Jean-Pierre Mustier is to step down as CEO of Unicredit Group, in which he restored Faith and Hope over the last few years. He baulked at Charity: agreeing a merger with Monte dei Paschi di Siena (MPS) on the terms acceptable to the Italian government.

There is a valuation gap of about €20 billion: the Italian government would be wanting about €6 billion – 68% of the balance-sheet capital at the start of the year – while Mustier wanted a deal that was “capital-neutral” to Unicredit. That means they would pay nothing, and receive protection from rumoured lawsuits of €10 billion, plus some cash and guarantees to help securitise toxic loans.

The political pressure to get a deal done and very quickly has overcome both business sense and any duty of responsibility to Unicredit shareholders, who will now be the “stuffee”. Mr Mustier looks as if he could not live with that and is going.

Rumours have been rife for some weeks that Unicredit was set to merge with MPS. Whilst the European Banking Authority wants to see cross-border bank mergers in the Eurozone, this one would follow the historical template of in-market mergers, with a domestic White Knight stepping up to bail out a flop, saving the authorities the trouble of doing so (or doing so again in this case).

MPS is cast as the flop. It has already been bailed out by the Italian government in a number of ways, most notably through its owning 68.247% of MPS’ shares: Generali owns 4.319%, and MPS owns 3.181% of itself. 75.747% of MPS’ shares are “strongly held”, as the saying goes, with only 24.23% traded, which is 36,280,248 shares out of 1,140,290,072. At a current share price of €1.25, MPS has a market capitalisation of either €345 million, or of €1.4 billion if you consider the “strongly-held” shares as well.

The weakness in the strength of the government’s grip on its shares is that it must sell them by year-end to pacify Brussels, as the price for the state aid that MPS has already received. The government cannot get an open-market price, which is not surprising as MPS lost €1.5 billion in the 9 months to September 2020 when its balance-sheet capital was €6.8 billion, down from €8.3 billion at 1/1/20. MPS has a market-to-book ratio of just 5% if you take its market capitalisation as €345 million, or of 21% if one takes it as €1.4 billion. Like many other figures in Italian bank accounting, the investor is presented with a “choice" price. There are two versions of the truth, and it is up to you whether you are feeling lucky.

Similarly with MPS’ regulatory capital position. MPS claims a CET1 ratio of 10.9% as of 30/9/20, based on a CET1 amount of €7.2 billion, balance-sheet assets of €146.3 billion, and Risk-Weighted Assets (RWAs) of €56.1 billion. RWAs are the risk-weighted equivalent of both on-balance-sheet assets and of all off-balance-sheet contracts. No clue is given as to the nominal amount of off-balance-sheet contracts, so no-one can be sure what degree of shrinkage is applied to either on- or off-balance sheet business to arrive at an RWA figure of €56.1 billion.

If one believes that MPS’ CET1 of €7.2 billion exists in the first place (and it is €400 million higher than its balance-sheet capital on the same date), then its CET1 ratio of 10.9% is comfortably more than its target ratio of 8.82%. MPS counts as well-capitalised on that measure, whereas its market-to-book ratio infers it is insolvent. “Choice” again.

The government would probably like to receive upwards of €5.5 billion for selling 68% of a bank that supposedly had a €8.3 billion net worth at the turn of the year. No such offer has been forthcoming, though, because, inter alia, the figures are not believed and there could be numerous uncaptured risks – a buyer paying nothing for the shares could still rack up a substantial loss from unquantified risks and liabilities.

Unicredit is itself not in such great shape as to be able to run that risk. With its shares trading at €8.84 (well down from the level just after its stock split and rights issue of early 2017), it has a market-to-book of 39%. Its September 2020 investor report did not even state the bank’s total assets (which were €855.6 billion on 1/1/20).

Unicredit attested an impressive CET1 ratio of 14.4% on €48.6 billion of equity, and RWAs of €350.7 billion. No figure for the nominal amount of off-balance-sheet contracts was given, and we have had to use the historical figure for total assets. All we know for sure is that the RWA equivalent of a balance sheet of about €850 billion and of a book of off-balance-sheet business of unknown quantum is €350.7 billion. Shrinkage is all in the RWA game; if Unicredit had no off-balance-sheet business at all, its shrinkage quotient is 500/850 or nearly 60%, reducing nominal assets of €850 billion to risk-weighted assets of €350 billion. MPS’ equivalent shrinkage quotient is 62%, shrinking nominal assets of €146 billion to risk-weighted assets of €56 billion. We need to remind ourselves that the actual shrinkage is higher, because off-balance-sheet business is included in the RWA figures but excluded from the nominal.

It should be unacceptable that neither Unicredit nor MPS give a table in their annual and quarterly reports of their off-balance-sheet business and what Risk-Weighted Asset amount pertains to it. The result is always a picture that appears rosier than the reality – both banks are less well capitalised than they are made to appear, with huge shrinkage quotients being applied through the same Risk-Weighted Asset methodologies that have resulted in major loan losses in the past. Do you believe in these methodologies? “Choice” again.

It is these methodologies that keep the Eurozone banking system afloat, though, with its illusion of solvency. This window-dressing still does not bring forward an acceptable offer to the Italian government for its MPS shares. Prospective buyers find themselves in the position of arguing in favour of these methodologies when selling their own banks’ shares and liabilities to capital markets investors, but against them when buying or being asked to buy MPS shares.

If past experience is anything to go by, a White Knight would go further than Intesa when it acquired Veneto Banca and Banca Popolare di Vicenza in demanding state support: cash, indemnities for unquantified risks, and guarantees for new, questionable securitisations of bad loans (Unicredit has plenty of experience in that field with its Project Fino).

There is a gap of around €20 billion between the amount that the Italian government would like to receive, and what it is realistic for Unicredit to pay if the deal is to be "capital-neutral": if Unicredit is consolidating all of MPS’ assets and its off-balance-sheet business by buying 71% of the shares (including the 3% that MPS owns in itself), it needs to consolidate at least MPS’ balance-sheet capital of €6.8 billion without reversing 30% out of it as a Minority Interest, and have a cushion besides. In other words it needs to receive the MPS business for free and have the Italian government spice the deal up with some substantial freebies, probably €13-14 billion's worth.

Even if all of that is forthcoming, it counts as state aid. Then, and presumably by the end of 2024, to re-pacify Brussels, the White Knight would have to sell off assets, branches or whatever, and so on, and would find itself with substantially the same sales prospectus that the government is touting around now. It’s called flogging a dead horse.

Now that Mr Mustier has been unseated, a new rider will be found to bring Unicredit and MPS together as an even larger dead horse with both near-zero market capitalisation and surplus CET1 capital. The elixir to magic away that oxymoron and give the horse an illusion of life will be an even more deftly tweaked Risk-Weighted Assets methodology, supported by some “restructuring”, “forbearance” and “securitisation” of Non-Performing Loans. No-one will feel the pain, except the Unicredit shareholders, who will be making a major wealth transfer to the Italian government.