The Italian Banking Crisis: No Free Lunch

Or Is There?

Italian Banking, Crisis, No Free Lunch, Brexit, bankruptcy, Macroeconomics, fx trader, forex

It has been called “a bigger risk than Brexit”– the Italian banking crisis that could take down the Eurozone. Handwringing officials say “there is no free lunch” and “no magic bullet.” But UK Prof. Richard Werner says the magic bullet is just being ignored.

On December 4, 2016, Italian voters rejected a referendum to amend their constitution to give the government more power, and the Italian prime minister resigned. The resulting chaos has pushed Italy’s already-troubled banks into bankruptcy. First on the chopping block is the 500 year old Banca Monte dei Paschi di Siena SpA (BMP), the oldest surviving bank in the world and the third largest bank in Italy. The concern is that its loss could trigger the collapse of other banks and even of the Eurozone itself.

There seems little doubt that BMP and other insolvent banks will be rescued. The biggest banks are always rescued, no matter how negligent or corrupt, because in our existing system, banks create the money we use in trade. Virtually the entire money supply is now created by banks when they make loans, as the Bank of England has acknowledged. When the banks collapse, economies collapse, because bank-created money is the grease that oils the wheels of production.

So the Italian banks will no doubt be rescued. The question is, how? Normally, distressed banks can raise cash by selling their non-performing loans (NPLs) to other investors at a discount; but recovery on the mountain of Italian bad debts is so doubtful that foreign investors are unlikely to bite. In the past, bankrupt too-big-to-fail banks have sometimes been nationalized. That discourages “moral hazard” – rewarding banks for bad behavior – but it’s at the cost of imposing the bad debts on the government. Further, new EU rules require a “bail in” before a government bailout, something the Italian government is desperate to avoid. As explained on a European website called Social Europe:

The EU’s banking union, which came into force in January 2016, prescribes that when a bank runs into trouble, existing stakeholders – namely, shareholders, junior creditors and, sometimes, even senior creditors and depositors with deposits in excess of the guaranteed amount of €100,000 – are required to take a loss before public funds can be used . . . .

[The problem is that] the subordinated bonds that would take a hit are not simply owned by well-off families and other banks: as much as half of the €60 billion of subordinated bonds are estimated to be owned by around 600,000 small savers, who in many cases were fraudulently mis-sold these bonds by the banks as being risk-free (as good as deposits basically).

The government got a taste of the potential backlash a year ago, when it forced losses onto the bondholders of four small banks. One victim made headlines when he hung himself and left a note blaming his bank, which had taken his entire €100,000 savings.