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Italy bank bailout may strain Europe's bail-in rules in first big test

Barelyhalf a year after Europe brought in a law meant to bail in bondholders if banksran into trouble, Italy wants to pump tens of billions of euros of public moneyinto its troubled lenders in a move which some analysts say could cast doubtover one of the fundamental pillars of European banking union.

Executive Board MemberBenoît Cœuré has warned that if Italy goes ahead with Prime Minister MatteoRenzi's plan to inject €40billion into banks it would be "the end of banking union as weknow it." Central to this union is the Bank Recovery and ResolutionDirective, which became operative at the beginning of 2016 and requires thatlenders only have access to public bailouts once creditors and shareholdershave borne losses equivalent to 8% of risk-weighted assets.

Newclasses of bonds have been created to meet the bail-in demands of BRRD andother similar global rules introduced since the financial crisis in order toensure no bank is too big to fail and to avoid costly public bail outs. Holdersof securities such as Additional Tier 1 bonds, who bought them assuming theyrisked being converted into equity or written off if the issuer breachedpre-specified minimum capital levels, will be watching the Italian case closelyfor indications as to whether governments might lack the will to enforce thetough new rules when push comes to shove.

"Youmake a lot of rules in peacetime and in wartime you suddenly bin them,"Michael Boye, a Saxo Bank bond trader, said in an interview. He added that AT1bond prices currently reflect some possibility of bail-in or suspension ofcoupon payments.

"Inthe [Additional] Tier 1 segment a lot of the valuation really hasn't beentested by events yet. So this is going to be a major input — how will thesubordinated debt of some of these Italian banks be treated?" he said.

Italyhas already overseen rescues of regional lenders and , butthese were carried out by its privately funded Atlante fund, depleting half ofits €5 billion in the process.

Thecountry's banks are struggling under the weight of about €367 billion of badloans, although on stricter definitions, this number falls to €196 billion,according to Scope Ratings. Taking into account provisions, net bad loans are€83 billion.

Despite the ECB warnings, the European Court of Justice islikely to rule later in July that countries in economic trouble can pump moneyinto banks if they fail stress tests, Reuters reported. European Banking Authority stress tests results are due onJuly 29.

Buta government-funded Italian bailout would be "contrary to the spirit ofthe banking union" and risk reigniting the feedback loop between sovereignand banking debt, Scope said, recommending instead that Italy increase the sizeof Atlante to buy NPLs.

Implementingbail-in procedures is complicated in Italy by the fact that about a third ofbanks' outstanding bonds are held by retail investors.

Monte dei Paschi

Inthe case of Banca Monte deiPaschi di Siena SpA, the world's oldest extant bank, nonperformingexposures are equivalent to 34% of RWAs. The ECB has told it to slash NPLs, butselling them would inflict losses at a time when its price-to-tangible bookratio is less than 10% — about a tenth of the rule-of-thumb price for a healthybank — meaning it would suffer capital losses with little possibility ofraising equity from the markets.

Meanwhilethe stress tests are set to highlight its capital weakness.

"It'sgoing to be one of those banks that are going to have a big dive in [commonequity Tier 1] capital," Sebastiano Pirro, a credit analyst at Londonhedge fund Algebris Investments, said.

Italy'sNPL problems are compounded by difficulties in recovering collateral pledgedagainst them, thanks to a slow court system. Smaller banks in particular struggleto muster resources to cope with the legal process, Pirro said.

Giventhat some of the banks that may be caught short, such as , are financially strongenough to be able to make up any capital deficit themselves, the Italiangovernment could effectively recapitalize its banks for as little as €20billion, the hedge fund analyst said. BRRD's bail-in requirements would not beundermined, Pirro added, because over-representation of retail investors inItalian bank bonds is a special case and the political and social cost ofbailing them in so great.

"Itmakes sense to avoid a very negative event for retail bondholders," hesaid.