Economic Nationalism and Bank Resolution in Italy

JCMS | 13 February 2020

Is economic nationalism still alive when it comes to banking in the EU, and if so, what drives it? How have EU institutions responded so far? And in the process, do the Commission and the Single Resolution Board (SRB) have flexibility on the enforcement of bank resolution rules and can these rules be actually broken within Banking Union? The answers to these questions shed light on the question of how strongly Banking Union has fulfilled its purpose. In this article, we provide a detailed legal analysis of the decision-making process in the treatment of three Italian banks with regard to resolution and recapitalization. And we get to the reasons why the actors would do this. The article has insights not only about when we should expect compliance with EU law or not, but why EU institutions sometimes let it happen. These have broader implications for how we see the EU as an entity, and Banking Union as a component of the EU’s broader financial stability architecture.

We show in this article that governments can act in economic nationalist ways to protect their own national variety of financial capitalism, particularly where banks are fragile due to increased reliance on market-based funding (Hardie & Howarth 2013), and where voters would be broadly harmed by applying EU law. In Italy, this is the case. The financial system is made more fragile through the introduction of increased bank reliance on market instruments for funding, while society is made more broadly vulnerable as depositors transform into creditors to banks. Economic nationalism is less about national ownership and national champions per se, and more about broad protection of the public, and institutional features that protect insiders and make an investment by outsiders unattractive. We show that where EU law can only be applied with widespread social harm, national governments will seek to break EU law, and both the Commission and Single Resolution Board will give them room to do so. Looking at Monte dei Paschi, Veneto and Vicenza banks, we examine decisions to provide state financial assistance to banks, and the terms of resolution, as proposed by the Italian government and accepted by the Commission and Single Resolution Board.

During the Global Financial Crisis of 2008, EU governments had to tackle the issue of too-big-to-fail (TBTF) banks that left taxpayers on the hook, whilst later on during the Eurozone Crisis that followed, a decade of austerity was introduced, in some countries more vicious than others, as governments sought to repay what they had borrowed to prop up their financial sectors.

Setting up a European Banking Union was envisaged as the necessary reform that would establish market discipline in the financial sector and break the negative feedback loop between insolvent banks and fiscally fragile national governments that were weak to support them. Banking Union relies on crisis prevention and management. Strong bank supervision, managed by the European Central Bank (ECB), focuses on prevention, whilst bank resolution, coupled with restrictions on state aid, focuses on crisis management, and is the focus of this article.

The Bank Recovery and Resolution Directive (BRRD) stipulates that when banks are ‘failing or likely to fail’ (FOLTF), the SRB has to decide whether to resolve a bank on public interest grounds or else send it to national liquidation. In resolution, shareholders are expected to be wiped out and creditors’ bonds to be converted to equity and written-down accordingly (‘bail-in’). Only once bail-in has occurred to a certain extent – at least up to 8% of a bank’s total liabilities and own funds – may collective industry funds be used, namely the Single Resolution Fund and national Deposit Guarantee Schemes. Beyond these collective financing arrangements, governments can also offer extraordinary financial support (resolution aid). However, when liquidation is suggested by the SRB, national authorities can illustrate higher flexibility when dealing with a failing bank by providing state aid in the form of liquidation aid. Moreover, state aid can be provided even prior to the FOLTF assessment, when a solvent bank has been identified with a capital shortfall during the ECB’s stress tests, and state aid is required to recapitalize a bank (‘precautionary recapitalization’). Resolution, liquidation, and precautionary recapitalization are the three alternatives to dealing with banking crises according to the BRRD.

By illustrating the enforcement of the BRRD in Italy, we show that a unique variety of financial capitalism exists that makes it politically impossible to apply the BRRD given its current architecture. Italian households are much more likely to be bondholders in their local banks, placing most of their savings in hybrid and debt instruments rather than savings accounts. This means that they are doubly vulnerable to bank insolvency: unprotected by deposit insurance; and exposed to the threat of having their savings wiped out by a bail-in before a problem bank can be assisted by the Italian government. These observations are added to the existing literature on varieties of capitalism.

We also show that this feature of Italian capitalism forces economic nationalism on the part of government. Faced with the prospect of financially devastating Italian households to comply with the bail-in requirements of the BRRD, the Italian government chose to provide state assistance to banks outside the bank resolution framework, and negotiate approval from the European Commission. Our article provides a detailed legal analysis, coupled with a review of the motivations of various participants in the resolution of Italian regional banks, and most notably that of the two Veneto banks in June 2017, to demonstrate that the Commission not only bent the law in order to help the Italian government out of a sticky situation, but that it actually broke it. In fact, it can be argued that Single Resolution Board by sending the Veneto banks into national liquidation opened up the way – consciously or not – for the Italian government to implement its own strategies which provided much more scope for state aid.

This article has implications for the study of varieties of capitalism, particularly varieties of financial capitalism, for the links between those varieties and economic nationalism, for the implementation of EU law and regulation, and for the development of financial stability in the EU (and institutions more broadly) in the face of national resistance. It points in particular to loopholes in the Single Resolution System as the system that provides the rules and standard operating procedures required to close down insolvent banks in an orderly fashion in a future crisis. Beyond the material provided here, the findings also speak to the continued strength of intergovernmental tendencies in EU politics, even as the EU attempts to develop strong institutions in time of crisis.

Read the full article.