Italy (2008) Capital Injections

The collapse of Lehman Brothers in mid-September 2008, and the ensuing Global Financial Crisis, triggered unprecedented responses from governments around the world. In October 2008, in a period of 10 days, multiple high-level government meetings took place in efforts to coordinate an international response and common measures to combat the crisis. The meetings included the European Economic and Financial Affairs Council (ECOFIN) on October 7, 2008; the Group of Seven (G7) summit in Washington, DC, on October 10; an emergency euro area summit of heads of state on October 12; and the Council of the European Union (European Council) meeting on October 15–16.

The ECOFIN approved a set of principles and extraordinary measures for European governments to combat the crisis (ECOFIN 2008). The G7 finance ministers and central bank governors pledged to take aggressive actions that included: support for systemically important financial institutions, all necessary efforts to ensure credit access to banks, temporary guarantees on short- and medium-term liabilities, expansion of guarantees on bank deposits, bank recapitalization through the use of public funds, and acquisition of illiquid assets (G7 2008).

The euro area heads of state released the “Declaration on a Concerted European Action Plan of the Euro Area Countries,” which committed efforts to reestablish confidence and the well-functioning of the financial system. In agreement with the European Commission (EC) and the European Central Bank (ECB), the plan outlined support to financial institutions by facilitating: (a) appropriate liquidity conditions, (b) funding of banks, (c) additional capital resources, (d) recapitalizations of distressed banks, (e) flexibility in the implementation of accounting rules, and (f) cooperation among European countries (Euro Summit 2008). A few days later, the European Council endorsed the plan of action and extended it to all countries part of the European Union (EU) (European Council 2008).

Italy, on October 9, 2008, issued Decree-Law N. 155, “Urgent Measures to Guarantee the Stability of the Credit System and the Continued Flow of Credit to Firms and Consumers in the Current State of Crisis in World Financial Markets.” The decree envisaged a government package focused on three areas of support to the Italian banking sector: (a) bank recapitalizations, (b) access to liquidity, and (c) expanded guarantees on bank deposits (Bank of Italy 2008). This case study exclusively examines the Italian bank recapitalization scheme.

At the time, Italy held a large and increasing public debt (estimated at 105% of GDP in 2008). Italian banks’ interest rate spreads over Italian government bonds had widened significantly in the past year. The head of the Italian Ministry of Economy and Finance (MEF), Giulio Tremonti, expressed that Italy, unlike other European countries, could not pursue a major fiscal stimulus through deficits or debt increases. However, Tremonti remained confident that the Italian financial system was in better condition than those of other European countries, as Italian banks relied on more traditional credit activities, such as retail deposits and bonds, and less on complex securities such as in the US or the UK (Economist 2009).

The reported aggregate Tier 1 capital ratio of the Italian banking system was 7.7% in 2007 and 7.6% in 2008. For the five largest Italian banks, it was 6.4% in 2007 and 6.7% in 2008 (see Figure 1).

The legal bases for the Italian government’s support package were passed through a fast-track procedure as Decree-Law N. 155/2008 on October 9, Decree-Law N. 157/2008 on October 13, and Decree-Law N. 185/2008 on November 29. These were converted into Law N. 190/2008 on December 4 and Law N. 2/2009 on January 28 (Bank of Italy 2009c).

On November 20, 2008, the ECB published a recommendation on the pricing of bank recapitalizations by national governments. The EC released guidance on December 5 to ensure that recapitalizations through EU State Aid did not grant banks undue competitive advantages and financial stability was preserved in line with the rules of the single market. The EC guidance envisioned two types of recapitalizations: for “distressed” banks and for “fundamentally sound” banks. In principle, recapitalizations for distressed banks required stricter requirements (Bank of Italy 2009a; EC 2008c; ECB 2008). For sound banks, recapitalization allowed governments to acquire securities issued by the banks with an “appropriate” yield of between 7% and 9%. Higher yields could be considered in order to encourage banks to buy back the securities as market conditions improved (Bank of Italy 2009a).

The legal basis for the Italian recapitalization scheme for sound banks was Article 12 of Decree-Law N. 185/2008, converted into Law N. 2/2009 (Bank of Italy 2009c; EC 2009c). The total available funds for the Italian recapitalization scheme was unspecified but expected to be between €15 and €20 billion (EC 2008d). Italian authorities made clear that support would be available “as needed” (Bank of Italy 2009d). In February 2009, when the scheme was amended, the size of the scheme was reported to be up to €12 billion (Reuters 2009a). The €80 billion Italian economic stimulus plan announced on November 15, 2008, was considered low at an estimated 0.6% of GDP (Bank of Italy 2009d; Financial Times 2008).

On December 18, 2008, Italy notified the EC of its recapitalization scheme, which the EC approved on December 23, 2008, after intensive exchanges with Italian officials. The scheme was in line with EU State Aid rules, as a temporary measure and compatible with Article 87 (3)(b) of the EC Treaty, intended to “restore stability of the financial system and to remedy a serious disturbance in the economy of Italy” (EC 2008d; EC 2008e).

The MEF was empowered to recapitalize banks until December 31, 2009, conditional on a notification to the EC after six months on the need to prolong the scheme. Eligible institutions included fundamentally sound Italian banks (including subsidiaries of foreign banks) with shares listed on regulated markets. The criteria of fundamental soundness were based on a bank’s credit default swaps spread, ratings, and a complementary assessment by the Bank of Italy. The Bank of Italy assessed each bank’s solvency, capital adequacy, and risk profile (Bank of Italy 2009c; EC 2008e; EC 2009c).

The scheme was expected to have its first operations by January 2009. However, in the first two months of the scheme, no bank participated. Then, in February 2009, the scheme was amended to offer an alternative option of remuneration. This change was intended to make the scheme more attractive to banks that expected to use the government capital for a short period. It consisted of higher annual coupons until 2014 in exchange for lower redemption prices fixed at nominal value until June 2013 (EC 2009a). On February 16, 2009, Italy notified the EC of the amendment, which was approved on February 20, 2009. Three days later, Tremonti signed a ministerial decree to allow the government to recapitalize banks by buying “special bonds” from banks, considered as common equity Tier 1 (CET1) regulatory capital (EC 2009b). These bonds became known as “Tremonti bonds.”

Italian regulators classified the Tremonti bonds as CET1 pursuant to the then applicable regulation EU Directive 2006/49/EC, as implemented at the national level (European Parliament and Council of the European Union 2006). The Tremonti bonds were perpetual and convertible into common shares after three years. The interest paid was noncumulative—paid only when a bank had distributable earnings, provided that the bank’s capital ratio was at least 8%. Remuneration included an initial coupon with fixed step-up clauses, increases in remuneration associated with dividend payments and financing costs of the government, and a redemption price premium that increased over time. Individual recapitalizations were limited to 2% of a bank’s risk-weighted assets, without surpassing an 8% Tier 1 capital ratio (Bank of Italy 2009b; EC 2008e; EC 2009a).

In 2014, Regulation (EU) 575/2013 (the Capital Requirements Regulation, or CRR), directly applicable to all European Union member states, replaced EU Directive 2006/49/EC, reflecting the standards set by Basel III after the Global Financial Crisis. The CRR set the new eligibility criteria for the instruments to be classified into the three layers of own funds: common equity Tier 1, additional Tier 1, and Tier 2, and it seemed difficult for the Tremonti bonds to qualify as CET1 under CRR (European Parliament and Council of the European Union 2013).

Banks participating in the scheme had to adhere to a “code of ethics” for policies on executive compensation. Additionally, banks had to sign a Memorandum of Understanding (MoU) in which they committed to: (a) increase lending for the next three years to small and medium-sized enterprises (SMEs); (b) contribute to the guarantee fund for loans granted to SMEs; (c) suspend up to 12 months of mortgage payments for borrowers who lost their jobs or benefited from public income support; and (d) ensure appropriate liquidity levels to creditors of public administrations. Banks were required to provide aggregated data on a quarterly basis to enable monitoring of the application of the MoU (Bank of Italy 2009b; Bank of Italy 2009c). On July 31, 2009, Italy requested that the EC prolong its recapitalization scheme until December 31, 2009, which the EC approved (EC 2009c). The scheme was reintroduced 10 months after the original expiration date, on October 23, 2010, and ended December 31, 2010 (EC 2010b).

By the end of 2009, when the Italian recapitalization scheme first expired, capital injections totaled €4.05 billion. The four participating banks included: Banco Popolare (BP) for €1.45 billion, Banca Popolare di Milano (BPM) for €500 million, Credito Valtellinese (Creval) for €200 million, and Banca Montepaschi di Siena (MPS) for €1.9 billion (see Figure 2).