Italian banks: The next weak link in Europe

The Italian government has been trying to find a way to shore up its struggling banks. The first option is to use taxpayers’ money to bail out troubled banks. 

However, that is against the European Union rules. According to the EU Bank Recovery and Resolution Directive, a bank’s private creditors must accept losses of at least 8 per cent of the liabilities (a bail-in) before the state can intervene (bailout). 

The rule is intended to protect taxpayers by ensuring that creditors suffer major losses first if a bank gets into trouble. Such a rule would not be too difficult to enforce in other countries because their private creditors are mostly large institutional investors. But in Italy, many small savers hold deposits in the form of bank bonds because of a tax loophole. These retail investors could be hit by the “bail-in”. 

A bail-in by private investors would also have an adverse impact on the banking system. Banks might not be able to place bonds with private investors. There would even be a risk of private investors reacting to the losses by withdrawing their deposits, resulting in a large-scale bank run. That is why the Italian government has been reluctant to force a bail-in. 

Pressure in the banking sector, if prolonged, could impair banks’ ability to provide credit to the real economy and undermine the European Central Bank policy to support bank lending. The disagreement between the Italian government and the EU banking authority could also contribute to public distaste towards the European Union. 

TISCO Financial Group contributed this article