European Banking: Where Taxpayer Money Goes to Die

Since last year, I have been telling my readers that a resolution of Europe’s banking woes was coming and that it would be one set of rules for Italy and another set of rules for the rest of the EU. Now, finally, we hear it is.

Three European banks were wound up in the past two weeks after months of failed attempts to recapitalize them. Spain’s Banco Popular followed the new European bank bail-in procedure established under the European Bank Resolution Mechanism, the EBRD. Banco Popular wiped out the holders of its most risky securities, including equity and unsecured bonds. What was left of the bank, good assets and bad, was sold off to Santander for €1, a process that took place without a glitch. Taxpayers contributed nothing.

Not so for Italy. Veneto Banca and Banca Populare di Vicenza, two banks large enough to be supervised by the European Central Bank, failed last week. Italy passed a decree that will sell the good parts of the two banks to Intesa, Italy’s second-largest and best-capitalized bank. Intesa said it was willing to buy the best assets for a token price of €1 as long as the government assumed responsibility for liquidating the banks’ large portfolio of sour loans.

The result? Italy said it would commit as much as €17 billion in taxpayer funds to clean up the two failed banks. The European Commission, in a separate statement, said it approved the plan. Just like that, Italy killed the European banking union and any credibility it might have had. The bailout has made a mockery of Europe’s new EBRD.

The rest of Europe is infuriated. Unlike the recent bail-in of Popular in which unsecured liabilities were wiped out, losing billions, the proposed Italian bail out ensures that creditors including junior bondholders will be totally refunded. The reason is authorities feared any punishment of bank creditors would generate an Italian bank run that could sink the entire financial system given how many zombie banks there are.

The Italian bail out is more significant that it might seem. The decision to create a banking union was the decisive moment in the euro zone’s response to the global financial crisis. The establishment of common banking rules and oversight institutions was intended to help restore trust in a financial system badly shaken by concerns that weak national supervisors were colluding with banks and corrupt politicians to hide the full scale of bad debts from investors and taxpayers.

The EBRD was the centerpiece of a grand political bargain: By committing that they would not bail out weak banks, the over-indebted governments agreed to the discipline that Germany and the European Central Bank required in order to begin buying government bonds. The critical issue was to establish a set of rules ensuring that no taxpayer money is used to bail out banks and that losses fall on private-sector creditors.

There is a bigger EU banking crisis on the way and we now have no idea how it will be resolved. My guess is that Germany will refuse to have any stake in preserving the stability of the system outside its own country. And that means the capital flight from southern Europe to Germany will continue.