Italian Bailouts Show EU Authorities Walk A Tightrope While Banks Transition Toward Bail-ins

To borrow from British idiom, tests of the new European bank resolution framework are like buses: you wait ages for one, then three come along at once.

Fresh on the heels of the June 6 resolution of Spain’s Banco Popular, on June 23 the European Central Bank (ECB) determined two long-troubled Italian banks, Veneto Banca and Banca Popolare di Vicenza ScpA, to be nonviable. With the Single Resolution Board (SRB) ruling out resolution because the banks were not considered systemically important, it instead placed them in orderly liquidation on June 25. While the circumstances leading to their failure differ from those of Banco Popular, and the cost to the taxpayer differs enormously also, senior creditors have again emerged whole, now buoyed up by stronger institutions. Junior creditors and shareholders have again been wiped out.
The exit from the market of the two ailing Italian banks closes a chapter in the long-running saga of weaker Italian banks being pushed to recapitalize in order to deal with their weak profitability and even weaker asset quality. Italy remains one of Europe’s most fragmented banking systems, and has the largest stock of nonperforming assets (NPAs)–accounting for around €330 billion or 19% of domestic lending at end-2016. The weight of NPAs varies significantly from bank to bank, and some have already made progress in reducing these balances. Still, many banks have plenty of work to do, and could yet be helped in part by contributions from the private sector-backed Atlante fund. Furthermore, the modest economic growth, low efficiency, and consequent modest profitability prospects that S&P Global Ratings sees among several institutions continue to pose broader structural and cyclical challenges for the sector.

As with Banco Popular, the recent regulatory intervention was in some ways a success, at least at first glance. Assuming that the government’s related decree is passed as law: financial stability was ensured–largely because the authorities avoided losses on senior liabilities, the “white knight” (Intesa Sanpaolo SpA) was not weakened, and a less fragmented, more robust banking system in Italy is one step nearer. However, this sense of success is arguably even more compromised than with Banco Popular. Whereas Spain avoided any taxpayer support, the Italian government has injected €5 billion into Intesa to sweeten its acquisition of good assets and senior liabilities from both Veneto banks, and has committed up to a further €20 billion in guarantees. And retail creditors holding €200 million of missold junior debt between them have had to be compensated.
These actions have the makings of a pragmatic solution that has ensured financial stability, while adhering to the rules of the European Commission (EC) on state aid and the restrictions of the Bank Recovery and Resolution Directive (BRRD). However, they have sparked consternation elsewhere in the eurozone among those who anticipated government-funded bailouts to be a thing of the past. So, one step forward for the Italian banking system, but a source of possible further delay in the push to make creditors rather than taxpayers suffer the costs of bank failures. Together with the apparently limited progress on addressing the “doom loop” between banks and their sovereigns, this is one reason why we do not expect eurozone policymakers to make rapid progress on the still-unfinished project to create a true banking union. Finalizing the banking union would, among other things, likely require eurozone countries to pool resources to guarantee deposits in all member countries.
The certainty of taxpayer solvency support for systemic banks in Europe has diminished. Junior creditors are clearly heavily exposed to losses when a bank weakens significantly, and certainly if it takes in state aid or becomes nonviable. But, as with Banco Popular, S&P Global Ratings considers that this Italian case highlights the problems the authorities have yet to address before banks can truly be seen as resolvable and before all eurozone taxpayers face a vastly diminished prospect of providing solvency support to failing or failed banks.

Truly Effective Bank Resolution Will Depend On Banks Bolstering Their Bail-in Buffers
We removed notches of extraordinary government support from our issuer credit ratings on Italian and most other EU banks during 2015. We previously viewed the relevant governments as supportive of private sector banks, but reclassified their stance to uncertain in response to the new legal constraints on governments’ ability to intervene without substantial burden-sharing by creditors. The uncertain label reflects our view that government support is possible under the framework stemming from the EU BRRD, but less predictable than before. Our opinion remains unchanged. That said, as was the case with Veneto, if a systemic bank comes under stress and we see clear evidence that support for senior creditors will be forthcoming, we can reflect this in the ratings as additional short-term support.
We expect that the authorities will use their resolution powers for systemically important European banks, where circumstances require and allow it. Although the resolution legislation is now in force, we do not yet consider most banks to be truly resolvable in practice. This limits authorities’ options when dealing with struggling banks. In most scenarios, we anticipate that resolution will only be effective if there is a sufficient buffer of proven instruments that can be bailed in to comprehensively recapitalize the bank. Equity and subordinated debt have proven to be effective for this purpose, unless they were missold, and we see no reason why the authorities would seek to avoid losses for new senior nonpreferred creditors. But thus far, (preferred) senior unsecured instruments issued by operating entities have not yet proved effective for bail-in purposes. The ability to bail-in some of this class of debt,
provided that no creditor worse off (NCWO) protections are met, remains theoretical while policymakers worry about the resulting impact on financial stability.
The progressive build-up of bail-in buffers across European banks, with very clearly marketed features to enable their use in bail-in, therefore remains the most important remaining factor required to enhance the credibility and effectiveness of European resolution tools, and to sharply diminish the prospect of taxpayer solvency support. With this in mind, over the next two years we expect that systemically important European banks will significantly bolster these buffers, and in some cases take other measures to improve their resolvability. This will make resolution a more-credible, less-risky alternative to the sort of taxpayer solvency support that is benefiting Italian bank creditors. In the meantime, we expect that the Italian government will, like some others in eurozone, seek to navigate this transitional period carefully, minimizing its support wherever possible but, in extremis, being potentially willing to commit support where (i) other options are even less attractive and (ii) it can justify it within the bounds of the resolution and state aid frameworks.

The Italian Taxpayer Has Shouldered A Significant Burden To Ensure Financial Stability
Even before the Italian taxpayer support committed in recent days, the government guaranteed €10 billion of senior liabilities issued by Veneto and Vicenza in the past six months. It has now committed a further €5 billion of immediate solvency support, and signed up to a sizeable contingent liability via a €12 billion guarantee. Of this, €10.5 billion will be used to ensure that the nonperforming exposures can be transferred to a new state-owned asset management vehicle, Societa’ per la Gestione di Attivita’ S.G.A. SpA., without jeopardizing the future solvency of SGA itself.
But this is not the end of it: the government has a further €15 billion available to support Banca Monte dei Paschi di Siena (MPS; not rated) and any other bank that requires solvency support. Indeed, restoring confidence in the banking system remains its key objective, along with helping the market to consolidate, notably through the acquisition or orderly exit of troubled institutions–the economy needs a stronger banking sector.
By contrast, and as with Banco Popular, the key private sector intervention has arrived after existing junior debt and equity capital providers have shouldered most of the losses. Indeed, the deal appears to be a good one for Intesa: it has not had to raise any new capital to absorb the acquired business, it gained a future profit stream for a token sum, and it is protected against higher risk loans that turn bad in the coming three years.

The Italian Solution Could Play Out Again
Interestingly, for Veneto and Vicenza–institutions that we regarded as being modestly systemic in Italy and certainly systemic in the Veneto region–the SRB saw no reason to use resolution powers. In part this may be because a viable scenario was available through the liquidation and carve-up approach that then played out. But it was also because the SRB did not see the banks as systemic enough to pass the public interest test needed to justify resolution. It noted that neither of these banks provided critical functions, and their failure was not expected to significantly hinder financial stability. This stance contrasts somewhat with the EC’s acceptance that state aid was needed to avoid economic disturbance in the Veneto region. Still, we conclude that resolution will be reserved for the most systemically important institutions, a view that is consistent with the EC’s recent factsheet(1) on the subject.
While we do not anticipate that other Italian banks will necessarily follow Veneto and Vicenza into nonviability, at this time we think that this solution could be used for any similar case anywhere in the EU, provided of course that the relevant government proves equally willing to commit state funds.

Monte Dei Paschi Is On The Path To Recapitalization
As for Vicenza and Veneto, addressing the financial weakness of Italy’s MPS has proved to be a lengthy process. For the last six months, MPS has waited for approval of a precautionary recapitalization with already-earmarked state funds. On June 1, the EC gave its agreement in principle for MPS to receive those funds, by which time the bank committed to a deep restructuring where shareholders and junior bondholders would assume losses. However, the agreement remains contingent upon confirmation that private investors will acquire the vast majority of the bank’s nonperforming “sofferenze” loans (a gross €29.4 billion at end-2016 or a net €10.4 billion). MPS is a more systemically important institution in Italy than were Vicenza and Veneto, and the prospect of avoiding a nonviability determination appears quite good. While it remains theoretically vulnerable to a setback if no private sector deal can be reached, we currently anticipate that the recapitalization will happen.
Vicenza, Veneto, and MPS were clearly the most troubled banks in the Italian banking system, in our view. However, as happened in Spain, investor attention has already turned to other relatively weak names. More broadly, reducing the high stock of NPAs accumulated by banks on the eurozone’s periphery remains a high priority for the ECB. Absent a solution, those unproductive assets will continue to burden banks’ capital, profitability, and confidence, potentially resulting in more nonviability and resolution cases down the road.

For Veneto, Hybrid Loss Absorption Worked As Anticipated
Unlike in the Banco Popular case, Veneto had already stopped paying coupons on its Tier 1 instruments long before it reached nonviability. We lowered the rating first to ‘D’ when it stopped paying the coupons, then to ‘CC’ when it resumed payment in December 2016, and finally lowered back to ‘C’ when it applied for precautionary recapitalization in anticipation of the very likely burden sharing. We also rated Veneto’s Tier 2 instruments ‘C’ in February after the application for government support in anticipation of the almost certain burden sharing. However, with the bank having then reached the point of nonviability, the result was the same–all subordinated bondholders have, in effect, been wiped out.
This path matches that envisaged by our general rating approach to bank hybrid instruments. Although we rate Tier 1 instruments below dated, “must pay” Tier 2 instruments, this is not because we assume that they face markedly different default prospects on receipt of state aid or at the point of nonviability. Instead, it recognizes that Tier 1 instruments face additional risks at an earlier stage, when a bank comes under stress. In particular, these risks include coupon deferral or nonpayment, and the fact that newer additional Tier 1 instruments also contain mandatory write-down or conversion triggers, typically when the bank breaches a fully loaded 7% common equity Tier 1 ratio.

Giles Edwards, Mirko Sanna – Credit Analysts – Standard & Poor’s