An Italian bank’s Christmas miracle?

Small investors in stricken Monte dei Paschi will suffer losses, but its rescue could save Italy’s economy.

‘Tis the season to be jolly but for thousands of small Italian investors, the long-running drama of Monte dei Paschi di Siena will result in a visit from Scrooge rather than Santa.

For almost everybody else, though, the state bailout of Europe’s oldest bank will bring the hope of a Christmas miracle: the disappearance of the huge dark clouds hovering over Italy’s banking system.

On Thursday afternoon, bankers, politicians, and regulators in Rome, Brussels, and Frankfurt bowed to the inevitable: MPS had failed to raise the €5 billion it needed on the market, all but forcing the Italian government to intervene. In the early hours of Friday, MPS officially asked the government for help.

Under EU rules, a state rescue, which could be confirmed on Friday, will inflict severe losses on both the 40,000 or so mom-and-pop investors who own MPS bonds and the big pension funds and insurance companies who invested in the doomed lender.

The MPS operation is likely to be cleared by Brussels and Frankfurt regulators, not least because neither the European Commission nor the European Central Bank has the appetite for a banking crisis in a key EU economy.

But the political hurdle in Italy will be higher. The regulatory greenlight won’t be enough to placate the 5Star Movement, the populist opposition party that will try to squeeze every ounce of political capital out of the entailing financial debacle that will hit small savers.

The silver lining? That this sorry saga may spark a wholesale overhaul of not just MPS but other sickly Italian banks, allaying investors’ and regulators’ fears of a financial time bomb sitting at the heart of Europe.

“Italian banks will continue their gradual healing process for months if not years, but what is going to happen over the next few days is to be considered a turning point,” wrote to clients Lorenzo Codogno, a former chief economist and director general at the treasury department of the Italy’s finance ministry, who now runs his own consultancy.

This optimism is predicated on the fact that the new government of Prime Minister Paolo Gentiloni has parliamentary approval to spend up to €20 billion to save Italy’s banks.

Coupled with other initiatives — including the establishment earlier this year of Atlante, a state-sponsored fund designed to deal with the €360 billion in bad loans on banks’ balance sheets as of the end of 2015— that firepower should be enough to restore the Italian financial system to a semblance of health. Indeed, Italian bank shares have been rallying this week despite the stream of bad news coming out of MPS.

Vicious circle

The chronic problems of Italy’s banks and its economy can be boiled down to a vicious circle: Poor management and cozy relationships with local businesses led to bad loans; the country’s sluggish economic growth made it difficult to get rid of the old bad loans and added new ones; as a result, crippled banks were unable to spur economic growth by lending; the resulting slow growth exacerbated the bad loan issue; and so on and so forth.

The €20 billion that Gentiloni and his finance minister, Pier Carlo Padoan, can spend should break that endless loop of gloom and set many banks, starting with MPS, on the long road back to health.

That won’t be any consolation for the thousands of Italian households who placed part of their savings in MPS bonds as part of the bank’s ill-fated marketing campaign that began in 2008. For them, the Brussels rules have only one prescription: pain and losses.

The EU’s guiding principle on its new regulation of the state rescue of banks is “burden sharing” to avoid taxpayer-funded bailouts. Bondholders and shareholders are supposed to do most of the sharing in “bail-ins.”

It wasn’t always the case. So, in a way, Italy’s government and the MPS’s small savers are victims of bad timing. The rules on burden sharing only came into force in January of this year. Before then, EU governments had a lot more leeway to rescue banks with taxpayers’ funds.

And they made use of it. Between the 2008 financial crisis and 2014, EU governments spent a total of 8 percent of eurozone GDP on rescuing ailing banks, according to the ECB. “The fiscal costs of the assistance … led to a deterioration in the euro area budget balance and debt by a cumulated 1.8 percent and 4.8 percent of GDP respectively,” the central bank said in a 2015 study.

In short, EU governments ranging from the U.K. to Spain, from Ireland to Greece, spent a lot of public money to prop up their banks after the crisis. Now, those procedures have been outlawed, and investors must pick up part of the tab. The 5Star Movement and other opponents of the MPS plan will make sure that Gentiloni and Padoan pay a political price for it.

The Italian government counters that EU rules do provide for some compensation to small savers, and Padoan has said the administration will use them to the maximum.

The key criterion for compensation, however, is that investors were “mis-sold” the bonds. In other words, before they get some money back, investors will have to argue that the securities were clearly too risky for their risk profile — something that might be difficult to prove.

As most Italians prepare for the traditional Christmas marathon of eating, drinking, and family time, many households face an anxious wait to see how much money they have lost on the country’s worst bank.

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