If Italy won’t accept bail-ins for its failing banks, how can the euro work at all?

In the financial crisis of 2007-2009, a central flaw in the West’s financial capitalist system was exposed. Since the Continental Illinois bank failure of 1984, no bondholder or depositor in any significant Western bank had been permitted to lose money when banks become financially distressed. That meant that lending to a bank was a one-way bet: you got higher returns than on government bonds or other risk-free investments in the good times, and if anything went wrong the state bailed you out.

Banks responded exactly in the ways economic theory would have predicted. They took on more and more debt and less and less equity as a proportion of their total balance sheets; they engaged in riskier and riskier activities (increasing their returns); and they grew larger and larger, funded by the debt. This process continued, exactly as economic theory would have predicted it would, until the point at which banks were so large, relative to economies, that bailing them out risked bankrupting governments.

That was bad enough when it concerned countries such as the US and UK. But in the Eurozone it created a whole extra world of pain, because if a Eurozone government went bust it risked being unable to borrow in financial markets and thus being forced to print money to fund day-to-day spending. But governments could only print new money if they left the euro. And if some countries started leaving the euro, others might quickly follow.

So in the euro area, when banks went bust, governments in countries such as Ireland and Cyprus bankrupted themselves, bailing out their banks, leading to those governments being bailed out in turn by other Eurozone states.

That meant that, no matter how well governments had controlled their spending and debt levels (and Ireland, for example, had had a very good record in that during its time in the euro), if they were allowed to bail out their banks they could blackmail other Eurozone members into bailing them out in turn.

Consequently, as part of its reforms to try to prevent a repeat of the 2007-09 financial crisis and subsequent Eurozone crisis, probably the single most important measure the European Union has introduced was the 2014 Bank Recovery and Resolution Directive (BRRD). This mandated that not bank could be bailed out by a state until the bank’s creditors had taken a hit first – the so-called “bail-in” principle.

That is a perfectly sensible idea. If I lend money to a chip shop and it goes bust, I will own a chip shop. If I lend money to a bank (e.g. by buying its bonds or giving it the sort of loan we call a “deposit”) and the bank goes bust, I should own a bank. Without that principle, the EU cannot function. The principle was first deployed in any full-blooded way during the Cypriot financial crisis, where bank depositors and bondholders were forced to take large losses (actually quite a lot higher losses than they would have had under a fully market system).

The big test, though, was always going to come when a bank in a large member state failed. Would France or Germany or Italy accept for themselves the principles they have forced on smaller member states? If they won’t – if euro members can extort bailouts from other euro member governments by bankrupting themselves standing behind their banks – the euro really cannot function.

It appears the answer is: No. The Italian Parliament has today voted to establish a bailout fund of €20 billion to bail out Banca Monte dei Paschi di Siena, following its failed private sector rescue attempt, along with other banks.

Some estimates suggest that’s just the start, with perhaps another €40 billion required quickly and maybe more to follow later. With Italian government debt already well over 130 per cent of GDP, with the traditional threshold for governments being near-certain to default lying at 120 per cent, added burdens from the banks place it in a truly bleak position.

Perhaps there will be bail-ins yet – the final details are still not completely clear – but the Italian government has stated publicly that no Italian saver will lose any money which is flat incompatible with the bail-in principles of the BRRD because the vast majority of debts that would be bailed in are held by domestic Italian retail investors.

If Italy is simply going to flout the central rules introduced to prevent a repeat of the Eurozone crisis, how can the euro function? What do Cypriots think of this one-rule-for-the-big another-for-the-small principle? If Italy won’t accept bail-ins, will Germany if its financial institutions become more distressed? How can any of the central financial architecture of the euro function at all? We may be about to find out.