Not that MPS is insolvent. Dear me, no.  The adverse 2018 scenario in the stress tests reduced its core Tier 1 (CET1) equity to negative 2.23%. That is, of course, insolvency. But hey, it’s just a scenario. Officially, it meets its CET1 and baseline solvency requirements. So it is solvent. Isn’t it?

It must be, because otherwise the planned bail-out would be impossible. MPS is to receive a “precautionary recapitalization”. As the European Central Bank (ECB) helpfully explains, the whole point of this is to avoid putting a solvent bank into resolution:

A precautionary recapitalisation describes the injection of own funds into a solvent bank by the state when this is necessary to remedy a serious disturbance in the economy of a Member State and preserve financial stability. It is an exceptional measure that is conditional on final approval under the European Union State aid framework. It does not trigger the resolution of the bank.

Now, you may well ask why, if MPS is basically solvent even though it is at risk in a stressed scenario, the private sector wouldn’t provide the necessary funds. Ostensibly, the reason is the outcome of the Italian referendum. Raised political risk after the resignation of Matteo Renzi is apparently sufficient to explain why private sector investors would not contribute 5bn euros to recapitalize a bank with a market cap of 442m euros. I suppose if you tell yourself private sector investors are stupid often enough, you might start to believe it is true. But to me, it is evident that the private sector was never going to contribute 5bn euros or anything like it.

A Picture shows the logo of Italian bank the Monte Dei Paschi di Siena (BMPS) on December 9, 2016 in Rome. Italy’s Monte dei Paschi di Siena saw its stock tumble more than 12 percent today over reports the ECB had denied it more time to raise the cash it needs to avoid being wound down. TIZIANA FABI/AFP/Getty Images

No matter. All that was needed to justify a precautionary recapitalization was a “serious disturbance” in the Italian economy. The Italian referendum was good enough. MPS is to be rescued. Or, more correctly, its depositors and senior bondholders are to be rescued, together with a fair proportion of its junior bondholders.

Politically, this is a huge relief. Putting MPS into resolution under the European Bank Resolution and Recovery Directive (BRRD) would have meant bailing in 8% of total liabilities before involving taxpayer funds. According to Silvia Merler of Bruegel, this would have meant bailing in all or nearly all of MPS’s junior debt, almost 65% of which was sold to retail investors – small savers for whom this represents part of their life savings. In a precautionary recapitalization, junior debt would still have to be bailed in, but there is potentially a way of protecting small savers:

Avoiding a bail-in of junior bond-holders might be possible…..This would require that (i) the Italian government obtains the green light for a precautionary recapitalisation under Article 32(4.d) of BRRD; (ii) the resulting state aid is approved under Article 107 TFEU and (iii) the “financial stability” clause in the 2013 Banking Communication is granted to suspend burden sharing of junior bondholders.

Ordinary Italian taxpayers might question why they should pay to protect the savings of people richer than them. But the ability of retail savers to tug at the heart strings of politicians is remarkable. Or perhaps not so remarkable. They vote.

Personally, I would rather that savers who bought subordinated debt instruments were not rescued, unless they can prove that the instruments were mis-sold. After all, they bought these instruments because they paid higher interest. Even small savers should understand that a higher interest rate means higher risk. But mine is an unpopular viewpoint: Italian politicians, mindful of an upcoming election, see things differently.

Anyway, the recapitalization procedure has already commenced, and it includes measures to protect retail investors. The ECB has confirmed that MPS meets minimum capital requirements, and has determined the amount of the capital shortfall under the adverse scenario of the relevant stress test. We thought we knew this, didn’t we? Wrong. The ECB has decided that MPS needs an additional 3.8bn euros on top of the 5bn that the private sector balked at providing – a total capital shortfall of 8.8bn euros. Part of this will come from bailing in large and institutional holdings of subordinated debt, but that still leaves a bill of about 6.6bn euros for the Italian taxpayer, of which about 2bn is compensation to retail investors.

Exactly why the ECB has increased the capital requirement by so much is unclear. The Bank of Italy explains that a “special meeting” of the ECB Board set the minimum CET1 ratio to 8% and the minimum “total capital ratio” to 11.5%. This is substantially above the legal minimum CET1 ratio of 5.5%, and as Bloomberg points out, also higher than the level reached by ten of the largest European banks in the stress tests, including Germany’s Deutsche Bank. Silvia Merler observes that 8% is the same CET1 ratio as was set for the Greek banks in the 2015 recapitalization.

But why has the ECB raised the bar? No-one knows. It seems to follow on from MPS’s warning that its liquidity position was deteriorating rapidly due to deposit flight. But a solvent bank should always be able to borrow from the central bank, even if its commercial depositors are running for the hills. So we are back to my original question – is MPS really solvent?

Silvia Merler suggests that the new CET1 requirement brings MPS dangerously close to baseline insolvency:

So it may be that the current adverse scenario for MPS is worse than before. But if the situation has deteriorated to the point that the banks suddenly needs 3.8 more billions, this would probably imply that the baseline scenario is also no longer valid, and the real baseline is much closer to the previous adverse. It would be very important to know just how close, because this could have important consequences on the applicability of precautionary recap.

If MPS no longer meets its baseline solvency requirement, then it is hard to see how state aid could be approved. Bundesbank chief and ECB board member, Jens Weidmann, has already warned that it “would need to be weighed very carefully” – a stark warning that the scheme could still fail.

If the precautionary recapitalization were to fail due to baseline insolvency, then the only other course of action would be resolution under BRRD. If Italy balked at this, the ECB could pull funding from MPS to force resolution, as it did in Cyprus.

This would be extremely bad news. MPS is not the only Italian bank that needs recapitalization: the Italian government has earmarked 20bn euros in additional borrowing to recapitalize banks. If MPS’s precautionary recapitalization failed, it is unlikely that others would succeed. And the hoped-for 13bn euros private sector recapitalization of Unicredit, Italy’s largest bank, would also be likely to hit the buffers.

Failure to recapitalize Italy’s wobbly banks would have serious consequences both for Italy and for the whole European banking system. Enforced BRRD resolution of some of Italy’s largest banks would impose losses on banks and investors across Europe. And it would knock a huge hole in the Italian economy, already highly indebted and mired in recession. The effect on the price of Italy’s sovereign debt doesn’t bear thinking about – and much of it is held by French and German banks. The ECB is no doubt well aware of the potential for Eurozone financial system meltdown if this recapitalization fails. Could it be that “weighing it very carefully” really means “how much of the cost of propping up the European banking system can we dump on the Italians?”

The EU has played this scene before. Four times, in fact. Ireland, Greece, Cyprus, Spain. Now it is Italy’s turn to be sacrificed to stop the European banking system collapsing. How much longer are European authorities going to play extend-and-pretend, while the people of Europe pay for the folly of European banks?