of those scars manifest themselves through the high percentage of Non-Performing Loans (NPLs) that Italian banks carry on their balance sheets. The figure stands at 14.8% of total loans in Italy, the third highest percentage in Europe after Greece and Portugal, whereas in Spain 5.5% of total loans are deemed non-performing.
Percent of Non-Performing Loans
High percentages of NPLs imply that a significant part of the banks’ capital is not deployed in productive activities, reducing the banks’ profitability and its ability to extend credit to the healthy part of the economy. The resulting credit contraction weighs on the ability of the country to generate growth, especially given the heavy reliance of most European countries on bank credit to finance economic activity.
The comparison between the Spanish and Italian cases reveal that the banks’ “pre-existing conditions” have a lot to do with the viability of the bail-in mechanism that has been the cornerstone of the European resolution plan. Therefore, one of the challenges for the application of this resolution plan is that these “pre-existing conditions” have not been dealt with prior to the creation of the European Banking Union. The stark differences in NPL levels across countries and their implications for economic growth in those countries seem to also impede the uniform application of the European banking regulations.
What are the Implications for the Credibility of the European Banking Union?
Italy’s bailout of its ailing banks dealt a blow on the credibility of the newly enacted banking regulations. Furthermore, the reasons behind this deviation from the rules in place suggest that the government-orchestrated rescue of Italian banks is unlikely to remain an isolated case.
In countries with high percentages of NPLs – countries that have severely hampered banking sectors – resolution with bail-in debt is difficult to implement. What worked in Spain has little chance of working in Italy, Greece or Portugal. The Italian experience also underscores that there will always be times when governments find it more prudent to intervene.
Banks in the countries with high percentages of NPLs need to write off their bad loans and be recapitalized. But when banks are so severely impaired, raising capital is not an option for them. In those cases, it may be appropriate for the state government to step in and inject capital, or orchestrate a restructuring that will minimize the collateral damage.
The Eurozone countries have many idiosyncrasies in their banking sectors and the issues that need to be dealt with are different across borders. Even in the case of NPLs, the sector concentration of the NPLs, the value of the collateral held against them (coverage ratio) and the forbearance of the loans can vary significantly from country to country. But until these legacy issues are fully addressed, the new European banking regulations have little chance of being uniformly applied across the region, and are unlikely to be viewed as truly binding.
The recent test of the European resolution regime is likely not the last time it will be found wanting. The heavy reliance of European banks on contingent convertible securities as part their capital reserves and their continued undercapitalization relative to their U.S. and U.K. counterparts are likely to complicate future bank resolutions. Try to imagine using the bail-in mechanism for a truly systemic bank like Deutsche Bank!
It would be nice to think that convergence of economic growth across the member-states would dispel some of this problem of the Euro area. But weak banks with poor quality legacy assets hold back growth and make deposit insurance infeasible. Until that changes Banking Union will remain an elusive concept.
 Source: European Banking Authority Risk Dashboard.