Italy's banking crisis could bring disastrous consequences

Wikimedia Commons

The current Italian banking crisis carries with it the possibility of bank failures. The consequences of these failures pyramid the crisis because of European Union regulations. Essentially, the position of the European Union is that the European Central Bank (ECB) and the central banks of member countries cannot bail out failing banks by recapitalizing them—in other words, injecting money to keep them solvent.

EU regulations go so far as to prohibit Italy from using its state funds to shield investors and shareholders of banks from losses, unless there is risk of “very extraordinary” systemic stress. Rather, the EU has adopted a bail-in strategy.

The bail-in strategy is, in theory, a way to ensure fair competition and stability in the financial sector across the eurozone. It protects countries, like Germany, from spending their money on bank failures in other countries. It also keeps the ECB from printing extra money and exposing Europe to inflation that would reduce the position of creditors. The fear of inflation is remote at this moment, but it still is an institutional principle of the ECB. And controlling national spending on banks imposes fiscal discipline on countries that seek to bail out not just banks, but the equity holdings of investors, who will lose their investment when the bank fails.

Who Pays When a Bank Fails?

The issue is this: who is considered an investor? In the view of the EU, depositors are—in cases of a bank resolution—investors in the bank. The bail-in process can potentially apply to any liabilities of the institution not backed by assets or collateral.

There is some insurance available, and there are EU regulations on deposit insurance, but there is no EU-wide system of deposit insurance. This is because creditor nations do not want to share the liability for bank failures in other nations. This means that while the first 100,000 euros ($112,000) in deposits are safe, in the sense that they cannot be seized, any money above that amount can be.

On the surface, 100,000 euros is a large savings. But if you consider the position of a professional who has saved all his life for retirement, he may have a lot more. And at current interest rates, even a bank account with a million euros would not generate enough income through interest to fund a retirement. The principal would have to be used, and in a bail-in, both the planned income and principal (above 100,000 euros) would be dissolved. As for businesses, particularly small and medium-sized enterprises (SMEs), the bail-in could dissolve payroll accounts and other working capital.

The idea of the bail-in erases a distinction that has become fundamental to European and American banking since the massive banking failures of the 1920s and 1930s. A savings account was supposed to be a safe haven for your savings or operating capital. The depositor paid for the safe haven by accepting extremely modest interest rates.

In contrast, an investor takes on greater risk and is responsible for evaluating the financials of an investment. The bank is an institution that is an alternative to riskier investments.

The Cyprus Example

We saw the consequence of a bail-in procedure during the Cypriot banking crisis. Claiming informally that Cypriot banks contained primarily Russian money meant for laundering, Germany insisted on the bail-in process. There was undoubtedly illegal Russian money in Cypriot banks, but there were also retirement funds for British expatriates who retired to Cyprus and accounts held by Cypriot businesses. The result was devastating.

Money that had been wisely deposited in a bank—so the depositor believed—was lost as depositors found out they were considered investors. Hotel workers, for example, were not paid for a month and then got about half a paycheck for a while. The hotels lost their investments in the banks without ever having realized that they were investors and without any chance to participate in the banks’ success, while unwittingly being exposed to its failure.

There is one tremendous side effect in this bail-in strategy. It increases the possibility of runs on banks, especially by large depositors. As it becomes known that depositors are investors—rather than creditors—and that their assets will be forfeited to pay debtors, the bank stops being a safe haven.

The more aware the depositor is that he will be treated as an investor, the more he will behave like an investor. Realizing that his bank deposit is all risk with no upside, any sign that risks are mounting will cause a rational actor to withdraw his money. This will increase the risk of a run and collapse.

The American Approach to Bank Failure

It is not clear what the EU is thinking. The American approach to the 2008 banking crisis was that some companies and banks were “too big to fail.” The concept operated on many levels. One was that the federal government ensured that the Federal Deposit Insurance Corporation (FDIC) had enough money to cover all guarantees. The relatively generous guarantees of the FDIC might not have been sufficient to deal with the crisis. The FDIC insures $250,000 in individual deposits and $500,000 for a married couple. In addition, it insures the same amount at the same bank in different types of accounts.

So, if someone had a personal account, a small corporate account and a foundation account, he could have $750,000 in guarantees at the same bank. And if he had more money, he could open accounts at another bank. The FDIC would cover all of it and the federal government was prepared to ensure the FDIC was able to do so.

The American approach also included the infusion of capital into banks to guarantee that the banks could honor their debts. This protected liabilities between financial institutions. It also protected SMEs and individual depositors. Whatever the vices of the bank management, it guaranteed not only that interbank debt was secure, but that the depositors were treated as depositors and not investors—nor even creditors.

This, plus aggressive intervention as banks failed, reduced the chance that depositors would panic and prevented the economic and political meltdown that a bail-in might cause.

This was possible because the US is a single country with an integrated system. Texans might not be happy stabilizing banks in California, but there is no systemic way for Texas to withdraw from the process.

The Pitfall of the EU System

Europe, for all the discussion of integration, is not integrated. Italy is not Germany, and Italy’s problems are not Germany’s problems. There is no EU-wide deposit insurance system because liability is not spread at an EU level. Nor, as there is only one currency, are the devices available to the ECB available to Italy. And finally, the European ethos of austerity creates liabilities among the most vulnerable classes.

The consequence of large banks failing is significant. The seizure of large numbers of deposits in what was regarded as a safe haven can also have significant consequences, and not just financial ones.

The sense of vulnerability that the bail-in concept creates among individuals has two effects. One is a shift in the pattern of saving. Some will decide that if savings are investments without an upside, they might as well get into the equity markets. The risk in these markets is high. Or they may decide that they are better off with their money in gold or hidden under their mattresses. The consequences of that on a large scale are also substantial.

But the biggest consequence is political. If retirees and others lose their savings, and SMEs are unable to pay their staff, the political impact on the established parties—which are already under attack—could transform Europe. If this strategy works to contain the crisis in Italy, fine. But if it spreads into a panic, which is not unlikely, it will resonate for a long time.

Watch George Friedman's Ground-breaking Documentary Crisis & Chaos: Are We Moving Toward World War III?

The EU’s potentially devastating bail-in strategy is one sign of a systemic instability engulfing a region that’s home to 5 billion of the planet’s 7 billion people.

In this provocative documentary from Mauldin Economics and Geopolitical Futures, George Friedman uncovers the crises convulsing Europe, the Middle East, and Asia… and reveals the geopolitical chess moves that could trigger global conflict. Register for the online premiere now.

NOW WATCH: Turns out LA’s shade balls actually worked