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The bail out of two Italian lenders highlights that progress towards banking and fiscal union will be far from straightforward, argues Oliver Judd*.
The Italian government on June 25 wound down two stricken lenders, with some of their assets and liabilities sold to Italy’s largest bank for a nominal amount. In doing so, Rome committed to using around €17.0 billion (US$20.0 billion**) of taxpayers’ money to take on the two banks’ bad loans – shielding not only depositors, but senior bondholders too, from losses.
Although Italy secured the European Commission’s approval, it is hard to avoid concluding the Single Resolution Board (SRB) – the EU agency responsible for dealing with bank crises – flunked arguably its first big test. After all, the winding up of the two Italian banks flies in the face of EU law, as established with the Bank Recovery & Resolution Directive (BRRD).
It charges the SRB with ensuring “an orderly resolution of failing banks with minimum impact on the real economy, the financial system, and the public finances of the participating member states.” In other words, one of the main aims of the BRRD was to transfer the cost of bailing out a bank from taxpayers to shareholders and creditors.
The Italian government found a loophole – a public interest clause – which allowed it, with the permission of the EU Commission, to avoid wiping out senior bondholders. Rome argued the banks’ failure would have wrecked the economy in their region and potentially beyond. Perhaps predictably, the decision sparked anger among German politicians, who claimed the liberal interpretation of the rules aimed at making sure taxpayer money is not used to deal with banking crises had destroyed the credibility of the bloc's banking union.
However, it is unclear Italy had a viable alternative course of action. We are inclined to agree with Fabio Panetta, the vice director-general of the Bank of Italy, who defended the way the banks had been dealt with, saying it was the only option to avoid a shock to the country’s financial system. The idea that Italy’s banking system, which according to some estimates is still weighed down by around €325 billion (US$383 billion) of bad loans1, was going to be able to clean itself up without public intervention was unrealistic. It is unclear how a crippled Italian banking system would be in anyone’s interests, including Germany. Besides, it would have been dangerous to do anything to threaten Italy’s nascent economic recovery, which remains fragile.
It is true the situation in Italy was in marked contrast to what happened in Spain earlier in the month, when one failing lender was bought by larger peer, protecting Spanish taxpayers. However, in that instance the larger bank was a willing buyer, whereas in the case of the failing Italian lenders the purchasing bank was not. Allowing the two Italian banks to collapse, separating the good assets from the bad and ensuring that senior bondholders – many of whom were retail investors – were protected, all seem like sensible steps to have taken, even if it did mean EU rules were flouted. If government intervention is needed to clean up the system and give up the good assets back to the private sector, this would seem to be a price worth paying.
As for the argument put forward by several German politicians that senior bondholders should have been forced to accept losses, it is difficult to see the logic here either. In Italy, much of this debt is held by retail investors. Although one can argue retail investors should never have been allowed to buy these bonds in the first place, the fact is they were.
Implications for bond investors
In terms of what this means for bond investors, despite the differing approaches taken by authorities in Italy and Spain, the result was effectively the same: subordinated bondholders bore losses but senior creditors were unaffected. This was a surprise as it went against the letter of the new law, which suggests all bondholders – regardless of ranking – could be affected.
It highlights an unwillingness on the part of authorities to take the most draconian action on a section of investors banks will continue to need to access to finance loan growth. This was positive for senior unsecured bank debt across the sector.
However, we are concerned that in many cases prices have risen too far and no longer reflect underlying fundamentals. We continue to favor bonds issued by “national champion” financial institutions in Italy and Spain. These banks look to be winners out of the consolidation process, with cleaned up assets transferring at nominal value to the advantage of the acquiring banks, especially in improving domestic markets.
By contrast, senior debt issued by lenders in weaker financial positions, especially Italian ones, now looks overvalued. With its banks still holding so many non-performing loans on their books, it is highly unlikely Italy will be able to clean up its banking system as quickly as some seem to be anticipating. In the meantime, prices look vulnerable to a correction as and when investors once again focus on fundamental factors – such as the strength of the capital base, the quality of the loan book, the access to diversified funding sources and the ability to generate consistent earnings.
As for less-highly-rated debt, it is hard to see why it has rallied too. Events in both Italy and Spain confirmed that holders of junior debt are likely to be wiped out in the event a bank fails, and hopes that these deals signal Europe is on the verge of cleaning up its banking system appear extremely optimistic.
Investors may be jumping the gun
Optimism over the prospects for closer European integration is riding high following this year’s political developments, most notably the election of the staunchly pro-European Emmanuel Macron as French president. However, investors may be in danger of jumping the gun.
While it is hard to see a better solution to the Italian situation, recent events have served to underline just how much more needs to be done to recapitalize the banking system in Europe in general, and Italy in particular. There is an urgent need for a way to be found to remove more of this toxic debt from banks’ balance sheets.
In truth, creating a fully functioning banking union along the lines envisioned by Brussels was never likely to be straightforward. But until Germany and others can be assured banking systems across Europe have been cleaned up to their satisfaction, they seem likely to resist efforts to move to a full banking, and hence fiscal, union.
All of this is not to deny there have been encouraging noises emanating from Berlin with regards to the prospects for closer integration of fiscal policy across Europe. For instance, Wolfgang Schäuble, the normally hardline German finance minister, recently told German news magazine Der Spiegel there was a need for transfers between wealthier and poorer EU states, arguing that “a community cannot exist if the stronger do not take responsibility for the weaker.”2 But as ever with Europe, it is important to recognize that progress toward closer integration still faces multiple obstacles and will not move in a straight line.
* Investment professionals are members of AIA/AIC's Participating Affiliate, Aviva Investors Global Services Limited ("AIGSL").
** Based on currency exchange rates as of August 14, 2017.
1 Euromoney, as of end of March 2017
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