Italy's political crisis looks set to trigger banking turmoil in the country. Brian Caplen looks at the wider implications when it comes to rescuing banks.

The thinking behind the EU’s bail-in rules for failing banks is to ensure that investors take a hit before state funds are used. The aim is to have a strict process for governments to follow in times of crisis. 

The problem is that bank rescues – whether bail ins or bail outs – always involve political considerations. This is why Italy is struggling to deal with its banking crisis, a matter suddenly made a lot more urgent following Sunday’s referendum and the resignation of reformist prime minister Matteo Renzi.

Italy’s banks need a lot more capital and the plight of Monti dei Paschi di Siena (MPS), the country’s third largest bank, is particularly worrisome. A €5bn rescue package being worked on for MPS now seems in doubt and the alternative could be state support. 

But the Italian government has been reluctant to go down this road with any bank as it involves bailing in retail investors who were sold bank securities. It is this nexus that has made bank bail ins politically difficult even before the referendum result. 

Even the halfway option of 'a precautionary recapitalisation' offered by the EU, and involving a bail in of junior bondholders, an injection of state funds and compensation for small investors who were mis-sold securities, has so far not been taken up. 

But if Italy cannot come up with a solution that is acceptable domestically, its banking crisis may become a matter of EU politics. A severe economic crisis in Italy involving bank failures and difficulties repaying sovereign debt threatens the entire eurozone. At that point, the EU’s leaders will have to decide how to deal with the situation in a way that is politically acceptable to German and French taxpayers – not an easy task. 

Even without the special problems of retail investors in Italy it is difficult to imagine a situation in any country – no matter how well prepared its rulebook – when rescuing a bank is not as much about politics as economics.

Brian Caplen is the editor of The Banker.

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