What Italy's banking crisis taught us: now is not the time to increase risk sharing 28 Jun 2017 12:33 Veli-Matti Mattila Italy's most recent banking crisis has roused sharp criticism against the functionality of EU's new resolution regime. At the same time it has served as a reminder of the wildly varying financial health of Member States' banking systems. Under these circumstances, increasing risk sharing in the Banking Union is completely unfeasible. In late June, Italy was forced to wind up two of its banks, Veneto Banca and Banca Popolare di Vicenza. Their combined balance sheets amount to over €60 billion. Italy's second-largest bank Intesa Sanpaolo will be acquiring the banks' remaining healthy operations at the nominal price of one euro. Their non-performing receivables will be transferred to a bad bank.Shareholders and junior bondholders will foot part of the expenses, in addition to which the Italian government – i.e. Italian taxpayers – will also be contributing an additional €17 billion. About €5 billion of this will be paid to Intesa, and the rest will be used to cover potential further losses. The final cost to taxpayers won't be known until years later. At least for now it is unlikely that banks' senior bondholders would be required to take part in financing the costs.The two crisis banks have been "failing or likely to fail" for some time already, and the Italian government has drawn up various plans to save them. Originally, the banks were meant to be recapitalised, but they failed to acquire a sufficient amount of new capital.The selected course of action ‒ winding up of the banks under Italy's national insolvency proceedings ‒ has been generally received with bewilderment. After all, the EU Bank Resolution and Recovery Directive (BRRD) was only just taken into use a few years ago. The Single Resolution Mechanism for all states in the Banking Union was also set in motion. If a bank runs into major difficulties, the primary course of action is to initialise resolution procedures, in which shareholders and bondholders will be the first to bear the losses. This is called bail-in, and the idea of the entire framework was that taxpayers' money would not be used.For the single resolution framework, the situation is worse. Its credibility has suffered a heavy blow.The course of action in itself is in accordance with EU regulations: if resolving the bank is not in public interest, then normal insolvency proceedings are a valid option. They can also be supplemented with public support under the EU State aid rules. There have, however, been many sceptical comments as to whether these conditions were genuinely met or whether the decision was partly political. It is general knowledge that the crisis banks' senior bondholders included a large number of retail investors. Had the banks been put into resolution instead of insolvency, these investors would have been required to contribute to the resolution financing. Now the outlook is better from their point of view. For EU's single resolution framework, the situation is worse. Its credibility has suffered a heavy blow.Regardless of the truth behind Italy's decisions, the situation gives food for thought to other Member States. Finland, for example, is also within the scope of single supervision and the Single Resolution Mechanism as a member of the Banking Union. The latter includes the Single Resolution Fund (SRF), into which Finnish banks also pay stability fees. The SRF's target level is about €55 billion, and its assets can be used to cover the costs of resolution if bail-in measures fall short.It set a worrying precedent, conveying the message that taxpayers' money may be used in future banking crises.For banks and their customers outside Italy it is, of course, positive that the problems of Italian banks are solved with Italian funds. This is in line with the principle that the Finnish financial sector insisted on the entire time the Banking Union was being built: each Member State must fix its banking system using its own funds before risk sharing can be increased. In Italy's case it would have been preferable to utilise bail-in to its full capacity, however. Now it set a worrying precedent, conveying the message that taxpayers' money can be used in future banking crises despite the new resolution regime.It is unlikely that the recent events in Italy are the last of their kind. We are already aware of new banks that will most likely soon require intervention from authorities. Even after that, there will be no shortage of problems, as the majority of banks in the entire Banking Union have not yet been subjected to comprehensive balance sheet assessment. When such an assessment was carried out by the ECB a few years ago, its scope only included about 130 banks, leaving out thousands of small banks. More unsurfaced problems may therefore be lying in wait in many other countries besides Italy.From Finland's viewpoint, the message should be obvious: the increase of risk sharing in the Banking Union should in no way be speeded up. In particular, this applies to the European Deposit Insurance Scheme (EDIS) proposed by the Commission in late 2015. Instead of building a common scheme, we should focus our efforts on ensuring that all EU Member States implement the decisions that have already been made on the harmonisation of national deposit insurance schemes.We should also hit the brakes in the negotiations concerning the permanent back-up funding arrangements of the SRF. Because the support paid from the SRF is reclaimed in full from the banks, it is important that full burden-sharing is not implemented until the EU banking sector's risks have been sufficiently reduced and the present problems of banks in Italy and other Member States solved by the States themselves.Increased risk sharing may only be reconsidered once it takes place on an equal footing and the resulting benefits and expenses are fairly shared.