When prospects dimmed for private funds to advert a collapse of the bank Monte dei Paschi (MPS), the Italian government stepped in before Christmas with a bailout to protect depositors’ savings and inject new capital so that the world’s oldest bank, and the country’s third largest, could survive.
The new Italian government agreed to provide $6.99 billion (€6.6 billion), while institutional investors are taking a $2.33-billion (€2.2 billion) “haircut” (meaning the value of holdings was cut by a straight percentage across the board). (MPS stock trading has been suspended since December 21, when the bank warned its excess liquidity may run out in four rather than 11 months.)
The rescue amount as determined by the European Central Bank, $9.32 billion (€8.8 billion), was surprisingly higher than forecast the week before when Rome first announced a $21.19-billion (€20 billion) fund to help Italy’s struggling banks. The deeper hole, the ECB explained, resulted from a “rapid deterioration” between November 30 and December 21, with the bank’s one-month liquidity falling from $12.82 billion (€12.1 billion), or 7.6% of its total activities, to $8.16 billion (€7.7 billion). Further, MPS lost $21.19 billion (€20 billion) in deposits in the first nine months last year and $2.12 billion (€2 billion) since early December. Still, the ECB’s explanation created more mystery than clarification, as noted by Silvia Merler, a researcher at the European think tank Bruegel.
Rome is structuring its support to MPS as “precautionary recapitalization” to avoid certain provisions in new regulations that would otherwise require investors in the bank and account-holders to take a bigger hit under the “bail in” requirements of the EU Bank Recovery and Resolution Directive (BRRD).
This directive established a common framework across all 28 countries in the EU on how to resolve troubled banks. “The directive introduces bail-in measures whereby investors and certain creditors of failing institutions are ‘bailed in’ (i.e., the liabilities of the institution are written down or converted to equity) before there can be any resort to public funds,” explains the Jones Day law firm in its analysis. Shareholders and creditors must absorb at least eight percent of the bank’s liabilities through a “bail in” before resolution authorities can access other funds, including public funds. “Equity and subordinated debt holders must be bailed-in first,” as the law firm White Case explains. “Senior creditors and non-covered depositors must participate in the burden sharing if this is required to reach the 8 per cent threshold. Only depositors with deposits of up to €100,000 that are covered by [the] mandatory Deposit Guarantee Schemes (DGS) are automatically exempted.” These provisions were engineered by Brussels in response to Europeans’ outrage that they were paying taxes to save profligate banks that lent money recklessly. Hence, the directive shifts liability away from the public to a troubled bank’s stock and bond investors and account-holders.
By invoking the “precautionary recapitalization” provision, Italy’s public funds can bail out MPS without implementing the tougher “bail in” provisions outlined above if certain conditions are met. However, “precautionary public sector recapitalisation is not permitted for banks that are insolvent or considered likely to fail in the near future under the 'point of non-viability test' in the BRRD. The article also permits public sector guarantees to be given in respect of access to central bank liquidity.” The supervisor, the ECB, must determine that the bank is solvent and calculate the capital shortfall under an
adverse stress-test scenario. The ECB completed those steps for MPS, so Rome must now seek approval from Brussels. The European Commission said it would work with Italy and the ECB to “assess the compatibility of the planned intervention by the Italian authorities with EU rules.” Its decision will likely serve as a template for how other failing banks within EU countries will be rescued.
Analysts and politicians are debating whether MPS qualifies for this exemption. Jens Weidman, head of Germany’s Bundesbank, is one such person. In an interview with the newspaper Bild, he posed two questions: Was the bailout necessary to remedy a “serious disturbance?” Would government funds cover losses? “If the Italian government wants to do that,” he argued in calling for careful scrutiny of the bailout, “it needs to prove that Monte dei Paschi is only temporarily in trouble and is in principle a healthy bank. Also, state money must not be used to cover any projected losses. Should any state money be used to rescue the bank, it should not be paid on the basis of fresh borrowing in face of the already high debt burden in the country.” His concerns are politically sensitive for Rome since they suggest that the 40,000 small investors holding MPS bonds must contribute financially to the rescue under the BRRD, against the promises of the Italian Economics Minister Pier Carlo Padoan that these investors would be protected fully. Yet, the BRRD never defined what either "serious disturbance" or "likely losses in the near future" is.
Meanwhile, the European Commission delayed the sale of three ailing regional banks in Italy to the country’s fifth largest (in terms of branches) bank, UBI Banca, Reuters reported. The sale of Banca Etruria, Banca Marche and CariChieti – all of which were bailed out in 2015 – was to have been finalized by year-end 2016, but Brussels wants to make sure, according to Reuters, that other bidders were not unfairly rejected before signing off on the deal. More of these deals are likely since Italy’s banking needs wholesale restructuring, from reducing the excessively high number of branches to gaining efficiencies through economies of scale. “Effective consolidation is the key to tackle some structural weaknesses of Italian banks,” S&P said. “Consolidation could help correct overcapacity, improve business models and create larger groups with stronger networks.”
The largest burden to Italy’s banks is the mound of non-performing loans from failed business ventures and real estate investors, amounting to $380.91 billion (€360 billion), of which 55.5 percent are the worst kind, sofferenze, or defaulted loans, according to the Bank of Italy. This burden far exceeds the $237.99 billion (€225 billion) in Italian banks’ equity.
CHART: GROSS NPE AND BAD LOANS TREND IN ITALY, 2008 – FIRST HALF 2016
CHART: NET BAD LOANS TREND IN ITALY, 2008 – FIRST HALF 2016
SOURCE: PwC, The Italian NPL market: Positive Vibes. December 2016. http://www.pwc.com/it/it/publications/assets/docs/npl-market-1612.pdf .
The consequence for Italian banks is that their costs of raising capital are far higher than those banks with low levels of bad loans and high levels of capital to weather economic difficulties. This is demonstrated, for example, by spreads in credit default swaps, essewntially an insurance that lenders buy to cover loan losses. The riskier the lender’s loan portfolio, the wider the spread between its costs for CDSs and those of a more sound bank. The gap between Italy CDSs and Nordic banks, for example, is three to five times wider.
CHART: COMPARISON BETWEEN CDS COSTS FOR ITALIAN AND NORDIC BANKS
SOURCE: Jim Edwards, “Italy's banks might need a €52 billion bailout.” November 29, 2016. http://www.businessinsider.com/statistics-non-performing-loans-npls-italy-banking-system-2016-11?r=UK&IR=T .
The challenging outlook for banks reflects Italy’s economic malaise. The country’s GDP has shrunk roughly nine percent in real terms since 2003. Negative interest rates, a consequence of the ECB’s quantitative easing initiatives, have narrowed, if not eliminated, the amount of profit banks can earn from lending activities. Borrowing costs for Italian banks are high, and may climb even higher if one authoritative rating agency (the ECB relies on this and three other agencies to gauge a country’s creditworthiness), DBRS, lowers ratings on Italy’s sovereign debt.
Despite these difficulties, Italian banks plan to off-load a large percentage of their NPLs this year. “Italian banks are expected to dominate the market, accounting for 80 percent, or $40 billion in issuance,” forecasts Standard and Poor’s Global. As Bloomberg columnist Marcus Ashworth explains, “post-crisis the preferred route to resolve failing banks without using state funds has been for banks to issue CoCos. These help firms meet ECB capital requirements for total loss-absorbing capacity, and they're designed to ensure orderly recapitalization by converting to equity when the core equity tier 1 (CET1) ratio of an issuing bank falls below a pre-determined threshold. This is regulators' much-beloved ‘bail-in’ process at work.”
“Comunicato stampa del Consiglio dei Ministri n. 5.” December 23, 2016. http://www.governo.it/articolo/comunicato-stampa-del-consiglio-dei-ministri-n-5/6410 .
Translation below by google:
Interventions to ensure liquidity
First, the Government will strengthen the ability of a bank to procure liquidity. The Treasury may grant to banks that they ask for a guarantee of new bonds to be issued, upon payment of a fee. Thanks to the public guarantee, bonds issued by banks will present to the subscriber the degree of risk of the State and not that of the issuing bank. In this way, banks will have access to the market even if subjected to tensions and finding the financial resources they needed on similar terms to those of the Italian State. Access to liquidity could also be assured by another type of state guarantee on emergency loans that the Bank of Italy erogasse to meet liquidity crisis of a bank (so-called ELA - Emergency Liquidity Assistance). The conditions for granting of guarantees have been agreed on with the European Commission.
For both forms of collateral it is required that the bank falls within the prescribed capital requirements and has shown no capital shortfall under a stress test. Where these conditions are not complied with, the guarantee may be issued prior positive decision by the European Commission on the compatibility with the legal framework on state aid.
Interventions in enhancing the legacy
The second dimension of intervention for the protection of savings concerning the capital. Banks that only the adverse scenario of a stress test submit a capital shortfall may request a precautionary recapitalization by the state. Of benefiting the public the bank will be required to prepare a capital strengthening program for approval by the European Central Bank. The recapitalization of a precautionary measure to carry forward the project of restructuring and securing the bank that requires it.
In accordance with the European regulatory framework on crisis management and state aid, the intervention of a precautionary recapitalization does not in this case the start of a dispute resolution process, or the application of the provisions on the so-called bail-in (ie rebuilding stocks through the elimination of certain categories of specific credits). Public action involves the conversion of subordinated bonds in the bank's shares.
The conditions of the conversion of subordinated bonds are determined by the Minister of Economy and Finance, on a proposal from the Bank of Italy, to be published in the Official Journal. In the case of Banca Monte dei Paschi di Siena conditions are determined in the decree:
- The conversion of Tier 1 bonds - underwritten mostly by institutional clients - will occur at a value corresponding to 75 percent of the nominal value;
- The conversion of Tier 2 bonds - underwritten mostly by retail customers - will occur at a value corresponding to 100 percent of the nominal value.
The investor protection scheme
The decree provides for the possibility that the bank concerned as a precautionary recapitalization by the State, which involves the conversion of subordinated bonds into shares, offer unsubordinated bonds in exchange for the result of the conversion shares. The Treasury may purchase such shares.
At the end of the clearing process geared to protect savers, those who initially hold subordinated bonds would thus have no subordinated bonds.
The compensation scheme at a glance:
1. The bank offers to exchange shares of the conversion result of subordinated bonds with newly issued subordinated bonds not.
2. The Treasury buys shares traded with non-subordinated bonds newly issued.
The repurchase of shares of the conversion result from subordinated bonds is intended to prevent legal disputes related to the commercialization of the bonds.
The fund for interventions
The decree provides for the creation of a fund with a budget of 20 billion euro, to which the Government may draw upon for individual interventions on capital and liquidity.
Chiara Albanese and Dale Crofts, “ECB Says Paschi Needs $9.2 Billion, More Than Bank’s Plan.” Bloomberg, December 27, 2015. https://www.bloomberg.com/news/articles/2016-12-27/monte-paschi-says-ecb-sees-the-need-for-9-2-billion-of-capital .
Silvia Merler, “The strange case of the MPS capital shortfall.” Bruegel. http://bruegel.org/2016/12/the-strange-case-of-the-mps-capital-shortfall/ . “So this leaves us with a puzzle. This change in the capital requirement may be the result of a meaningful change to the applicable stress test scenario – which may preclude the option of precautionary recap. Or, it may be the result of a model adjustment – in which case precautionary recap is still an option but the problem could go past MPS and require a re-assessment of the whole system. Both these alternatives have potentially serious consequences, for MPS and potentially the other Italian banks.
“The ECB needs to disclose what the justification for this is, and it needs to do it as soon as possible. Transparency and reliability of supervisory actions are crucial elements to the effective functioning of the EU common supervision framework and to finally give certainty to investor as to how banking sector problems should be dealt with. This kind of volatile decision-making certainly go in a different direction.”
Directive 2014/59/EU of the European Parliament and of the Council of 15 May 2014 establishing a framework for the recovery and resolution of credit institutions and investment firms. http://eur-lex.europa.eu/legal-content/EN/TXT/?uri=celex:32014L0059 . European Commission, “EU Bank Recovery and Resolution Directive (BRRD): Frequently Asked Questions.” April 15, 2014. http://europa.eu/rapid/press-release_MEMO-14-297_en.htm .
Jones Day, “Bank Recovery and Resolution Directive Contractual Bail-In.” White Paper, March 2016. http://www.jonesday.com/files/Uploads/Documents/Bank%20Recovery%20and%20Resolution%20Directive.pdf .
Andreas Wieland, Christoph Arhold, Kai Struckmann, and Michael Immordino, “The new bank resolution scheme: The end of bail-out?” White Case, September 29, 2016.
http://www.whitecase.com/publications/insight/new-bank-resolution-scheme-end-bail-out?s=monte dei paschi .
See: Alexander Schäfer, Isabel Schnabel, and Beatrice Weder di Maur. “Bail-in expectations for European banks: Actions speak louder than words.” European Systemic Risk Board, Working Paper Series No 7. April 2016. https://www.esrb.europa.eu/pub/pdf/wp/esrbwp7.en.pdf . “… [A]ctual bail-ins lead to stronger market reactions than the legal implementation of bank resolution regimes, supporting the saying that actions speak louder than words.”
White Case; Jones Day.
White Case; Jones Day.
Boris Groendahl, “ECB’s Monte Paschi Capital Bar Would Trip Up 10 Other EU Banks.” Bloomberg, December 30, 2016. https://www.bloomberg.com/news/articles/2016-12-30/ecb-s-monte-paschi-capital-bar-would-trip-up-10-other-eu-banks .
“Bundesbank chief wary of Monte dei Paschi rescue plan.” Deutsche Welle, December 27, 2016.
Andrea Mandala, “Sale of small Italian banks to UBI delayed at Commission’s request: source,” Reuters, January 2, 2017. http://www.reuters.com/article/us-eurozone-banks-italy-ubi-idUSKBN14M11O .
Marco Ferrando, “The three unknowns facing Italian banks in 2017.” Il Sole 24 Ore, December 30, 2016. http://www.italy24.ilsole24ore.com/print/ADET4PMC/0?refresh_ce=1 .
See: Isabella Bufacchi, “Italy’s NPL burden must be lifted somehow, no matter how you define the “sofferenze.” Il Sole 24 Ore, January 26, 2016. http://www.italy24.ilsole24ore.com/art/markets/2016-01-25/analisi-npl--180126.php?uuid=ACwKS1GC . “The NPEs are made of: 1) bad loans or bad debts (Italian ‘sofferenze’) which are the defaulted loans; 2) unlikely to pay in full and in a timely manner (Italian ‘incagli’); 3) past-due of more than 90 days (Italian ‘scaduti o sconfinanti’); 4) restructured loans (Italian ‘ristrutturati’).”
Financial Times opinion, “Italy’s banking system needs intensive care.” Financial Times, November 24, 2016. www.ft.com . Also, see: Andreas Jobst and Anke Weber, “Profitability and Balance Sheet Repair of Italian Banks.” International Monetary Fund, August 19, 2016. http://www.imf.org/external/pubs/cat/longres.aspx?sk=44195.0 . “Many banks should become more profitable as the economy recovers, but their capacity to lend depends on the size of their capital buffers. However, a number of smaller banks face profitability pressures, even under favorable assumptions. There is thus a need to push ahead decisively on cleaning up balance sheets, including through cost cutting and efficiency gains.”
Mehreen Khan, “Ratings: The other cloud hanging over Italian banks.” Financial Times, January 5, 2017. www.ft.com . See: www.dbrs.com .
Joe Rennison, “Issuance of non-performing debt securities set to jump in 2017.” Financial Times, January 5, 2017. www.ft.com .
Marcus Ashworth, “Lovin' That Italian Bank Risk.” Bloomberg, January 5, 2017.
https://www.bloomberg.com/gadfly/articles/2017-01-05/risky-italian-bank-bonds-wannabe-the-new-thing-for-2017 . He refers to CoCo bonds. “Contingent convertibles, also known as CoCo bonds, Cocos or contingent convertible notes, are slightly different to regular convertible bonds in that the likelihood of the bonds converting to equity is ‘contingent’ on a specified event, such as the stock price of the company exceeding a particular level for a certain period of time.
“They carry a distinct accounting advantage as unlike other kinds of convertible bonds, they do not have to be included in a company's diluted earnings per share until the bonds are eligible for conversion.
“It is also a form of capital that regulators hope could help buttress a bank’s finances in times of stress.” Source: Financial Times lexicon. http://lexicon.ft.com/Term?term=cocos .