The decision to create a banking union was the decisive moment in the eurozone's response to the global financial crisis.
The establishment of common banking rules and oversight institutions were intended to help restore trust in a system badly shaken by concerns that weak national supervisors in thrall to local political pressures were colluding to hide from investors the full scale of bad debts. It also formed the centerpiece of a grand political bargain: By committing to sever the link between weak banks and over-indebted sovereigns, governments prepared the way for European Central Bank president Mario Draghi's 2012 promise to do "whatever it takes" to save the eurozone, including buying government bonds.
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Yet the decision over the weekend to spare two failed Italian lenders from the full force of those new rules raises questions about the effectiveness of the banking union.
The centerpiece of the new regime was the Bank Resolution and Recovery Directive -- rules to ensure that no taxpayer money is used to bail out banks and that losses fall on private-sector creditors -- and the creation of the Single Resolution Board to oversee the process. There was relief last month when this new regime was tested for the first time by the failure of the Spanish lender Banco Popular, which was sold to Santander for one euro after its shareholders and junior bondholders had been wiped out, with no adverse effect on the market.
But Veneto Banca and Banco Populare di Vincenza will be spared the same treatment. Using a loophole in the BRRD, the Single Resolution Board has ruled that the two banks are not systemically important and therefore can be liquidated under Italian insolvency rules, which permit the use of government cash without the need for senior bondholders to take losses. The plan is that the good assets of the banks will be transferred to Intesa Sanpaulo for a euro, but the bad assets and the cost of redundancies will be left with the government, which faces losses of up to EUR10 billion.
The EU Commission insists this is not a loophole and that the possibility of using national as opposed to eurozone-level insolvency regimes was clearly envisaged under the Bank Resolution and Recovery Directive. It points out that a number of failed banks have been liquidated using national insolvency regimes since 2015.
Even so, this decision has still taken most observers by surprise. The two Italian banks, though smaller than Banco Popular, were large enough to be supervised by the European Central Bank. It therefore was widely assumed that their resolution would also be handled at the European level. Instead, it now appears that the SRB has discretion as to whether to apply the BRRD rules.
Meanwhile the eurozone finds itself in the odd situation where systemically unimportant banks are eligible for state aid, while systemically important banks must be subject to full bail-in.
It is hard to avoid the conclusion that the SRB's decision to spare senior bondholders in the two lenders is primarily political.
The Italian authorities have been fighting a rear-guard action to save the two banks from insolvency for two years, not least because they are major employers in the region and because many of the bondholders are retail customers of the banks who may not have known of the risks they were taking when they bought what were marketed as high interest savings products. Liquidating the banks under national rules at least removes the risk that 300,000 retail investors might be hit by substantial losses less than a year before a general election is due.
No one wants to reignite a new political crisis in the eurozone just as the economy, including that of Italy, appears to have finally turned a corner.
But where does this leave the banking union?
Importantly, the decision to put the liquidation into the hands of the Italian authorities is not being questioned by Germany. From Berlin's perspective, it is enough that it has headed off a long-standing attempt by Rome to try to keep the banks alive by injecting government capital using another controversial BRRD loophole known as precautionary recapitalization. The decision to spare senior bondholders represents a pragmatic compromise to a saga that has cast a shadow on the Italian and eurozone banking system for too long -- and which German officials believe should have been addressed years ago.
Nonetheless, Berlin wants reassurance that this deal doesn't set a precedent and that the state aid rules will be rigorously applied to minimize the use of taxpayers' money, according to German officials.
In recent weeks, there has been much speculation about a fresh political push to strengthen the eurozone, including the creation of new mechanisms to pool banking risks via a common backstop to the eurozone's Single Resolution Fund and a common deposit-insurance scheme.
But the Italian episode highlights that before any steps can be taken to complete the banking union, new measures may be needed to strengthen the rules already in place.
Write to Simon Nixon at email@example.com
(END) Dow Jones Newswires
June 25, 2017 12:40 ET (16:40 GMT)