Tuesday 06 June 2017 by Opinion

Hybrid investors versus the EU

The latest Italian banking sector saga will test the EU’s resolve as Basel III regulations are put to the test.  At the heart of the issue are Italian hybrid investors, who like Australian investors are almost exclusively “mama and papas”, – should they lose their savings or should senior bond holders be bailed in and foot the bill?

boxing ring

The Italian government has formally proposed a bailout of Banco Monte dei Paschi di Sienna. 

For the first time, global Basel III regulations and the EU’s own banking regulations will be tested, and the world is watching how the Italian government and the EU will react. Will they protect retail hybrid investors over public funds or even over senior bond holders, decimating the capital structure? Or will the principles of the regulations prevail and hybrid investors share in the losses in order to protect the bank from a government bail-in?

As the EU only recently passed new regulations prohibiting the use of public funds to bailout insolvent banks and forcing the losses on to equity and bondholders, the proposal requires European Central Bank approval.

The challenge is that Monte dei Paschi’s hybrid investors are middle class individuals and an election is due within the next year in Italy – no political party wants to force the hybrids to convert to shares and thus lose money and potential votes. Monte dei Paschi’s share price has fallen by 75% in the last 12 months.

Italy’s anti-EU party, the Five Star Movement, is using the predicament to its advantage – it has already organised protests outside Monte dei Paschi’s HQ in Siena to protest the possible loss by hybrid investors.

To add to the drama, Germany seems to have changed its tune on this topic.  While Germany was the most vocal opponent to the Italian government’s support for Monte dei Paschi, now they are declining to comment.  This could be because the German government may need to support their own HSH Nordbank ahead of German federal elections in September.

Post-GFC regulations force investors to take losses before any public bailout 

The credit crisis of 2007-2009 sent many banks in the US and Europe to the brink of collapse.  Governments were forced to bailout several institutions, despite the fact that equity, hybrid and bondholders should have taken losses first.  The cause is the complex interbank funding system that means that if one bank fails, there is a rising risk of other banks failing and creating a domino effect.  So, in the face of a potential failure, governments and central banks can be more motivated to prevent the first major collapse than investors are, resulting in a dangerous game of chicken. 

New regulations introduced across the world were designed to ensure this standoff didn’t occur.  The regulations required an orderly “bail-in” of certain types of securities in the event that capital falls below trigger levels heightening insolvency as a possibility.  In other words, if capital falls below a certain level, hybrid investors’ capital should convert to equity to increase capital of the bank and support its ongoing survivability. The theory being the conversion averts the use of public funds.

Monte dei Paschi is potentially the first time the rules (introduced on 1 January 2016) and European leaders’ willingness to abide by them, will be tested. Will the EU bow to political pressure?

Proposed deal for Monte dei Paschi

If Monte dei Paschi is insolvent, the EU’s new rules require that hybrid investors’ capital is converted to equity or written off altogether before any government support is provided, as per the arrangements worldwide.  If it is not insolvent, the rules do not come into effect and the Italian government is free to invest in the bank.

The issue with Monte dei Paschi is that there is an argument either way.  On 29 July 2016, the European Banking Authority (EBA) ran stress tests on 51 major banks and found Monte dei Paschi to be in the worst shape.  The EBA requested Monte dei Paschi recapitalise, in other words raise more money from investors or remove loans from its balance sheet.  Eight months later they have failed to do either and so the bank has turned to the Italian government for support.

The proposal put forward involves the Italian government providing “temporary” funding to Monte dei Paschi.  The proposal’s architects are suggesting that it is does breach the rules prohibiting bailouts on the basis that Monte dei Paschi is still solvent, and as such, subject to certain conditions, the Italian government may be able to provide capital.  In this case the proposal is that a “precautionary recapitalisation” is undertaken, which is allowable but not to absorb past losses and subject to the European Commission’s right to insist upon private investors’ funds being bailed in first.

To date the European Commission has been firm on the requirement that junior bondholders (hybrid investors) share the burden.  Extraordinarily however, the current proposal involves senior bondholders to bear most of the losses with the hybrid investors being compensated, justified by a claim that they were victims of “false marketing”. 

End result – More instability for the EU

This extraordinary proposal from the Italian government clearly shows that the bailout is entirely politically motivated.  If approved, this is going to be a major test for the credibility of the EU’s new banking regulations and the EU itself.  If not approved, and hybrid investors are forced to take major losses before a government bailout, the Five Star Movement will have a stronger case for its election later this year or next, potentially threatening the stability of the EU itself.