How Italy Checkmates the European Union

July 11 2016

Gold investors tend to fear “bail-in” laws for banks, but it seems Italy cannot avoid a “bail-in” for its bankrupt banking system. Last month, I showed how delinquency rates are moving up in the Eurozone. However, most delinquencies are concentrated in the country of Italian prime minister Matteo Renzi. Matteo Renzi complained about the European bail-in law. And why wouldn’t anyone want to make an exception for the Italians? We will see that the concept of a bail-in is perfectly fine, but Renzi does not want a bail-in and has substantial leverage in negotiating a bailout of the bankrupt Italian banking system because of Brexit.

Why Are Gold Investors Averse to Bail-ins?

What is a bail-in? A bail-in procedure is pretty straightforward: banks can become insolvent. That means a bank’s debt exceeds the total value of its assets. In other words, it means a bank’s shareholder equity goes negative.

The issue at stake is that the European Central Bank, whatever it decides to do, cannot fix insolvency in the short run. They are powerless when it comes to solvency.

The European Central Bank, as “lender of last resort”, can at most provide liquidity, but it can change very little about a bank’s solvency. By providing liquidity it can prevent a “death spiral,” in which banks, in order to raise liquidity, are forced to sell off assets against fire sale prices, impairing their solvency. But when solvency is a fact, little remains that Draghi and his team are capable of doing.

Three options remain:

  • The market recapitalizes the bank;
  • The government recapitalizes the bank;
  • The bank enters into bankruptcy/a bail-in occurs.

The first option can be ruled out almost entirely. The bank can issue new shares and strengthen its capital. But a bank which has a delinquency rate of over 20% (which simply means that over 20% of its borrowers stopped paying), is shunned by investors for very good reason. In such situations, it will be a tough thing to raise capital from the financial markets to recapitalize the bank.

The second option is what happened on a massive scale in the midst of the 2008 recession. Not only the Dutch government defaulted to this option, with its bailout to ING Bank, but other governments followed exactly the same path. Bailouts are not popular among the electorate, of course, and for good reason. It means bank losses are covered by the tax payer. “Bad banks” are being rewarded for their reckless behavior. Capitalism, some say, is about profits and losses. But in the case of the banking crisis of 2008, governments appear to have forgotten the latter. Whereas normally badly managed companies go bankrupt and their assets are taken over by well managed or new companies, “bad banks” are artificially propped up and kept in live. “Zombie banks,” the Japanese call them. It readily explains why economic growth came to a screeching halt at the other side of the Pacific Ocean.

The third option sounds as something new to many people. European “bail-in” laws were first applied in Cyprus, when the small island suffered a severe banking crisis. Curiously, laymen view bail-in’s as an invention by European bureaucrats, while in essence it differs little from common bankruptcy procedures. It is a first attempt to simply apply the rules that already apply to everybody else to banks. Shareholders lose everything. Bondholders (long-term debt) generally incur a “haircut” and are converted into shareholders (equity for bonds). And accountholders, who also hold a claim against the bank, usually get off lightly with relatively little damage. Depending on the value of the assets, in some cases depositors or accountholders have to take a partial loss on their holdings.

The advantages of a bail-in are evident. Sometimes the parts have to be sacrificed to make the whole stronger. Sometimes trees have to go up in smoke to make the forest stronger. Sometimes shareholders, bondholders and accountholders of a specific bank have to lose money to make the entire banking sector more robust. If we would socialize losses in every industry (that is, spread them over the entire society), then our society is bound to collapse. It would be capitalism without losses, or “Christianity without Hell.”

Why then do gold investors find so much fault in bail-ins?

The government, after all, guarantees (up to a certain level) bank deposits through deposit insurance. And the idea that precious metals investors, who are indiscriminately sceptic about banks, also own shares in J.P. Morgan or Deutsche Bank seems contradictory.

The only reason that gold investors should be against bail-ins, is that the concept is fundamentally sound. It makes an economy stronger, not weaker. And gold in particular has much to gain from a fragile economy, rather than a robust economy.

The fact remains, however, that bail-ins are not popular among the general electorate, which includes the Italian electorate.

While prime minister Matteo Renzi is feeling the hot breath of the opposition parties in his neck, especially the breath of Beppe Grillo’s Eurosceptic party M5S, the last thing he wants is a bail-in. And so Matteo Renzi calls for a “suspension” or exception to the recently drafted bail-in law, which has been enacted by our very own Jeroen Dijsselbloem. Renzi does not want a bail-in, Renzi wants a bailout. He wants to recapitalize Italian banks with government money, preferably from other countries than Italy.

Renzi has quite some negotiation power. If Merkel and her friends decline to cooperate, while they are still recovering from the Brexit hangover, then Renzi will threaten with the prospect of an Italian EU-referendum: “Italeave” is the term many journalists began to use to their own amusement. And if Renzi will not sabotage Merkel with the prospect of an Italian EU-referendum, then certainly Beppe Grillo will step in to do it. Renzi will try to convince his fellow European leaders that a bail-in would only put Beppe Grillo into power at the next Italian elections. In the polls the M5S party of Beppe Grillo is already Italy’s biggest political party. And the next Italian elections might be sooner than expected. If in October voters do not rectify the constitutional changes proposed by Renzi in yet another referendum, then the Italian prime minister will step down and resign, making way for Beppe Grillo.

Matteo Renzi is using Brexit to opt out of the European bail-in laws. He does not want to have visible losers, but rather spread the cost of Italy’s bad banks over the entire society. A politician has no reason to consider the long run when his term lasts only a few years or perhaps even a few months.

Surprisingly, nobody is pricing in this “Brexit-risk” in Italian government bonds. Italian rates went down across the entire yield curve after the British decided to turn their backs to the European Union.

In the face of the next bank stress test later this month (July 31), the battle between European legislators and Matteo Renzi will reach a climax. The Italian banking sector cannot bear much longer. And Renzi is ready to ignore European bail-in legislation and recapitalize the Italian banking sector on his own with taxpayers’ money.

By doing so, he will make the Italian economy and banking sector more fragile, not more robust. But perhaps he is able to last longer in office than until next October and save his political career, which is of course his number one priority. “Rent-seeking,” public choice economists would call it. Matteo Renzi might cause a premature end to the European banking union in trying to avoid political suicide by dodging the European bail-in law.

Newsletter

Sign up for our periodical newsletter to stay informed about the gold and silver markets and special offers.