At first, deny, deny, deny. Then taxpayers get to bail out bondholders.

By Don Quijones, Spain & Mexico, editor at WOLF STREET .

Spain’s Banco Popular had the dubious honor of being the first financial institution to be resolved under the EU’s Bank Recovery and Resolution Directive, passed in January 2016. As a result, shareholders and subordinate bondholders were “bailed in” before the bank was sold to Santander for the princely sum of one euro.

At first the operation was proclaimed a roaring success. As European banking crises go, this was an orderly one, reported The Economist. Taxpayers were not left on the hook, as long as you ignore the €5 billion of deferred tax credits Santander obtained from the operation. Depositors and senior bondholders were spared any of the fallout.

But it may not last for long, for the chances of a similar approach being adopted to Italy’s banking crisis appear to be razor slim. The ECB has already awarded Italy’s Monte dei Paschi di Siena (MPS) a last-minute reprieve, on the grounds that while it did not pass certain parts of the ECB’s last stress test, the bank is perfectly solvent, albeit with serious liquidity problems.

By contrast, Popular was also liquidity challenged but, unlike MPS, it passed all parts of the ECB’s 2016 stress test, which shows you how ineffectual these tests are — and how subjective the resolution process of a European bank can be.

In a speech to the Italian Banking Association on Thursday, the Vice President of the ECB, Vítor Constâncio, suggested that under certain circumstances, it might be wiser to save a bank than to resolve it. What’s more, taxpayers should be called upon not only to save banks like MPS but also to make whole all holders of the bank’s subordinate debt, under the pretext that they were misled into purchasing them (as indeed some retail customers, but certainly not all, were).

A taxpayer-funded bailout of bondholders is also on the cards for the two mid-sized Veneto-based banks, Banca Popolare di Vicenza and Veneto Banca, which have already received billions of euros in taxpayer assistance. Italy’s Minister of Economy Pier Carlo Padoan continues to insist the two banks will not be wound down. This is the same man who insisted last year that a) there would be no need of any future bail outs; and b) Italy did not even have a banking problem on its hands.

Padoan has no choice but to deny all rumors of a bail-in; otherwise there would be a massive rush for the exits. In the weeks and even days leading up to Popular’s collapse, Spain’s Economy Minister Luis de Guindos repeatedly reassured investors that the bank was perfectly safe and solvent. All the while government agencies, including Spain’s social security fund, and regional government authorities were emptying the deposits they held with the bank as fast as they could. The total is unknown but it certain ran into billions of euros.

To avoid a similar fate, Banca Popolare di Vicenza and Veneto Banca were instructed by the European Commission last week to find an additional €1.25 billion in private capital. That money still hasn’t arrived, and now Italy’s government is trying to persuade the European Commission and the ECB to water down the requirement to €600-800 million, while also urging Italian banks to chip in to the bank rescue fund. If they don’t and the two Veneto-based banks end up being wound down, they will have to cough up as much as €11 billion to refund the banks’ depositors.

If the money is found in time, another bailout will proceed with the ECB’s full blessing. As Constâncio reassured Italy’s senior bankers, the ECB’s rules on bank resolution allow for precautionary recapitalization of banks by the public sector in cases of significant financial stability concerns. “We have to bear in mind that it is not only direct public support for banks that has a cost for taxpayers, but also financial instability – indeed, the costs of the latter may, in some circumstances, be higher,” he said, invoking unpleasant memories of the global fallout from the collapse of Lehman Brothers.

As Constâncio well knows, in Italy financial stability concerns are off the charts. So chronic and widespread are the banking sector’s structural problems that there is a very real risk that bailing in one or two midsize banks could prompt depositors and investors to move funds from weak banks to stronger ones (including banks outside the country), accelerating liquidity stress and even bank runs.

Even in Spain, which already restructured its banking sector years ago at a total cost to taxpayers of around €300 billion (including government guarantees), it didn’t take long for contagion to spread after Popular’s collapse. The most affected bank was Liberbank, Spain’s eighth largest lender, whose shares collapsed by a third in the three days following the bail-in of Popular. By Monday morning Spain’s stock market regulator, the CNMV, was sufficiently spooked to institute a one-month ban on shorting the bank’s shares, which, at least for now, seems to have stalled the rout.

In Italy, the contagion from a banking crisis would be a lot more difficult to contain. That’s the main reason why MPS was given such a generous stay of execution. If Banca Popolare di Vicenza and Veneto Banca are also bailed out with public funds, the message from the ECB will be resoundingly clear: banks will not be wound down if the banking system they operate in is deeply unstable. It’s a whole new variant of moral hazard: as long as the banking system is in terrible shape, the bank investors will be bailed out with public money. By Don Quijones.

Liberbank’s stockholders and junior bondholders fear a “bail-in.” Read… Is Another Spanish Bank about to Bite the Dust?

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