Italian bank bail outs have muddied the waters for investors

Major inconsistencies with the recent Spanish bank rescue leaves investors none the wiser over what to expect next time around

As published in Financial News

Corks were still popping in the corridors of the European Central Bank to celebrate a seamless resolution to Spain’s Banco Popular when, a week later, the Italians went and made a rather different splash. If the resolution and sale of Popular seemed to conform to most of the much-heralded Bank Recovery and Resolution Directive principles, the ‘resolution’ of Veneto Banca and Banca Popolare di Vicenza looked like a step back to the old days.

The way in which the Italian banks were wound up offers a contrasting and cautionary note to investors looking for consistency and predictability in the application of the new bail-in rules. Popular was a bail-in, but Popolare and Veneto looked like a classic bail-out using over €17bn of public funds.

The BRRD was supposed to save the taxpayer from the future bail-out of failing banks, and thereby also sever the systemic link to the sovereign. In some cases, notably Ireland, that link threatened economic mayhem at a national level when banking bad debts outstripped the national ability to cover the losses. The BRRD’s stance to force shareholders along with wholesale lenders to banks to absorb the costs of future salvage operations through ‘bail-ins’ was widely viewed as sensible and workable.

It was always going to be a challenge to transition away from the bail-out tradition, which had largely left wholesale senior unsecured lenders untouched, including in most cases the holders of explicitly subordinated notes (Lower Tier 2 debt). Yet the recent surgical strike on Spain’s Banco Popular seemed to demonstrate that the ECB and the Single Resolution Board were able and willing to implement the much discussed, but hitherto never used BRRD. The shareholders along with all holders of subordinated forms of debt were wiped out to make good a capital shortfall. The Spanish lender was then sold for a nominal euro to Banco Santander.

The actions in Spain may have upset some creditors, notably the holders of the subordinated Lower Tier 2 notes. The latter found themselves treated as harshly as the far higher yielding and deeply subordinated Contingent Convertible notes. Nevertheless, the consensus was that the intervention worked and was broadly consistent with the aims and mechanisms of the BRRD. Questions remained over the quantum of the write-down, its calculation and timing, but the bank was sold without taxpayers being exposed.

However, just when the markets were digesting the pain in Spain, the Italian intervention has muddied the waters. In the case of the failed Italian lenders, taxpayers’ money was back on the table as the regulators in Italy intervened by liquidating the troubled banks (as opposed to resolving them), having seemingly failed to identify any other solutions after the European authorities denied the country the ability to keep them going by injecting its own funds. The two banks’ good assets were sold to national champion Banca Intesa and a bad bank will absorb the non-performing problems credits.

Markets should not really be surprised at the apparent inconsistency of the Italian actions. For one thing, they had been widely anticipated. Bondholders and other creditors had been watching the slow-motion car crash of Monte dei Paschi for some time and it was no secret that the Vicenza and Veneto regional banks needed some serious help. Italy continues to suffer from significant legacy bad debts. Holders of senior and subordinated notes issued during the earlier bail-out era argued that these legacy issues should first be dealt with before a fully functioning bail-in should be implemented.

The Italians authorities were, moreover, highly sensitive also to the awkward fact that a lot of senior unsecured bonds are held by retail investors, making a bail-in of these notes very difficult politically. Therefore, although the shareholders and any subordinated note holders may have lost out, the senior notes were left intact with state money making up the substantial difference between the total write-down and the capital available.

Some will note that senior noteholders were not involved in the Popular case either and may well conclude that these cases set a precedent that senior unsecured notes issued prior to the BRRD will not be touched. While this might be a logical assumption it would be foolish to draw too many firm conclusions from these actions. Neither should too much be read into the ECB and SRB suggestions that the Italian actions are entirely consistent with the BRRD. The two banks were hardly bailed out because they were globally systemic.

Perhaps the most it teaches us is that local regional political considerations will continue to colour the way the rules are applied, particularly during this transitional phase as we move from bail-outs to bail-ins. Clearly bail-ins will only work once the quantum of capital available across the industry reaches a level commensurate with the potential for loss. And this assumes that losses are measurable and predictable.

In the meantime, some investors will be ringing their lawyers. The Spanish may feel annoyed that the Italians got away with using seemingly legacy policies and the Germans will fume that rules appear to have been bent. Sometimes pragmatism is necessary, but it leaves investors none the wiser over what might happen the next time a bank wobbles.

Tim Skeet is a career banker and consultant to the financial services sector