The end is nigh for Italy’s most troubled bank. Trading in the shares of Monte Dei Paschi Di Siena (MPS) was suspended on Friday when the share price tumbled on news that the ECB had refused to give the bank an additional five weeks to raise 5bn euros in new capital. Government bailout is almost certain now.
MPS, the oldest bank in Europe, has been in trouble for years. It has twice been bailed out by the Italian government. Its balance sheet is stuffed with toxic assets: non-performing exposures make up 38% of its assets, of which the largest proportion are the deeply distressed sofferenze (bad debts). MPS’s results for the third quarter of 2016 show a loss of 1.15bn euros, caused entirely by increased loan loss provisions. Even more worryingly, the results also show that lending and deposit-taking activity is falling, as confidence in the bank is eroded. This is a bank in terminal decline. Unless its balance sheet can be repaired, it will eventually die.
The bank issued a repair plan in July 2016 in response to anticipated disaster in the ECB’s stress tests. The plan aimed to create a “de-risked and well-capitalized” bank which would fully meet the ECB’s asset quality targets. The original version had three key elements:
- increasing the coverage ratio for bad debts to 67% and for “unlikely to pay” and other non-performing exposures to 40%
- removing 27.7bn euros of distressed loans from MPS’s balance sheet by transferring them to a securitization vehicle at 33% of balance sheet value
- raising up to 5bn euros of new Core Tier 1 equity by means of a rights issue underwritten by an unspecified consortium of international banks.
The capital raising element was essential, since increasing the coverage ratios and writing down non-performing loans by two-thirds prior to securitization would knock a very large hole in the bank’s capital.
But there was a problem. MPS had already tapped its investors for 8bn euros in the last two years, most of which had vanished into the black hole of loan loss provisions. And 5bn euros was over five times its market capitalization. The risk for investors was clearly huge. There was a serious risk that the rights issue would flop.
So, in September 2016, MPS added another element to the plan – a debt for equity swap. The securitization of the non-performing loan portfolio would be part-funded by converting subordinated debt to equity, thus significantly reducing the size of the rights issue that would be needed to recapitalize the bank. The swap was launched in November.
But there was a problem. 1bn euros worth of subordinated notes issued in 2008 could not be included in the swap. Nonetheless, the bank managed to raise more than a billion euros from the swap, reducing the amount of new equity needed by about a fifth.
It wasn’t enough, of course. Contributions from “anchor” investors would be needed to reduce the rights issue to something more credible. But management were hopeful that the Qataris might bite. After all, they like a flutter on dodgy banks, don’t they?
Then came the referendum. On December 5th, 2016, the Italian population rejected wide-ranging constitutional reforms proposed by the country’s youthful prime minister, Matteo Renzi. He resigned, plunging the country into political crisis and increasing the possibility of an anti-EU party gaining power. The increased political risk has gutted MPS’s chances of raising substantial capital either from “anchor” investors or by means of a rights issue by the end of the year, as the ECB had demanded. So when the ECB refused to extend the deadline, the capital plan died – and with it, MPS.
Unless, that is, government bails it out. But there is a problem. The bailout rules in the European Bank Resolution & Recovery Directive require creditors to take losses. Specifically, at least 8% of total liabilities (including own funds) must be bailed in before taxpayer money is used. And subordinated debt must be bailed in before senior debt (bonds and deposits) can be touched. So the subordinated debt holders that did not participate in the debt for equity swap will be wiped.
The trouble is that lots of them are retail investors – ordinary people, many of them elderly, who were persuaded to buy subordinated bonds as a higher-yielding alternative to bank savings accounts. Many of them will not have understood the risks. These instruments should never have been sold to ordinary bank customers. As Silvia Merler of Bruegel says, they were mis-sold.
In today’s febrile political climate, stripping pensioners of their savings is politically toxic. The last time Italy bailed in retail investors in the course of a bank resolution, one pensioner committed suicide after losing his entire savings. There was a general outcry. So, the government is desperately looking for a solution for MPS that gives some protection to its retail investors.
But it does not seem likely that one will be forthcoming. As this is the first major test of the EBRRD since the introduction of the bail-in tools in January 2016, EU authorities will not want it to be watered down. And the fact that Italy has previously bailed in retail investors sets an uncomfortable precedent. If MPS retail investors were spared bail-in, surely those who lost their savings last year would deserve compensation? Though nothing, of course, would bring back the man who died.
No, if the EBBRD is to be at all credible, those retail investors must be bailed in. But the fact that they should never have been sold the bonds at all should also be recognized. They deserve compensation for their losses, not because the EBRRD is not fit for purpose but because the bonds were mis-sold. And banking regulation needs to be strengthened throughout Europe to outlaw the mis-selling of risky investments to ordinary people looking for higher yields on retirement savings. Italy is by no means the only country where people have been ripped off. As Mark Taber reminds us, the similarities with the UK’s Co-Op Bank are remarkable.
The future of MPS is highly uncertain. But it is unlikely to disappear. For many reasons, not least its symbolic importance as Europe’s oldest bank, its future is more likely to be nationalization than failure.
Zombie banks like MPS drag down the economy. They should either be repaired promptly or killed. MPS has been allowed to cling on for far too long. So although there will no doubt be recriminations over the ECB’s decision to pull the plug, ending this agony now is the right thing to do.
This post has been amended to clarify the EBRRD bail-in rules and add a link providing further information.
