The European Court of Justice upheld the principle of making creditors bear the burden for investment in banks that sour before government funds can be used. Italian banks are particularly sensitive to the ruling, which cannot be appealed because the European Banking Authority and European Central Bank stress tests on July 29 are expected to show that some Italian banks are under-capitalized.Â
The problem is that the private sector does not have much appetite and the government-facilitated Atlas fund does not appear to have sufficient resources after buying equity in two banks. The Italian government has been engaged in what at times seem like acrimonious negotiations with the EU over the construction of a recapitalization plan.
Italian officials want to tread carefully around bailing in junior creditors. In Italy, the junior creditors are often retail investors, especially in the domestically focused banks. Retail ownership of bonds accounts for 15%-20% of total direct funding for several banks and nearly 12% for Monte dei Paschi, which is the focus of so much attention recently. Â In the more international banks, the retail share of direct funding is considerably less, like less than 6% for UniCredit and 7.5% for Intesa. Â
The Bank of Italy’s July 2016 Economic Bulletin notes that nearly half of the bank bonds held by households at the end of last year mature by the end of 2017, and 90% mature by 2020. This offers Italy to put into place new rules to educate and protect retail investors. However, it does little to address the immediate exposure of junior creditors. Â
The European Court of Justice was clear: “Burden-sharing by shareholders and subordinated creditors as a prerequisite for the authorization, by the commission, of state aid to a bank with a shortfall is not contrary to EU law.” Â There is an exception to the principle, and that is if bailing in “would endanger financial stability or lead to disproportionate results.” Â
