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Monte Pasci di Siena Crisis: Bail-In or Bailout?

The 'Moral-Hazard' Debate

Background

In 2016, following a decade of substantial losses and rising non-performing loan volumes, the oldest Italian bank, Monte Pasci di Siena, failed the EU stress test highlighting an urgent need for additional equity capital. Given it’s financial distress, the bank was unable to attract additional equity from private investors, leaving support by the state as the only option if bankruptcy was to be avoided. 

However, EU regulations adopted after the financial crisis of 2007/08 do not allow for capital injections by the state (a so-called bailout of a bank) before private investors in the bank are included in the loss absorption (so-called bail-in). The intuition behind this rule anchored in the EU Banks Recovery and Resolution Directive (BRRD) is that taxpayers’ money should not be spent on bailing out banks before bank investors suffer at least part of the losses generated by a failing banks’ risky strategies. 

In the case of Monte Pasci di Siena, this implied that the Italian Government could only support the bank with fresh capital after private investors (those were mostly investors in subordinate bonds which were hybrid instruments combining bond and equity characteristics) suffer a loss. Since a substantial portion of Monte Pasci di Siena’s subordinate bonds were held by retail investors, the prospects of a bail-in were met by huge public protests. 

In December 2016 and driven partly by the public pressure to avoid any losses by retail investors, the Italian government and Bank of Italy designed a recapitalization scheme which formally complied with EU rules but still shielded retail investors. To do this, the subordinated bonds were converted into equity, thus officially applying BRRD rules. However, the market value of the equity resulting from the conversion would have been much lower than the nominal value of the original bonds. To avoid the resulting loss for retail investors, the subordinated bonds held by retail investors were instead effectively exchanged for senior bonds with little default risk. The Italian government then stepped in and bought the remaining equity shares so that the capital ratio of the bank could increased.

There has been plenty of debate in the last three years on the consequences of the above policy intervention for the effectiveness of the bail-in clause of BRRD. 

You are a financial expert working for the European Commission which has to review this policy intervention. You have been asked to prepare a 1,500 word report on the circumstances surrounding the Monte Pasci di Siena crisis.

Assignment Requirements: 

Prepare a word business report covering the following areas: 

a)Outline the so called ‘moral-hazard’ debate that led to the inclusion of a bail-in clause in the EU Bank Recovery and Resolution Directive.

b)Explain why the public protests were so effective and the Italian Government and Bank of Italy proceeded with the restructuring scheme described above. 

c)Discuss whether the recapitalization of Monte Pasci di Siena can be classified as a bail-in or rather as a bailout event.                                                                                                            

d)Discuss the impact of the applied recapitalization of Monte Pasci di Siena on the future of bank bail-ins. In summary, do you think the actions of the Italian Government and Bank of Italy were appropriate?

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