Winston Churchill famously said that America can be counted on to do the right thing once all other options are exhausted. These days, this condition must surely apply to the Eurozone as well. In contrast to the United States, the Eurozone and ECB have, at the behest of who-know-you, enacted strict rules which forbid member nations from bailing out failing banks. This policy may have great populist appeal, but it is yet another economic straight jacket which will crush any chance of recovery in Italy, the third largest economy in the Eurozone.
By its very nature, banking is a risky business. Because the process of maturity transformation entails issuing short term liabilities to fund longer term investments, banks always need access to the credit markets. Banks typically fund themselves in via their depositor base, the wholesale funding markets, and bond sales. In the United States, as in Italy, deposits are guaranteed by the state. However, the credibility of the Italian deposit insurance scheme is somewhat reduced because Italy cannot print Euros while the United States can print dollars. In both countries however, investors in the wholesale funding markets and bank bonds are receive no government protection.
For this reason, the withdrawal of even a single large investor from the market can cause panic. In the short run, a bank's ability to pay off its creditors is based solely its ability to access the funding markets, no matter how sound its books are. This is because a banks loans are long term and illiquid and its liabilities come due in the short term or even on demand. Even if a bank is completely solvent, the belief by a few or even only one of its creditors that it is insolvent can result in all of its investors withdrawing credit as it becomes unclear if the bank can roll over its borrowings.
When only a single bank that is in trouble, its usually okay to allow nature to take its course. However, during systemic crises, when the failure of one firm will spook markets into believing that all firms are on the brink, government must intervene to stop panic from spreading. In the United States, this is exactly what the government did despite several mistake along the way. There is now wide consensus that placing Washington Mutual into receivership of the FDIC in 2008, which proceeded to haircut the bank's unsecured creditors, accelerated the crisis by causing markets to panic. This forced the government to act more aggressively than it otherwise would have to make sure that solvent firms like Wells Fargo or JP Morgan retained market access.
This brings us to the situation in Italy. The Italian banking system is in crisis. A staggering 18 percent of its loans are non-performing. The Italian government wants to proceed with a 40 billion Euro bail out, but that would require the suspension the aforementioned Eurozone rules. Germany, for its part, favors a so called bail in, whereby unsecured creditors, possibly even retail depositors, would receive haircuts in exchange for an equity stake in the bank. Theoretically, this imposes so called 'market discipline' and avoids moral hazard. However, here is where it must be stressed that it only takes the belief of a few creditors of solvent bank that it is insolvent to force a liquidation during a crisis. Furthermore, a fire sale of the assets of a few failed banks will depress the economic value of all bank assets, which would only accelerate the crisis. With the situation this perilous, a bail-in will result in a full blown financial crisis and bank run in Italy. This would ultimately force the government to take over all the banks. A bail-in will only ensure a massive bail out.
Finally, the only reason the Italian government has the capacity to act is that it already receiving the implicit aid from the European Central Bank, which has more of less pledged to keep Italian bond yields from rising. If Italy defied EU rules and went ahead and raised 40 billion Euros on the capital markets to bail out its banking sector, its unclear how the ECB would respond. It may cut off both the Italian state and emergency liquidity assistance to the Italian banks. This would essentially force Italy to supply its own liquidity by exiting the Eurozone. Let's hope Brexit wasn't the calm before the storm.
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