Bank Bailout Italy Could Be Next

Italy risks following Britain's path out of the European Union if Brussels doesn't ease up on rules allowing the government to rescue its failing banks, writes Stanford professor Melvyn Krauss.
Italy's Prime Minister Matteo Renzi.

The most important item on the E.U. agenda in the wake of Brexit is Italy’s October referendum on constitutional change. It is tantamount to a referendum on the performance in office of Italian Prime Minister Matteo Renzi, and even whether or not the country stays in the European Union.

To insure Mr. Renzi wins the referendum and Italy stays in the soon to be 27-nation bloc, the European Union should scuttle its rules that require bail-ins when government money is injected into failing banks.

Mr. Renzi is in real trouble because Italian banks are facing imminent collapse. The banks desperately need an injection of public money to survive, but E.U. rules on state aid require private investors to share in the losses —the so-called "bail-in" rule, which the E.U. adopted to make bank bailouts more acceptable to taxpayers.

The law of unintended consequences explains how the bail-in rules can lead to an Italian Brexit.

A bail-in would damage Mr. Renzi at the polls, because it would hurt not just wealthy creditors but many ordinary Italian families who have invested their life savings in the banks. The populist opposition Five Star Movement party would be the most likely beneficiary – and they are keen to take Italy out of the European Union.

Besides, government bank rescues don’t need bail-ins to be politically acceptable. The recent Spanish elections, won by the incumbent, show that using European taxpayer money to bail out local banks can be a wise investment for Europe.

The unintended consequence of E.U. bail-in rules may well be to put a populist into the Palazzo Chigi and send Italy out of the European Union.

Coming just three days after Brexit, the main establishment party, the Popular Party or PP, led by Mariano Rajoy made unexpected gains at the polls and the anti-establishment Podemos party unexpected losses, quelling fears that Brexit would lead to a great E.U. unraveling.

Spain has good growth and the voters didn’t want to risk it on a political fling.

Here’s where the bank rescues come in for Italy: Just as Mr. Renzi has inherited bad banks that are a legacy of past bad decisions by his predecessors, Mr. Rajoy too had a legacy problem with the banks and chose to bail them out. He understood his pro-growth package of tax cuts and labor reforms would not work with an imploding financial sector.

And so, European taxpayer money was used to set up a "bad bank" in Spain that bought the distressed assets of commercial banks like Banco Popular and Banco Santander. That "investment" paid off handsomely during the recent elections. Now Europe must make the same type of investment in Mr. Renzi, though the rule change on bail-ins, enacted only at the start of this year, has made the job harder.

Faced with the need to support Mr. Renzi on the one hand and the E.U. rules on bail-ins on the other, the authorities are said to be considering a variety of financial contortions and shenanigans to get around the rules while maintaining the fiction that the rules are not being violated.

One scheme making the rounds is for Mr. Renzi to do a bank bail-in and then use the Italian budget to compensate the Italian families – but not the institutional investors – for their losses. The problem: That’s a budget buster that will put the Italians in violation of E.U. fiscal rules. How they get around that one is anyone’s guess.

Instead, let’s get rid of bad E.U. rules like bail-in that, in their attempt to make bank rescues seem fairer to public opinion, hamstring the authorities in their proper function of stabilizing the banks and encourage financial contortions that can make matters worse rather than better.

In the Renzi case, the unintended consequence of E.U. bail-in rules may well be to put a populist into the Palazzo Chigi and send Italy out of the European Union. That’s too high a price to pay.


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