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A visit from the Grinch or Christmas cheer?

21 December 2016 by Gary Kirk

As we come to the final throes of 2016 we have been giving some thought to events that may have the potential to derail the ‘Santa-rally’ that risk markets have enjoyed since the Trump victory last month.

The first of the potential road blocks is the finalisation of the settlement between the US DoJ and Deutsche Bank, surrounding the mis-management of the German lender’s US mortgage unit. We know that DB has balance sheet provisions of circa. €5.9bn and that market expectations are for a DoJ settlement in the range of $5-7bn; so even though an agreement of this magnitude would not be a welcome Christmas gift in the DB Frankfurt HQ we believe the market will act with indifference at such an announcement (and could even breathe a sigh of relief at seeing an end to the uncertainty).

However, for us the bigger uncertainty surrounds the Italian banking situation and the ongoing saga that is the recapitalisation of Monte Dei Paschi di Sienna (MPS). It is a well-known fact that MPS are in need of a €5bn capital injection and have until the year end, after which they will be under instruction from the ECB to bail-in creditors, including a significant number of domestic retail investors. The retail investor book for this equity raise closes today while the institutional investors have until tomorrow afternoon to subscribe, so we will soon know whether or not a messy bail-in process will be triggered. This of course would pose a number of challenges for the Italian government, which could potentially impact the wider Eurozone stability further down the road.

The market has understandably become more concerned about the longer term ramifications should MPS fail to raise the required €5bn this week. The Italian government are naturally concerned about the political fall-out from bailing in a swathe of retail investors, particularly after years of austerity measures; hence the government have requested approval from parliament to’ temporarily’ increase the nation’s public debt by €20bn in order to provide a backstop to the banking system (via public guarantees to restore short/medium-term lending ability). This precautionary funding could also be used “for capital-strengthening programs of banks within recapitalizations that include the sale of shares”, which we assume relates to the immediate support of MPS. If only it were that simple! Italy is part of the EU and therefore has to adhere to strict sovereign debt rules (and Italy currently runs a high Debt:GDP ratio of 133%) and strict rules which effectively curb state aid.

So it all looks a bit ominous should MPS fall short in attracting the required €5bn investment – or does it? Burden sharing requirements under the state aid regime are triggered if there is state aid. However, EU directives are drafted in a wonderfully unique manner, which invariably contain a considerable amount of wriggle-room and exceptions. Article 32 Section 4 D BRRD, is one such exception which permits public funds to be injected into banks without triggering a resolution. In summary, the article permits capital injection from state funds so long as the injection is ‘precautionary’, follows a stress test, and addresses the capital shortfall implied by an adverse scenario. A state is not allowed to apply a precautionary recapitalisation to an insolvent bank or one that is close to the point of non-viability. Additionally, if a state invests alongside, and on the same terms as the public in a recapitalisation, then it is also not state aid. MPS does potentially fall into one of these situations so, should they fail to raise the €5bn, then the Italian government potentially has a way out of the quandary. It would be a very EU-style solution to what seems to be a very worrisome binary outcome for the world’s oldest lender and the wider Italian banking sector.

We are not in a position to see how the book building is developing at MPS and we do understand why investors have concerns, but the outcome may not be quite so stark as some observers are predicting. If the resolution avoids a retail investor bail-in it may well be a cheerful Christmas for the credit markets and the Grinch will remain in hibernation.

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