Key Points

The Italian bank Monte dei Paschi di Siena (MPS) is expected to fail the 2016 EU-wide stress test conducted by the European Banking Authority (EBA), whose results are due to be presented Friday, 29 July 2016. When taking a closer look at the bank, it becomes apparent that the bank has so far failed or nearly failed all the EU-wide supervisory exercises that have been undertaken in the past six years. Almost every time the bank has managed to raise just enough capital, including public funds already contributed twice by the Italian government, to close the capital shortfalls or meet the threshold. This allowed the bank to live on the edge, which is costly to society. Supervisory, resolution and competition authorities should therefore discourage banks from following in MPS’ path of doing the minimum required, by imposing extensive recapitalisation requirements with a proper resolution.

Policy Recommendations

• Supervisors should subject banks that perform poorly in several consecutive supervisory exercises to additional scrutiny.

• The stress test is unlikely to be very helpful in the case of MPS since it looks at the impact of an adverse scenario on earnings, and not the true value of existing non-performing loans, which constitute the real issue. Accordingly, the supervisor should use its discretionary powers to undertake a detailed assessment to determine the current market value of the bank’s loan book.

• Bail-in of retail investors in subordinated debt also seems feasible since most of the instruments are held by the wealthiest families. Moreover, in the event that the instruments were mis-sold, the government could compensate them. The conduct-of-business supervisors should closely follow the sales practices of bail-inable instruments to avoid further mis-selling and ensure that banks now inform their clients, take the risk-profile into account and diversify their portfolios.

• The supervisory, resolution and competition authorities should impose the standard procedure as foreseen in the resolution scheme with bail-in to cover the losses and arrange the recapitalisation. If the resolution authority faces some obstacles in the execution of the bail-in, it could use its discretionary powers to prioritise certain creditors.

• The authorities should use their experience to correct the weaknesses in the resolution framework (e.g. cross-holding of bail-in instruments, exclusion of politically sensitive exposures), improve ongoing work (e.g. recovery and resolution plans, setting MREL-levels) and prepare for future resolution cases (e.g. sufficiently high recapitalisation).

Willem Pieter De Groen is Research Fellow in the Economy and Finance research units at CEPS.