Italy has been the next crisis waiting to happen in the EU since Brexit in June 2016, but the referendum on 3rd December has baffled many international observers. So why did the ‘No’ vote send markets into a jitter and what might it mean for the future of the European Union?
First of all, the referendum did not concern economic reform. Prime Minister Matteo Renzi asked Italy’s voters to approve constitutional changes that would have strengthened the lower house and prevented the country’s senate from holding up laws passed by the government. In other words, he wanted to ensure future general elections would have more chance of producing a majority government not bogged down by horse-trading and compromises with minority parties.
Britain resolved this question in 1911 when the House of Lords accepted it could no longer block bills passed by the House of Commons. Italy in 2016, perhaps fearful of giving too much power to the executive after its disastrous rule under Benito Mussolini (1922-1943), has decided to stick with its current system and reject Matteo Renzi. For some unknown reason, the media have painted the referendum as a vote on economic reform; but this betrays a fundamental misunderstanding of the European Union’s 2008 Lisbon Treaty and presents the EU and Italy with a dilemma.
The heart of Italy’s woes lie in its banking system and, in particular, Banca Monte dei Paschi di Sienna (BMP), founded in 1472. Like RBS’s woeful timing when buying ABN Amro, BMP’s problems began when it purchased Banca Antonveneta SpA for 9 billion EUR in 2007. Skip forward to 2016 and Banca Monte dei Paschi has a portfolio of non-performing loans that would make Lehman Brothers blush. The bank needs 5 billion EUR in new capital or it will have to recapitalise by passing its losses onto bond-holders and depositors. Bond-holders in this instance are pension funds and Italian savers that have lent money to BMP in return for a yield. BMP will pay-out interest over a defined period of time to these people before returning the principal amount it borrowed when the debt matures.
Many will recall the 2007-08 western banking crisis saw an unprecedented wave of bail-outs funded by taxpayers’ money. No bond-holders suffered during this period, so why can’t the Italian government do the same thing?
In his seminal book, 'The Alchemists: Inside the Secret World of Central Bankers', Neil Irwin characterises it as ‘perhaps history’s most consequential stroll on the beach’ when referring to the Franco-German decision to rule out future bail-outs in the Eurozone. For October 18th 2010 is the day when French President, Nicolas Sarkozy, and German Chancellor, Angela Merkel, announced that pension funds and investors in possession of Greek bonds would have to take write-downs. In other words, no taxpayer money could be used to re-capitalise the banks weighed down by Greek sovereign debt until ordinary retail and institutional investors had taken losses. Bail-outs were no more, but bail-ins were the new policy.
Economist, Jim Rickards, describes how a bail-in works for those pension funds and savers holding BMP’s bonds in 2016.
‘Imagine if you had $500,000 on deposit at the bank and you got a notice in the mail that said your deposit was now $250,000 (the insured amount) and the other $250,000 had been converted into stock in a “bad bank,” which might or might not produce returns in the future. That’s what happens in a bail-in.’
This scenario is also why former European Central Bank President, Jean Claude Trichet, was so furious to learn of the ‘Merkozy’ announcement with no consultation back in 2010. In his view, guaranteeing full value for holders of Greek debt was a necessary price to prevent the markets from going into a tailspin about what might happen if bail-ins were applied to bigger countries. Well, Mr Trichet, here is your worst dream come true! Italy’s banking system holds up to 360 billion EUR in non-performing loans but has only 225 billion EUR in equity.
The prospect of Marine Le Pen’s Front National winning France’s 2017 Presidential election is enough to put the European Union at risk of crumbling, but could Italy get there first?
As usual, all eyes will be on Berlin. Chancellor Merkel knows that Deutsche Bank is in trouble, but her own rules prevent German taxpayers from coming to its rescue without severe losses placed on its bond-holders and depositors. The new Italian government could rip up the rule book and re-capitalise BMP and the nation’s beleaguered banking system with taxpayers’ money. Germany will fret, but may also use this belligerence as an opportunity to sort out problems with Deutsche Bank. The European Union is a master of compromise if nothing else.
There’s no doubt this is a crisis moment for the European dream. Banca Monte dei Paschi di Sienna is the world’s oldest surviving bank and could argue its continued existence is integral to Europe’s intellectual heritage, just as Oxford University is integral to England or Al Azhar University is to Egypt.
For now, few people see where the 5 billion EUR needed to keep BMP afloat will come from unless the Italian government stumps up some of the cost. The fact this is illegal under European Commission rules may be the least of the EU’s worries.