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What we just learned about Banking Union from Italy

Erik Jones / Jun 2017

Paolo Gentiloni, prime minister of Italy. Photo: Shutterstock

 

The Italian government passed a series of decrees yesterday (25 June) to allow Intesa San Paolo to buy the healthy assets of two small banks from the Veneto region – Banca popolare di Vicenza and Veneto Banca. The state will move the distressed assets into a ‘bad bank’ for orderly liquidation. This action closes a chapter on the Italian banking crisis that started in late 2015 when regulators made it clear that the two small Veneto banks needed more capital. Over the intervening period, investors threw good money after bad as the banks continued to haemorrhage deposits and mount up non-performing loans. The government did not want to step in because it did not want to impose losses on large depositors or junior bond holders. Ultimately, though, the situation for the two institutions was unsustainable. Now we know what the solution looks like. The question is what we learned from the process. The short answer is that Europe’s banking union is still dangerously incomplete.

There are lessons for everyone. Some of these we have known for a while. For example, we learned that governments do not like to impose losses on retail investors – specifically large depositors but also junior bondholders. We also learned that banking resolution becomes more expensive the longer problems fester. And we learned that these two obvious lessons interact in an obvious way: the more European rules try to force governments to bail in retail investors, the longer governments are likely to delay in addressing bank resolution problems and the more expensive banking crises become. The solution is either to restrict governments’ ability to delay the banking resolution process or to make the process less onerous (politically) for governments to embrace. No doubt much debate will take place about whether and how to achieve either of those objectives.

There is another lesson we learned that is less obvious and yet potentially significant in the European context. That lesson is about the connection between small banks and national banking systems. On 23 June, the European Central Bank determined that Banca popolare di Vicenza and Veneto Banca were ‘failing or likely to fail’. This determination was important to trigger resolution proceedings. The same day, the Single Resolution Board announced that: ‘neither of these banks provides critical functions, and their failure is not expected to have significant adverse impact on financial stability. As a result, the banks will be wound up under normal Italian insolvency proceedings.’ Two days later, European competition authorities in the European Commission authorized the Italian state to provide capital injections and credit guarantees for Intesa San Paolo to ensure that resolution of the two banks under national procedures would not have ‘a serious impact on the real economy in the regions where they are most active.’ These seems like a closed loop in terms of justification. Nevertheless, there is a piece missing in the logic – and that is the alternative.

If the two small banks would have gone under, the rest of the Italian banking system would have had to cover their deposits. This is the point made today by Federico Fubini in Corriere della Sera and Francesco Manacorda in La Repubblica. The premise in both articles is the same. The Italian funds for deposit insurance are inadequate to cover the deposits of the two small banks without calling for additional resources from other institutions in the Italian system. If the other banks paid in these resources, they would run down their capital buffers enough to attract the attention of the regulators – who would call for them to raise capital, all at the same time. These capital calls would be no more successful than the efforts were to bolster the capital of the two small Veneto banks last year. Of course, some of the larger banks like Unicredit might not have any trouble, but many of the smaller institutions would fail. The government would try its best to insulate these institutions so long as possible, but they would not be able to prevent either the flight of deposits or the drag on economic performance. This is how the failure of two systemically insignificant banks could bring down the whole of the Italian financial system. This explains – at least partly, according to Fubini and Manacorda – why the European institutions were willing to allow the Italian authorities to step in the way they did. The alternative was unacceptable.

If Fubini and Manacorda are correct, there is an important lesson for Europe’s banking union: national deposit insurance creates systemic vulnerability and the more European authorities interfere with national banking resolution, the greater this vulnerability will be. There are multiple solutions to this problem. Europe’s banking union could move toward greater national responsibility and accept that will require greater national autonomy or it could move toward greater European responsibility and accept that will require more risk-sharing across countries. If the two Veneto banks had been underpinned with European Deposit Insurance, the cost of their failure would not have been systemically significant. Further efforts at risk reduction – like the ‘good bank, bad bank’ program being implemented in Italy this week – can help with either transition. But the half-way house where some elements are European and others are strictly national is not a viable long-term arrangement.

Erik Jones

Erik Jones

June 2017

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