What Monte dei Paschi says of banking As a thriller the story of Monte dei Paschi di Siena is hard to beat: corruption, the evils of high finance, and of political influence in corporate boardrooms are all there. As Italy heads towards a closely fought general election, it is not surprising that the story of the Siena-based bank has caught so much attention, and is being manipulated for partisan purposes in Italy. And yet this drama has broader significance in terms of what is says about the state of European banking and the financial crisis. The tale itself is familiar. We have seen versions of it before in regional banks in Spain, Germany and elsewhere. It starts with ambitious expansion in the boom years that peaks with an expensive acquisition. Then the crisis comes and losses mount. With the help of international investment banks, Monte dei Paschi's management set up derivatives transactions, hiding the losses by deferring or amortising them over many years. A capital injection, demanded by the Bank of Italy, is achieved through the use of derivatives rather than seeking new investors as the controlling Monte dei Paschi Foundation resists a dilution in its stake. Then in the wake of the sovereign debt crisis, the state encourages Italy's banks to buy government bonds. Not a happy investment. Despite some financial engineering, losses eventually force the bank to seek new management. The new team discovers the derivatives deals, hidden from regulators and the bank's own auditors. Cue chaos and recrimination. Why was this allowed to happen? No doubt the original mistake was poor management and ineffective governance. But at some point, bad judgments turned into unlawful actions. It is now hard to distinguish between incompetence and corruption. At this stage legal responsibilities have not been established. The specific issues are technical, and there is plenty of scope for argument about how blame should be spread. But whatever the findings of the courts, there are three general lessons. First, as with the Spanish regional saving banks, the Cajas, and Germany's state-owned Landesbanks, incompetent management may be responsible for imprudent risk taking, lack of transparency and wrongdoing. But the risk is magnified many times by the dangerous interaction between local banks, which are essentially governed by political bodies, and global investment banks. Details may vary across countries but the financial bubble in Europe cannot be explained without understanding what went wrong at this nexus. Second, politicians often want control over banks, but more often come to regret it. Commentators have suggested banks should return to their roots, and to the idea of local ownership and control as a way to protect against the dangers of poorly understood or managed risks. Yet local ownership and control did not save Monte dei Paschi, one of the world's oldest banks. Despite being publicly listed and the third-largest Italian commercial bank, Monte dei Paschi is effectively controlled by the charitable Foundation, which in turn is controlled by the local government. The Foundation is a minority shareholder yet dominates the appointment of the bank's board. In Italy, many dislike the Anglo-Saxon idea of a board being responsible to all the shareholders, preferring a hybrid involving public and private sectors to guarantee stability and long-term returns for the community. The Monti dei Paschi affair should make them think again. Third, the bailout looks more like a delay of the inevitable than an effective resolution mechanism. The bank has been offered convertible bonds at a high interest rate. If it is unable to repay, the state will automatically acquire about 80 per cent of the equity. Given the severity of the bank's problems, this looks like a delayed nationalisation. A cleaner solution would have been immediate nationalisation, restructuring and then sale. This is what happened with Northern Rock in the UK, with the Irish banks and in the Nordic countries in the 1990s. Sadly, in Italy, with a government debt to gross domestic product ratio of about 130 per cent, the latter option would be politically and economically costly. Monte dei Paschi may be too big to fail, but too expensive to save - regardless of who wins the elections. The writer is a professor of economics at the London Business School