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Italy’s banking problems: A useful guide to the implications of “bail-in”
by Daniel Munevar , Chiara Filoni
24 July 2016

Obscured since the beginning of the crisis by more dramatic developments by banks elsewhere in Europe and the US, Italian banks have long dragged issues of low profitability and near insolvency.

Now, after the surprising results of the Brexit vote, they have been identified as the trigger of the next existential crisis of the Euro zone. In the hope that the problem would take care of itself once an economic recovery took place, the government stalled the adoption of any significant measures. Such recovery never took place, and now the Italian authorities are desperately attempting to find a quick solution that allows them to simultaneously rescue the banks, protect small retail clients and fulfill EU regulations. This struggle provides a fundamental insight into another aspect of the sprawling set of conflicts between EU regulation and policies with national interests and citizen concerns. As such, it’s important to understand the origins of the problem as well as the implications of the different policies being proposed to deal with it.

The fragile situation of Italian banks can be understood in the context of years of economic stagnation following the crisis of 2008. After a deep contraction the Italian economy has been unable to recover. In a context where austerity is the order of the day, it is expected that Italy will only be able to return to its pre-crisis GDP level by 2025. Based on this trend, the IMF pointed out recently that the country is likely to experience nearly 2 lost decades. [1] This pattern of low economic growth feed into the problems of banks through two main channels. First, it reduces the incentives for investment, as firms are unable to find demand for their products. As a consequence, there is little demand for credit from banks. Second, low levels of investment and growth translate into problems of low profitability. This leaves Italian firms with a small margin of maneuver to avoid falling behind their loan payments, or even bankruptcy, in the event of an economic downturn. Taken together, these dynamics are responsible for the vicious circle in which the Italian economy has found itself where credit stagnates, incomes and employment remained depressed while bad loans keep growing.

In the current context, the main concern regarding the health of Italian banks is centered around this last issue, the bad loans sitting on their balance sheets. The so-called Non Performing Loans (NPLs) have experienced a dramatic increase over the last couple years. Since 2011, it is estimated that NPLs on the balance sheet of Italian banks have increased by 85%. [2] The total stock of loans where borrowers have experienced some degree of difficulties with their payments amounts to €360 billion. [3] Out of these, it is estimated that around €210 billion correspond to bad loans, that is borrowers that are actually insolvent and therefore unlikely to pay back any meaningful amount. [4] Most of these bad loans were taken by companies, representing nearly 80% of the total, with households accounting for the remaining share. Even though Italian banks have raised provisions against these bad loans, the scale of the problem has rendered these efforts meaningless. In the case of the bad loans, even after setting aside €123 billion to offset the impact of writing down those loans, Italian banks are left with €87 billion of potential losses. [5]

An interesting example of this pattern is Monte dei Paschi di Siena (MPS), the oldest bank in the country, as well as its 3rd largest (by number of branches). The bank has earned a dubious reputation for its unscrupulous purchases and ensuing operations to cover its losses. This institution has been already bailed-out back in 2012 with the so-called Monti Bonds. The loan to the bank amounted to €3,9 billion, which were financed through a tax on primary residences of Italian taxpayers at that time. After receiving the bail out, MPS registered losses for €2 billion in 2012 and €4,7 billion in 2013 due mostly for its operations on derivatives. Acting like nothing happened, MPS continued following this pattern despite a changing in management in 2013.

After years of mounting losses and a steady increase on the bad loans on its balance sheet, the ECB recently asked MPS to sell 20% of the bank’s non performing loans (for a total amount of €9,7 billion) by 2018. [6] The lack of interest by investors on either bank shares or its portfolio of loans have sparked uncertainty regarding the capacity of MPS to remain solvent. Trying to raise capital or performing a fire sale of its loans would only increase its problems. As the ECB is expected to publish the finding of its latest round of stress tests by July 29th, pressure has increased to find a solution by this date as most analyst expect the bank to register a capital shortfall between €2 to €6 billion. An option being currently discussed is to use the private fund “Atlante”(more information below). The fund has at its disposal €1,7 billion to invest in order to close the capital gap of the bank. However, its seems unlikely that this would be enough to cover the capital needs of MPS and its possible that the bank might have to rely on State Aid in order to avoid imposing losses on the retail clients holding shares and subordinated bonds.

In this regard, the recent debate has centered precisely on how to avoid imposing loses on those clients as part of a bail in. [7] Once losses on the overall portfolio of NPLs materialize, Italian banks could be facing in a worse case scenario a gross capital gap of €38 billion. [8] If the country were to follow the rules of the Bank Recovery and Resolution Directive (BRRD), the recently enacted European mechanism to deal with insolvent banks, this would entail the bail in of 8% of liabilities, including shareholders, subordinated and senior creditors, before any public resources could be used to support the recapitalization of troubled banks. In the Italian case, the problem with this approach has to do with the large exposure of households to the instruments that would be subject to a bail in. This is a result of the regular practice of Italian banks of selling their own bonds and shares to their retail costumers as a safe investment instrument (until recently with tax incentives). [9] Thus, households hold about half of the subordinated bonds of banks (€31 billion) and a third of the senior bonds (€200 billion). An exercise done by the IMF for the 15 largest Italian banks shows that the 8 percent bail in requirement would require wiping out in all cases the subordinated retail bonds. Furthermore, in two thirds of the cases, it would also imply the bail in of some senior bondholders. [10]

For example, in the recent bail-in of a series of regional banks in central Italy (Banca delle Marche, Banca Popolare dell’Etruria e del Lazio, la Cassa di Chieti and Cassa di Risparmio di Ferrara (Carife)) the losses for senior bondholders amounted to 350 million euros on a total of 2 billion euros of losses (counting all the shareholders and the bondholders). [11]

This potential to inflict losses on thousands of small savers as a result of the problems of Italian banks and the ensuing political fallout is what has triggered the desperate attempts by the Renzi administration to search for alternatives to the BRRD. However, this new European legislation severely restricts the options available to the Italian government. In the past, countries like Spain and Ireland were allowed to set up a bad bank to deal with this type of problem. The FROB (Spain) and NAMA (Ireland) bought NPLs from banks in order to clean their balance sheets. However, by paying prices above the market for those bad loans, this constituted a direct subsidy to banks, which has since become prohibited under the EU State Aid Rules. In Italy, it is estimated that bad loans in the balance sheet of banks are worth around 20 cents on the Euro. In this area, the Italian government has tried to set up a guarantee scheme for the sale of NPLs by banks in order to prop up their prices to 40 cents on the Euro, but so far it has failed to have any meaningful impact. [12]

An alternative approach explored by the Italian authorities has been the direct injection of capital into troubled banks. In other words, to bail banks out in order to avoid imposing losses on households. To justify this approach, the government has made the case that the current crisis is a result of the Brexit vote and as such falls under a special exception of the BRRD that states that under “special circumstances… allow for extraordinary public support… in order to remedy a serious disturbance in the economy of a Member State and preserve financial stability”. [13] However, the arguments of the government have faced stiff resistance by Brussels, Frankfurt and Berlin as a breach in the implementation of the BRRD in its first real test, setting up a negative precedent, which other countries could follow in the future. An option within this approach, would involve the injection of public funds into Atlante, a private capital backstop fund established in April 2016. The fund, which received resources from different banks and financial institutions in the country to support the recapitalization of troubled institutions, could potentially be used to circumvent State Aid regulation by receiving additional funds from the government and use them to either recapitalize banks or buy NPLs above market prices. [14]

From the perspective of the Italian taxpayer it is clear that none of this options seems attractive. In both scenarios, be it bail in or bail out, they are being asked to foot the bill of a long brewing problem that arose from both mislead macroeconomic policies and poor bank management. A recent proposal to avoid this issue, involves creating a special mechanism to reimburse small investors who were misled into buying bank shares or bonds. [15] Nonetheless, this is far from ideal. Even though it would allow the government to implement the BRRD, it is unclear the type of criteria that would be used to determine who was misled as well as the time frame required to pay the ensuing claims. For example, in the case of the 4 regional banks alluded earlier, a “solidarity fund” has been put in place by the Finance Ministry with a total of €100 million to provide compensation to small investors. However, given the scale of the losses involved, more than 3 times the assets of the fund, this is far from ideal. Furthermore, as unemployment remains high and incomes depressed, to wait for years to get their money back might not be an option for many Italian households as evidenced by the suicide of two retail investors who lost their savings last year. [16]

Thus, a systemic solution must address the fact that if the provision of basic services of a modern economy such as the safeguarding of deposits, payments system and provision of credit is regularly threatened by the instability of their private providers, then these functions should be socialized and be provided as a public utility. Only then it will be possible to stop the practice of justifying bailouts of banks as a way to ensure financial instability. If the profits of such institutions are privatized, while their losses are regularly socialized, it makes little sense to keep them as private profit seeking entities. This is specially the case in a country like Italy where the problems of low profitability and high risk of insolvency are widespread in its banking system.

Furthermore, in the case of the bail in measures, it does remain important to ensure that while private investors bear the losses incurred by banks, small savers are properly protected.

However, by taking a blunt approach to the issue, the BRRD has the potential to create more problems than it solves.
On the one hand, in order to impose losses, the BRRD relies on the stress test organized by the ECB to evaluate the solvency of banks. In theory, this allows to simultaneously highlight troubled institutions to be subject to a bail in while providing reassurances to clients of other solvent banks regarding the safety of their investment so as to prevent a bank run. In reality, the stress tests lack much in the way of credibility, which establishes the potential for a serious bank run once the process of bailing in retail clients takes place. On the other hand, the BRRD promotes a flight to quality from depositors in banking systems in the periphery, as they fear their life savings might be in danger, to the core of the Eurozone. There is already evidence of this pattern, as the Target 2 negative balances of Italy have reached levels not seen since 2012. Thus, we are being left with an increasingly dysfunctional European financial system where the banks in the periphery will be left saddled with an increasing share of bad private and sovereign credit, as well as a weak depositor base, while the banks in the core will be flushed with deposits in a regime of negative interest rates and negligible investment opportunities.

From a more general perspective, it is clear that neither a bailout nor a bail-in as proposed by the European directive are solutions to the Italian banking crisis.
In the case of the former, the bail-out aims to socialize the losses of the banks and for this reason should be considered as illegitimate. Since the beginning of the crisis, most of the problems derived from insolvent financial institutions have been “solved” with a bail-out procedure. The public debt that has been acquired through this process can be consequently considered as illegitimate and should be repudiated according to the illegitimate debt doctrine of international law. [17] As for later, the bail-in option, some considerations should taken into account:

- Adam Lerrick proposes an interesting option to protect small savers in a bail in regime that is worth taking into account. In it, subordinated and senior bondholders would be offered complete protection up to a given threshold and suffer losses after it. In his proposal, the threshold would be set at €200.000, and all investors whether institutions or retail clients, domestic or foreign, would receive the same protection under it and suffer the same losses after it. [18] This would protect the Italian government from the type of lawsuits faced by the government of Portugal in its handling of the resolution of Novo Banco.

- In case of bank failure, the deposits of clients of the commercial bank must continue to be guaranteed by the State, up to the limit of a reasonable amount of savings for an upper-middle household (estimated today at 150,000 euros – amount that can to be subjected to democratic debate). [19] In case of orderly failure deposits should be transferred to a public bank, as it was done in Iceland in 2008.

Likewise, other proposals should be considered in order to curtail the speculative behavior of banks, among which it’s possible to mention [20]:

- Reduce bank leverage by forcing banks to hold a much higher capital ratio.
- A more fair taxation: banks do pay a rate, which is significantly below the legal rate (which is itself far too low).
- Systematically prosecute bank directors who are guilty of financial crimes and misdemeanors.
- Radically reduce the size of the banks.
- Separate commercial banks from investment banks.
- Prohibit trading with Over The Counter (OTC) derivatives, tax havens and bank secrecy.
- Socializing the banking sector under popular control.

Footnotes :

[1IMF. (2016). Italy: 2016 Article IV Consultation, IMF Country Report No. 16/222. Retrieved from

[2Financial Times. (2016, July 13). In charts: Italy’s banking crisis. Financial Times. Retrieved from

[3IMF. (2016). Italy: 2016 Article IV Consultation, IMF Country Report No. 16/222. Retrieved from

[4IMF. (2016). Italy: 2016 Article IV Consultation, IMF Country Report No. 16/222. Retrieved from

[5IMF. (2016). Italy: 2016 Article IV Consultation, IMF Country Report No. 16/222. Retrieved from

[7This type of bank resolution implies recognizing the losses incurred by the financial institution by writing down equity and/or converting into common equity certain liabilities based on their seniority, before recurring to the use of public funds. Two examples can serve to illustrate how this mechanism works in practice. In one instance, if losses are equal to the capital base of the bank, authorities could wipe out existing shareholders and convert into new shareholders the junior and senior bondholders of the bank. In this way, if new losses materialize, the former bondholders/new shareholders stand first in line to absorb them. In a more extreme scenario, if losses are on a ruinous scale, they can be allocated by writing down not only shareholders but also all of bondholders and un-secured depositors with holdings above €100.000. The clear advantage of this approach is that it reduces the need of public funds to recapitalize insolvent financial institutions by allocating most of the losses to private shareholders, creditors and depositors.. Nonetheless, precisely because it spreads the losses through the system, potentially making other private agents insolvent, it might spark a bank run.

[8Financial Times. (2016, July 10). Italian banks: Essential repairs. Financial Times. Retrieved from

[9Veron, N. (2016). Italy’s banking problem is serious but can be fixed. Retrieved from

[10IMF. (2016). Italy: 2016 Article IV Consultation, IMF Country Report No. 16/222. Retrieved from

[12Merler, S. (2016). Hard Times for Italian Banks. Retrieved from

[13Financial Times. (2016, July 7). Italian banks, this is euro area politics. We think you already know each other? Financial Times. Retrieved from

[14Financial Times. (2016, July 20). Italian bank shares rise amid “last ditch” MPS bailout plan. Financial Times. Retrieved from

[15Veron, N. (2016). Italy’s banking problem is serious but can be fixed. Retrieved from

[16Financial Times. (2016, July 10). Italian banks: Essential repairs. Financial Times. Retrieved from

[18Financial Times. (2016, July 13). Saving Italy’s Banks. Financial Times. Retrieved from

[19Toussaint, E. (2015). Bankocracy. Resistance Books / IIRE. Retrieved from

[20Eric Toussaint, Michel Husson , Costas Lapavitsas , Ozlem Onaran , Patrick Saurin , Stathis Kouvelakis , Stavros Tombazos , Pete Green , Gilbert Achar , Alan Freeman , David Harvey,... (2016). What is to be Done with the Banks? Radical Proposals for Radical Changes. Retrieved from,13315

Daniel Munevar

is a post-Keynesian economist from Bogotá, Colombia. From March to July 2015, he worked as an assistant to former Greek Finance Minister Yanis Varoufakis, advising him on fiscal policy and debt sustainability.
Previously, he was an advisor to the Colombian Ministry of Finance. He has also worked at UNCTAD.
He is one of the leading figures in the study of public debt at the international level. He is a researcher at Eurodad.

Chiara Filoni

CADTM Belgium