On Friday the ECB Shut Down Venice-based Veneto Banca and Banca Popolare di Vicenza as failed or failing banks.

The bailout cost is purportedly €5.2 billion ($5.8 billion), but costs nearly always exceed initial projections.

Under the announcement, senior bondholders and depositors will be protected.

The European Central Bank said Banco Popular was “failing or likely to fail” due to its dwindling cash reserves. The good assets of Banca Popolare di Vicenza and Veneto Banca will be taken on by Intesa Sanpaolo. Economy Minister Pier Carlo Padoan said Rome would also offer guarantees of up to 12bn euros for potential losses from bad and risky loans.

Let’s discard the “likely to fail” category. Those banks are insolvent and have been walking zombies for years. The entire Italian banking system is in a zombified state.

I believe those loan guarantees are illegal under ECB rules but the ECB may simply look away. The price tag now is another €12 billion.

Rush to Keep the Banks Open

Bloomberg reports Italy Rushes to Approve Decree Law to Keep Two Veneto Banks Open.

Italy is rushing to approve emergency rules outlining liquidation procedures for two failed banks in the northern Veneto region in time for them to open on Monday.

The government is set on Sunday to approve a decree law setting up rules that would let Intesa Sanpaolo SpA buy some assets of Banca Popolare di Vicenza SpA and Veneto Banca SpA at a token price and determine the state intervention needed to avoid losses for senior bondholders.

The Finance Ministry has said all measures would be taken to ensure that senior creditors and depositors are protected in their liquidation under the national insolvency law, and customers would see no interruption in service. The Bank of Italy is expected to appoint administrators to liquidate the bad assets, while Intesa may formalize its purchase of good assets by Monday, according to local press reports. State intervention may cost as much as 7 billion euros ($7.8 billion), Corriere della Sera reported.

The government tried for months to rescue the two banks, but its efforts ended on Friday when the ECB turned the matter over to the Single Resolution Board in Brussels for disposal. The SRB, in turn, passed the issue to Italian authorities after concluding there was no public interest in resolving them under European Union law, a process that would have exposed senior debt holders to losses.

Brave New World of Bail-Ins on Display

Junior bondholders are going to be wiped out. That is for sure.

But why should senior bondholders be protected?

Reuters discussed the Brave New World of Bank Bail-Ins on January 14, 2016.

The European Union entered a brave new world of bank “bail-ins” at the start of 2016. Europe has wasted so much taxpayers’ money on bailing out bust banks in recent years that it is right to try to get investors to help foot the bills in future. However, the tough new regime carries big political risks.

The key new rule is that no bank can be bailed out with public money until creditors accounting for at least 8 percent of the lender’s liabilities have stumped up. So-called bail-ins typically mean wiping out creditors’ investments, slashing their value or converting them into shares in the bank. Uninsured depositors could get caught along with professional investors.

Moreover, within the euro zone, national authorities will no longer be responsible for dealing with bust banks as this job has just been transferred to the new Single Resolution Mechanism.

The theory is that shareholders should take the first hit because they know they are risking their money. If that isn’t enough to stabilize the bank, subordinated bondholders should step up because they too should know such investments are risky. Next in line are senior bondholders and, finally, uninsured depositors – which, in the EU, means those with more than 100,000 euros in their accounts. The small depositors should not be touched.

Unfortunately, bail-ins are harder in practice than in theory. A big test came during the Cypriot crisis of early 2013. The euro zone’s initial instinct was to tax all depositors, big and small, to fill the gap in bank balance sheets. Although that bad idea was abandoned, large depositors suffered swingeing losses, helping cause a steep recession.

Other countries do not want to repeat the Cypriot experiment. No wonder Italy and Portugal rushed to rescue some of their troubled banks before the tough new regime kicked in at the start of January.

Not that Rome and Lisbon had a free hand over what to do. Since mid-2013, the commission has said public money could only be used to bail out lenders if shareholders and subordinated bondholders shared the burden. Still, this was not as tough as the new 8 percent rule, which could require senior bondholders and uninsured depositors to take a hit too.

That said, applying even the old rules has caused a political rumpus. Italy used a new industry-funded bailout scheme to pump 3.6 billion euros into four small banks in November. The problem was that many of the subordinated bondholders who had to be bailed in were ordinary savers who had been sold these investments without appreciating their risk. One committed suicide.

Who are the Senior Bondholders?

The bail-in rules appear to be bent to the tune of €12 billion in public money guarantees.

Who are the senior bondholders protected under this sweetheart deal?

I don’t know, but I have two guesses.

1. Italian political class
2. ECB

If the ECB is protecting its own portfolio of garbage Italian debt, this is exactly the kind of rule-bending, no details, no discussion activity that we could expect, and now see.