The severity of the problem
The market tensions, which have manifested themselves in the Italian banking sector in the past few days, have highlighted a fragility of our financial system which seems above all to be due to the presence of a high amount of problem loans in most of the bank balance sheets. This situation has been known for some time, but which became more difficult to contain at the beginning of 2016 when the new European rules relating to the second pillar of the Banking Union entered into force. Furthermore, these regulatory changes were preceded by the outbreak of the crisis of some regional and local Italian banks and by a worsening of the global macroeconomic prospects.
The objective of the proposal presented here is to allow even the most fragile Italian banks to solve the problem of excess credit non performing loans (NPL) through market instruments that are backed, only as a last resort, by guarantees provided by the State. Without this guarantee, which in our proposal is added to that provided by the banks themselves and which thus leads to a "double guarantee", the solutions under discussion (including the different forms of bad banks or recourse to market guarantees) appear ineffective. Furthermore, the feasibility of our proposal presupposes that the European Commission recognizes the systemic nature of the problem, ie that it considers the situation of NPLs as a concrete threat to the financial stability not only of Italy but of the entire Eurozone. In accordance with the European Treaties, such a situation would require suspending the rules on bail in – ie the involvement of shareholders and subordinated creditors in the resolution of the bank – in the presence of the activation of public support.
The factors of instability
The end of 2015 and the beginning of 2016 were marked by a change in the prospects for the international economy which reproduced, but with the opposite sign, what had occurred between the autumn and winter of 2014. The crisis in one part of emerging countries, the very excessive collapse in the price of oil, the slowdown of the Chinese economy, the fragility of US growth which add up to the inversion of the interest rate cycle by the Federal Reserve, the still undetermined possibility of further monetary stimulus actions by the European Central Bank are a combination of factors that has worsened growth expectations also for the economies of the Eurozone.
Added to that was one shock specific to Italy, caused by the resolution of four regional and local banks which represented a minimal share of national banking assets (about 1%). In principle, the episode should not have had systemic significance. However, the impact was accentuated by two factors: first of all, due to the European rules passed in the summer of 2013, the restructuring method of the four banks involved the holders of subordinated bonds (small or large); secondly, this modality has made it clear to everyone that the entry into force - precisely from 2016 January XNUMX - of the new European regulation on bank resolutions focused on the lease in would have further increased the cost to investors of any bank restructuring.
The worsening of the macroeconomic situation and the shock idiosyncratic of Italy explain why it has become even more urgent to find a solution to the excess of problematic loans, which has weighed on our banking sector since at least the first half of 2012 and which represents its major structural problem. Defining an effective solution is more difficult than in the recent past, as the new European rules require the use of market mechanisms. As already mentioned, however, these new regulations continue to recognize the possibility of State intervention, in the form of guarantees to the related capital strengthening processes of the banks involved, if mere recourse to the market does not guarantee the fulfillment of orderly financial conditions .
The criticalities of the bad banks
To deal with the problem, it is necessary that each of the Italian banks has the opportunity to sell a quota of problem loans sufficient to bring the weight, with respect to its balance sheet assets, back within physiological proportions. In principle, these assignments must take place at market prices and have securitization vehicles (so-called 'special-purpose vehicle':SPV). However, it should be considered that, in the last three/four years, the average differences between the average market prices of each NPL and the corresponding value recorded in the bank balance sheets (book value) are high. A rough calculation indicates that, on average, these gaps are around 25/30 basis points. If our calculation were correct, the disposal of an adequate share of problem loans would lead to such huge losses for the most fragile Italian banking groups that they would require new recapitalisations. There is therefore a non-negligible risk that any attempt to solve the problem in one fell swoop (frontloading) generate shocks of such magnitude as to threaten the stability of the entire Italian banking and financial sector with repercussions on the rest of the Eurozone.
The establishment of a bad banks by each of the banking groups concerned would encounter similar problems. Although the sale of problem loans on the market by each of the bad banks can be graduated over time, the transfer of problematic loans from the originating bank at market prices would bring out the losses immediately - as, moreover, happened in the case of the four Italian banks that have just been resolved. Conversely, if this transfer were to take place at non-market prices, i.e. closer to book prices, there would be a reallocation of expected losses to the detriment of the specific 'bad bank' balance sheet, which must also be included in the group consolidation of the originating bank. It is moreover very probable that, especially in the latter case, the constitution of bad banks would trigger the opening of a resolution process, pursuant to the European BRRD directive, with the consequent application of the new rules on bail in. As already mentioned, such a restructuring of Italian banking groups would take place under even more onerous conditions for savers than what happened for the four small banks restructured at the end of 2015.
The launch of an (unthinkable) European resolution process for a substantial part of the Italian banking sector would become almost certain in the event of the establishment of a single bad banks public for all the banks involved. It is true that, in such a case, each banking group with an excessive incidence of problem loans would maximize the advantage of the phased sales on the market of that part of the loans it has transferred to the bad banks publish. As the Italian government has learned in the past months, the European Commission has nevertheless underlined the impracticability of such a solution because it is centered on a public bailout.
The resulting confrontation between European institutions and the Italian government seems to have led to a compromise solution, foreshadowed both in the interview of the EU Competition Commissioner - Margrethe Vestager - with Corriere della Sera on 21 January, and in the declarations of the Italian Economy Minister Pier Carlo Padoan. The compromise should provide that each of the Italian banks can sell, at market prices, an adequate portion of their problem loans to SPVs. Furthermore, in order to smooth the gaps between these prices and the accounting ones, each of the banks concerned is allowed to purchase state or public insurance coverage with respect to its various problematic loans. The crucial aspect is that such insurance coverage must be purchased at market prices. This poses two difficulties which tend to render the compromise ineffective. The first difficulty concerns the (im)possibility of fixing former before the specific market price for each of the guarantees relating to each of the many types of problematic loans, since the actual purchase and sale of these guarantees does not take place on the market. The second difficulty is that, even if it were possible to fix the individual equilibrium conditions by means of a mark to model, the cost of the market collateral on each of the NPLs would be exactly equal to the increase over the price that would be set by the unsecured market transaction between the bank and the SPV.
The need for a state guarantee
To get out of the vicious circle described, it is necessary to introduce a state guarantee which allows, albeit in indirect forms, to support the selling prices of problem loans. In this way, even the most fragile Italian banking groups could sell a part of their various types of problematic loans at prices closer to the accounting ones and, if necessary, could resort to recapitalization operations without having to act in emergency conditions.
Our proposal envisages having recourse to multiple SPVs dedicated to the purchase of problematic loans. These SPVs should benefit from a system of incentives through the application of two levels of guarantees: one by the banks themselves and a second - as a last resort - by the State. With each purchase of slice with different seniority of problematic bank loans, the SPVs would benefit from a guarantee from each of the banks involved to cover – up to pre-set limits – any losses they could incur due to a positive difference between the costs incurred for the purchase of each slice and the revenues induced by the subsequent, gradual and partial collection thereof slice with the original borrower. In addition, they would benefit from a guarantee back stop public if individual banks were unable to comply with the guarantee provided: the State or one of its agents would undertake to guarantee, even in this unfavorable eventuality, coverage up to the specific pre-established limits through the recapitalization of the banks in difficulty.
The proposal as a whole therefore implies: (a) support for the selling prices of each slice of problematic loans, capable of making their liquidation convenient even by the most fragile banks; (b) the possibility of not resorting to the bail-in. Point (b) is based on the belief that the state aid of last resort, envisaged by our proposal, is compatible with the TUEF Treaty (Treaty on the Functioning of the European Union) and therefore does not require the application of the resolution mechanisms envisaged by the Banking Union.
State aid
Before going into the analytical details of the proposal, it is essential to justify the last statement made. In our opinion, the serious tension that occurred on the financial markets last week and which involved Italian banks in an unjustified way due to changes in their previous capital solidity conditions, indicates the presence of conditions of systemic instability such as to justify a reconsideration by the European Commission of the methods of application of the rules governing state aid to banks. In this regard, it should be recalled that article 45 of the Communication from the European Commission, relating precisely to the application from 1 August 2013 of the rules on state aid to measures to support banks in the context of the financial crisis (the so-called "Communication on the banking sector”), provides for the possibility of derogating from the new rules relating to the resolution of banks if the implementation of these measures endangers financial stability or leads to disproportionate results.
This has already happened at the beginning of the international financial crisis of 2007-'09, when the Commission adapted the traditional ways of applying State aid control to the changed economic context, temporarily introducing elements of greater flexibility to ensure the safeguarding of of the financial system. The TUEF provides: in article 107, paragraph 2, letter b that aid granted to "make good the damage caused by ... exceptional events" must be considered compatible; in Article 107(3)(b) that the Commission is allowed to consider aid "intended to remedy a serious disturbance in the economy of a Member State" compatible. This second provision constituted the legal basis, used by the Commission during the crisis, to adjust the methods of controlling the European (and, only minimally, Italian) banking crisis in the general interest of the system.
Consistently with this approach and since 2008, the Commission has issued various Communications which took into account the changing conditions of the economic and financial context. It first made the criteria for assessing State aid to the banking sector more flexible, until the summer of 2013, and then progressively stricter, with the aim of returning, after the turmoil, to criteria for assessing aid from apply stably. It is in this context that the Communication of July 2013 fits. In the latter Communication, the Commission announced that it would no longer consider compatible State aid for bank recapitalizations that were not based on a budget burden sharing payable by shareholders and subordinated creditors.
Recent events, which have led to serious volatility in the prices of some Italian banks in a more general context of decline in share prices, constitute an objective threat to the stability of our banking sector and - consequently - of the European one. Furthermore, the instability does not derive from an average deterioration in the quality of bank balance sheets or from new losses of individual Italian banks, but from the application of the burden sharing to four regional banks and by signals – real or perceived – coming from the European supervisory authorities and erroneously interpreted by the market as the start of a new asset valuation exercise or a request for an increase in provisions on problematic loans. Basically, although the situation of the Italian banks is in line with the prudential requirements, a chain of events took place which seriously destabilized the markets. The fact that the stock sell-off has since subsided does not imply that it cannot repeat itself; fragility, from which the recent was born shockremains and can give rise to new turbulence.
In the above circumstances, it would be reasonable, fully justifiable and in line with the approach followed so far in emergency situations, to agree with the Commission a new legal instrument of public recapitalization guarantees, usable within a limited time window and applicable to all European banks come to find themselves under attack and that they are - therefore - in a position not to support the commitments undertaken with respect to the securitization process. The activation of this tool should exclude, until the situation normalizes, the application of the bail in to the individual banks that use it. A process of bail in in fact, it would tend to have a destabilizing impact at the system level.
Attachments: NPL-liquidation.pdf
