Get out of fail free

ECB's MPS kid gloves are a necessary evil

The European Central Bank's kid gloves for Monte dei Paschi di Siena are a necessary evil. The Tuscan lender was allowed to disregard losses on a 10 billion euro bad debt sale for internal models, it said on July 29. Bending regulatory rules is usually a bad idea: it undermines risk management and incentivises bad lending. Yet an argument for making an exception can be made.

MPS' internal models were a wildcard in its rescue. The bank needs to sell bad loans, generating a loss on the difference between its marks and the price paid by Italy's Atlante bailout fund. But if that price became the default loss assumption that gets fed into its model, then it would need more capital for good loans. That could have increased its capital need by 2 billion euros, according to one banker involved.

Disregarding the loss is no small thing. European capital rules that use internal models to calculate capital update them once a year, to capture "all relevant data". Whereas small loan sales may not affect loss rates, it would be hard to ignore a sale that covers all MPS bad debts, and roughly a quarter of its loan book. Allowing banks to ignore data and fudge models is all a bit pre-crisis.

Still, the rules allow some wiggle room. Banks need to ensure conditions when the loss is incurred are relevant to "current and foreseeable" conditions. One could argue that MPS is unlikely to have to sell its bad debts in one go again. Equally, the bank has updated its risk systems and has outsourced bad loan management since the loans were made, in some cases decades ago.

The ECB looks to have taken a pragmatic view. If banks are discouraged from cleaning their books and raising fresh capital, then lending will suffer. In Italy, where non-performing exposures exceed 300 billion euros, there is an obvious need for a broader clean-up, and a robust MPS would mean a healthier sector.

Lastly, while other banks may fancy a bit of MPS' model fudge, they may not get to taste it. While some banks could need to do a large clean-up - UniCredit, for example, fared worse than expected in the July stress tests - not all will want to sell bad loans on a massive scale. Some of the smaller banks do not use internal models. While controversial, the ECB was right to err on the side of leniency.