Volume 35, Number 3, February 2018

Volume 35, Number 3, February 2018

Answers

Italy’s 2017 banking crisis

Jon Guest

This resource provides answers to the questions set in the article on Italy’s banking crisis, on pp. 26–8 of the February 2018 issue of Economic Review.

Question 1

What impact might it have on the lending decisions of banks such as Popolare di Vicenza and Veneto Banca if their managers believe the government will bail them out if they get into financial difficulties?

The managers of the banks may engage in a more risky lending strategy. Higher-risk lending may offer the bank the chance of higher returns but there is also a greater probability the debts will never be paid off. If the managers of the banks believe the government will bail them out, they have an incentive to encourage their staff to make far more of these risky loans than they would have without the bail-out. If most of the risky loans are paid then the banks will make large profits and the managers get large bonuses. If the majority of the loanees default on their loans and the banks get into financial difficulty then the managers know the government will bail them out. This is an example of moral hazard —where the actions/behaviour of one party (i.e. the banks) changes in a way that reduces the pay-off to the other party (i.e. the taxpayer). This is the result of incentives changing after an agreement has been reached (i.e. a bail-out).

Question 2

What are the three core elements of the Recovery and Resolution Directive?

The three core elements of the Recovery and Resolution Directive are planning, early intervention and resolution. In the resolution stage when a bank is failing or likely to fail the government can:

sell or merge the bank with another business
set up a temporary bridge bank
allow a ‘bail-in’ to take place where the creditors and depositors lose some or all of their money

Question 3

What are the potential disadvantages to the authorities of using a bail-in instead of a bail-out?

One big disadvantage of a bail-in is that it might cause a panic among the creditors and depositors of the other banks. Creditors such as bondholders might demand higher interest rates in the future to lend the banks money. Depositors may try and withdraw their money on mass which might cause the bank to collapse.