LONDON (Reuters Breakingviews) - Rome and Brussels will have to get tough if they want to save Monte dei Paschi. The Sienese lender has been a serial pest on the European regulatory scene for almost a decade. Italy is devising increasingly quixotic attempts to prevent small investors in the bank from taking losses. Realism is needed.

The main entrance of the Monte dei Paschi bank headquarters is seen in Siena, Italy, March 13, 2012. REUTERS/Max Rossi/File photo - RTSSRBS

Rome’s problem is that the recent “no” vote in a national referendum on constitutional reform has upended plans to find 5 billion euros of private investment to plug MPS’s capital hole. Over half of the 3.3 billion euros of subordinated bonds outstanding, which are the ones that would be wiped out first, are held by retail investors. This group could cause a political stink. Even if those were written down in full or swapped for shares, the bank would still need 700 million euros of new cash.

Italy has tried a host of workarounds. Earlier this year it asked healthier domestic banks to pay into a fund called Atlas that would take stakes in weaker banks. That merely undermined the system, and was in any case inadequately sized to tackle MPS. Following the referendum, options include a loophole in European Union fine print that might let it suspend bail-in rules, or using 2 billion euros of state money to buy retail investors’ bonds for cash.

European regulators might cave in. They could convince themselves that using public money to bail out a special interest group is okay if done at market prices. Meanwhile the European Central Bank, which directly supervises MPS, could grant a request submitted by the bank on Dec. 7 to give the bank more time to raise capital. Private investors might then come through after all.

Bailing out the retail creditors would be a poor outcome, though. It only works with very optimistic assumptions of MPS’s future value. Otherwise, everyone else ends up with less than is fair - or nothing. The retail-held bonds have a face value of 2 billion euros, but were trading at little more than half that as of Dec. 9.

MPS reckons its tangible book value following its restructuring would be 9.1 billion euros. If the bank could fetch a market capitalisation of half that, there would be 4.6 billion euros to share out between various investors. Take off a further 2 billion euros for the retail investors, and a further 1 billion euros already pledged to bondholders who exchanged their paper in an earlier offer. What’s left is 1.6 billion euros.

That value would have to be shared between 1.3 billion euros of MPS’s remaining junior debt holders and the providers of 700 million euros of new cash. What’s more, the new investors would demand a steep premium in return for helping MPS out of a hole. There would therefore be little or even nothing for the non-retail bondholders. And if MPS doesn’t trade at 50 percent of its book value but 40 percent instead, providers of new cash would actually end up worse off.

Imposing losses on retail investors could undermine the popularity of the European project at a febrile time. But the political impact might be overstated. Over 85 percent of Italian bail-in instruments are held by the wealthiest 10 percent of domestic households, according to the Centre for European Policy Studies. If bonds were mis-sold, compensation could be added as needed - as happened in the case of Spanish lender Bankia.

If Rome does bail out the small investors, it will send a terrible signal. Troubled banks around Europe would call for taxpayers’ money rather than inflict losses on investors. First among them would be other Italian banks. Collectively they might need 20 billion euros in capital in order to be shored up against bad debts if the economy deteriorates, according to Mediobanca analysts.

There’s one other potential way to sort Italian banks - a mooted 15-billion-euro loan from the European Stability Mechanism, the euro zone’s bank recap pot. That’s the equivalent of shock and awe. Europe would impose tough terms, as it did in Spain, Portugal, Greece and Ireland. It would decimate the government’s popularity, and probably hand power to the anti-establishment 5-Star movement at looming government elections. That ought to leave Rome in little doubt over the best course of action.

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