As Italy's oldest bank looks destined for state rescue, analysts said Italy would do well to clean up its entire banking system at the same time.
Shares in Banca Monte dei Paschi di Siena SpA plunged more than 14% in between a series of suspensions the afternoon of Dec. 9, eventually closing down just over 10.5%, after reports that the ECB's Single Supervisory Mechanism had rejected the lender's request to extend the timeline for its €5 billion recapitalization plan. JPMorgan and Mediobanca, which have advised Monte dei Paschi on its restructuring plan, were said to be meeting at the Italian treasury with CEO Marco Morelli to establish the framework of a bailout to be launched over the weekend.
A spokesman for Monte dei Paschi told S&P Global Market Intelligence that the bank was working with the Italian government on a rescue package and that details would be made public in due course.
Given the power vacuum in Italy after Prime Minister Matteo Renzi submitted his resignation Dec. 7, a U.K. bond analyst said he was "very surprised by the timing of the ECB rejection." But despite the uncertainty, he said in an interview, Italy should take the opportunity to clean up the entire banking sector, which is burdened by some €360 billion in bad loans.
"If Italy does not make this a trigger for setting up a real bad bank structure, whether funded by a one-off increase in deficit or the European Stability Mechanism, it would be yet another missed opportunity to address the cancer of sick banks," said the analyst, who asked not to be named. "But there is no government."
The analyst speculated that the ECB's decision a day earlier to reduce the monthly volume of purchases under its quantitative easing program may not be unconnected with Italy's problems.
Referring to ECB President Mario Draghi, he said: "Do I see some tactics by Super Mario in announcing the trim on QE so that he can get the dogmatic Germans to allow for some proper state aid in sorting out the banks problem?"
A state-backed bank recapitalization without winding down the recipient can be done under special circumstances described in Article 32 of Europe's Bank Recovery and Resolution Directive, a Paris-based bond analyst observed, also asking not to be named. The BRRD, which came into force at the start of 2016 and requires stock and bond holders to share in the losses when a bank collapses, has yet to be applied, making Monte dei Paschi potentially the first to be subjected to its provisions.
"Article 32 is basically untested," the analyst said in an interview. "We have not had a resolution since BRRD was implemented."
He said the Italian public would welcome a decisive initiative to clean up the banking system, but noted that there are questions over the political leadership that is necessary to carry out the process.
"At the end of the day, when financial stability is at stake, I'd expect the government to do its duty and step in," the analyst said. "My uncertainty is about what Renzi will do. Officially Renzi has resigned but he remains a caretaker. When you are just a caretaker, do you feel empowered to undertake dramatic measures?"
Both analysts said junior bondholders will suffer losses in any rescue but that senior debt will likely remain intact.
"For it to be palatable to the European Commission, the Italian government would have to show that there is some burden-sharing on the part of the debt holders," said the French analyst, who noted that a debt-to-equity offer carried out at the end of November was itself a form of burden-sharing.
The amount of debt to be written off depends on the structure of the bailout, the U.K.-based analyst said, adding that the essential condition of any bailout package would most likely be enforced conversion to shares of upper Tier 2 and Tier 2 bonds, convertible FRESH bonds and no-recovery Tier 1 bonds issued by Monte dei Paschi. The situation also remains uncertain for retail bondholders, which hold a reported €2 billion of Monte dei Paschi's subordinated debt, but who the analyst said could not be separated from institutional holders at this stage.
"[Retail bondholders] will have to be addressed by a separately set-up distressed fund," he said, while observing that a similar fund for retail bondholders in four smaller lenders rescued in November 2015 "seems to have compensated very few people if any at all."
The sale of bank bonds, and in some cases shares, to retail investors has been highly politically sensitive in Italy since the 2015 rescues cost many people much of their life savings, and led one elderly saver to take his own life. The leader of the opposition Five Star Movement, Beppe Grillo, wrote on his blog Dec. 9 that "Monte dei Paschi can only be saved by state aid" and that Italy would have to take the risk of EU sanctions to avoid bailing in small investors, something that would have "disastrous, almost apocalyptic [consequences] given the size of MPS."