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June 26, 2017

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The Italian job

The big news this weekend is the liquidation of two failing Venetian banks at a cost of up to €17bn to the Italian treasury. In a surprise move the Commission has ruled that the operation conforms with state aid rules. The argument given is that, as state aid will go to fund the "market exit" of the two Venetian banks, it doesn't distort competition. But the recipient of both €5bn cash and €12bn guarantees is explicitly Intesa Sanpaolo, which most definitely is not exiting the market. The near unanimous reaction of commentators has been to see this as a failure of the European bank resolution regime, and a capitulation of the three European institutions involved. The question is whether this is a case of "Italy is Italy", or other member states will be allowed to do the same in the future.

The Italian plan approved by the European Commission's competition authorities to liquidate Banco Popolare di Vicenza and Veneto Banca involves transferring the good assets and liabilities to Intesa Sanpaolo. The €12bn in government guarantees are to ensure the repayment of the financing Intesa will provide to the SGA vehicle, which will liquidate the bad assets of the Venetian banks. The €5bn in government cash will be used to preserve Intesa's capital ratios, to cover the costs of restructuring the business of the Venetian banks, and to provision for legal risk.

The central inconsistency in the deal is that the Single Resolution Board argued that the Venetian banks could be liquidated as they are not systemic, whereas the Commission accepted the Italian argument that they needed to be saved in order to protect the real economy of the Veneto region. Further, if a liquidation under Italian law involves a good bank/bad bank separation and a transfer of the good bank to a receiver institution, why wasn't this considered as a resolution plan by the SRB? Though, if this is what liquidation looks like, no resolution scheme designed by Brussels would have passed muster under the "no creditor worse off than in liquidation" principle of the Bank Recovery and Resolution Directive. Finally, it is beginning to look like bank resolutions will always wipe out subordinated creditors in full, and stop short of bailing in senior creditors.

As to the process, on Friday the European bank supervisor SSM determined that the capital plans previously presented by Banco Popolare di Vicenza and Veneto Banca were not credible, and declared them banks "failing or likely to fail". Then the European bank resolution authority SRB ruled that the resolution of the two Venetian banks was not in the public interest. This is because they don't provide critical functions, and their failure is not a threat to financial stability, despite being large enough to fall under the purview of the SSM rather than being supervised by the Bank of Italy. The BRRD is designed as an alternative for normal insolvency procedures, when these are deemed to be impractical. An often overlooked fact is that, under the BRRD, the default outcome in case of bank failure is liquidation. This is done under national law, and this is where the case of the Venetian banks gets interesting. Meet the Liquidazione Coatta Amministrativa (Compulsory Administrative Liquidation), which the Italians didn't invent for this occasion as it's been in the statute books for 120 years.

The details of the liquidation decreed by the Itallian government on Sunday had previously been approved as state aid by the European commission competition authority. It is important to note that, in case of liquidation, state aid is still governed by the Commission's 2013 banking communication. This is because the BRRD does not regulate liquidation. The Commission accepts the Italian government's justification for state aid, which is that the winding down of the two Venetian banks would have a serious impact on the real economy of the Veneto region. As the state aid is given to two banks that are exiting the market, the Commission interprets that this does not distort competition. 

As anticipated by the Italian finance ministry on Friday, the Italian government worked over the week-end to take the necessary measures to ensure the continuity of banking operations, and to protect depositors and senior bondholders. This is the result, implemented through a legislative decree:

  • the SGA, the bad bank created to manage the impaired assets of Banco di Napoli twenty years ago, is named administrator of the Venetian banks;
  • the administrator transfers to Intesa Sanpaolo parts of the business and assets and liabilities of the Venetian banks, not including equity or subordinated debt, and without legal liability for acts or fact occuring prior to the transfer, but including deferred tax assets;
  • Intesa Sanpaolo advances to the SGA the necessary funds to manage the liquidation of the assets and the servicing of the liabilities not transferred, with a state guarantee of under €5.4bn (extensible to €6.4bn) in case the proceeds of liquidation is not sufficient to repay Intesa's loan in full, and a commitment to repurchase within three years up to €4bn worth of the loans transferred to Intesa, if they turn out to be nonperforming;
  • the Italian government gives Intesa: up to €3.5bn in financial support to make up for additional capital needs caused by the transfer, up to under €1.3bn to cover the costs of restructuring the transferred businesses, up to €1.5bn in state guarantees for obligations to Intesa by the bad banks, and under €500m to cover legal risks above and beyond what the Venetian banks have already provisioned;
  • the Italian government takes charge of compensating bailed-in retail investors;

In total, Intesa receives up to €5bn cash and €12bn state guarantees. Unless the hole in the Venetian banks is larger than these €17bn, this looks like an operation where all the upside is for Intesa and all the downside for the Italian treasury. One struggles to see how this can be compatible with European rules on state aid, bank resolution and bank supervision. Federico Fubini explains how it came to pass that, as he puts it, each of the three guardians of European banking one after the other took decisions questioning their own role. Intesa drove a hard bargain because the alternative, outright liquidation, was untenable. Ferdinando Guigliano goes further: the Italian solution to the Venetian bank situation makes a mockery of the rules and principles of the banking union. Unlike Fubini, Guigliano does not see that the chosen solution is better than the alternatives. 

Intesa will not be required to raise capital to support the increase in its balance sheet, which is unlike in other cases of acquisitions. Fubini cites two reasons. One is that, in case of liquidation of the Venetian Banks, it is estimated that the Italian bank resolution fund would have had to compensate insured depositors by over €12bn. This money would have had to be contributed by the Italian banks as a whole, and it would have required them together to raise that amount in the capital markets. This is unrealistic under current conditions and, had it failed, it could have triggered a systemic crisis in the Italian banking system. The second reason is the good personal rapport between the head of the SSM Danièle Nouy and the CEO of Intesa Carlo Messina.

Fubini concludes that the SRB is implicitly admitting that European resolution cannot work as long as it doesn't have a fiscal backstop in the form of European deposit insurance fund, and a European resolution fund. And finally, the Commission had no choice but to approve the Italian state guarantees for Intesa which are necessary for the SSM to accept that there is no need for Intesa to raise additional capital.

Now, there are doubts that the solution adopted was the least onerous available. Reuters writes from unnamed sources that a consortium of four international hedge funds offered to put €1.6bn into the two Venetian banks at the end of May. This contradicts the official story that the Italian finance ministry had been unable to find private bidders willing to contribute the €1.2bn the European Commission was demanding as a precondition for a €5bn precautionary recapitalisation by the Italian state. 

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