Bank of Italy's secret loan to Monte Paschi was classic central banking

The Wall Street Journal reports that the Bank of Italy made a secret loan to Monte Paschi in 2011 and claims it did nothing wrong as the Bank of Italy was simply performing a classic central bank role of providing liquidity.

The €2 billion ($2.7 billion) emergency liquidity loan the Bank of Italy extended to troubled lender Monte dei Paschi di Siena in 2011 was a "classic" central-bank move, although it didn't appear on the European Central Bank's balance sheet and no other Italian bank entered a similar deal, a senior Bank of Italy official said Saturday. 

"The Bank of Italy acted on its own" said Fabrizio Saccomanni, the deputy governor of Italy's central bank, when asked about the at-the-time undisclosed securities lending transaction with MPS. 

The deal, in the fall of 2011, represented "the classic type of operation central banks engage in since the times of Bagehot," Mr. Saccomanni said, when asked about the loan on the sidelines of a banking conference here. 

Walter Bagehot wrote "Lombard Street," a 19th-century treatise on how central banks should act as lender of last resort.

Walter Bagehot did not argue that central banks should make secret loans in their lender of last resort role.

In fact, the banks of his day can be characterized by their willingness to provide ultra transparency and disclose their current global asset, liability and off-balance sheet exposure details.

Why were banks willing to do this?

Because it was a sign of a bank that could stand on its own two feet.

A bank that was unwilling to provide ultra transparency was seen as waving a red flag and declaring that they had something to hide.

Regular readers recall that Mr. Bagehot's dictum was that central bankers were suppose to lend freely against good assets at high rates.  When banks provide ultra transparency, the loan from a central bank was suppose to be a signal to the depositors so that would stop engaging in a run on the bank.

Mr. Bagehot would not have favored either banks hiding their exposure details behind a veil of opacity or central banks hiding loans that they make to the banks.

Italy's central bank arranged the loan in October 2011 because MPS was running short of liquidity and had largely exhausted its ability to keep borrowing from the ECB. The loan was aimed at staving off a liquidity crisis at a key Italian bank at a delicate moment in the country's economic history. 

The loan wasn't disclosed at the time by either the Italian central bank of MPS. In a conference call shortly after receiving the emergency loan, MPS executives described the bank's liquidity position as sound.

Please re-read the highlighted text because the stated rational for the loan is to assist MPS executives in misrepresenting the financial condition of the bank.

Regular readers are familiar with the FDR Framework which is the basis of our global financial system.  The FDR Framework combines the philosophy of disclosure with the principle of caveat emptor (buyer beware) to achieve financial stability.

Under the framework, governments and their financial regulators are given the responsibility for ensuring that market participants have access to all the useful, relevant information on each bank in an appropriate, timely manner so the market participants can independently assess this information and make a fully informed investment decision.

Clearly, the secret loan means that investors did not have access to all the useful, relevant information.

Why is it important that investors have this information?

Because under the framework, investors are responsible for all losses on their investments under the principle of caveat emptor.  As a result, investors have an incentive to use this information to assess the risk of an investment and make sure that they do not have a greater exposure than they can afford to lose given the risk.

By letting Monte Paschi hide the loan, the Bank of Italy undermined the ability of market participants to assess the risk of the bank.

In turn, this action by the Bank of Italy created a moral obligation on the part of the Italian taxpayers to bailout the investors in Monte Paschi.

Mr. Saccomanni said that, with its loan to MPS, the Bank of Italy—which was led at the time of the loan by current ECB President Mario Draghi—didn't violate any rules. The loan was "utterly normal central bank behavior," he said.

It is not clear that no rules were violated since neither the central bank nor Monte Paschi reported the loan.

Under the deal, MPS swapped loans and mortgages for some €2 billion of mainly Italian government bonds. 

In discussing the transaction, Mr. Saccomanni said that Italy essentially has two central banks that are both lenders of last resort. One is the European Central Bank, which, via the Eurosystem, includes national central banks of member countries. The other is the Bank of Italy, which can conduct lender-of-last-resort operations on its own account. 

"Anyone can do it," Mr. Saccomanni said, adding that similar transactions have been carried out by other national central banks in the euro area. 

Some central banks, such as those of Greece and Ireland, have used their own balance sheets for such lending to domestic banks, under the Emergency Liquidity Assistance, a special dispensation from ECB protocols.

I wonder how many other Eurozone countries are providing their banks with secret loans?