By Francesco Canepa and Huw Jones
FRANKFURT/LONDON (Reuters) - The European Central Bank hopes its decision to confront struggling Italian bank Monte dei Paschi at last will draw a line under a multi-year crisis that has risked tarnishing its reputation as a credible supervisor.
Reuters exclusively reported on Friday that the ECB rejected Monte dei Paschi's (MI:BMPS) request for more time to complete an ambitious, 5 billion euro (£4.2 billion) cash call - effectively leaving it up to the Italian government to bail out the bank.
ECB officials told Reuters they hoped that a "precautionary recapitalisation" of Monte dei Paschi by the Italian state will pave the way for similar injections of government money into other Italian banks plagued by bad loans totalling 360 billion euros.
A precautionary recapitalisation is a type of state intervention in a struggling bank that is still solvent.
It means only a modest bail-in or write down in the value of a bank's bonds is likely, though the Italian government can buy shares or bonds in Monte dei Paschi only on market terms endorsed by EU state aid officials in Brussels.
"There is consensus that Monte dei Paschi needs a precautionary recap," one of the officials said, requesting anonymity. "Once that is done, it could serve as a template for other banks."
This scenario is subject to a number of open political questions, such as who will be in the new Italian government following Prime Minister Matteo Renzi's decision to resign and how much fiscal room the European Commission is prepared to give Rome for bank rescues.
Deutsche Bank analysts estimated in a note that 30 billion euros, equal to less than two percent of Italian gross domestic product, could be enough to address market concerns about all the troubled lenders.
Italy's anti-system 5-Star Movement said on Friday the government should intervene to save Monte dei Paschi and protect the small savers from losses. However, next year's state budget passed on Wednesday already exceeds the deficit level agreed with the European Commission.
A government-led recapitalisation will also raise questions about whether rules introduced since the 2007-09 financial crisis to prevent taxpayers having to fund bailouts in future banking crises have been worth it.
Monte dei Paschi's problems date back several years but until now the ECB, as the bank's main supervisor since November 2014, has avoided confronting matters head on.
This is despite the bank failing the EU's regular stress test of lenders twice in a row - the latest was in July this year - showing how Monte dei Paschi is suffering from bad loans and too little capital.
Further delays by the ECB would start to undermine its reputation as a banking supervisor or single supervisory mechanism (SSM) that is meant to cut through national vested interests in the euro zone.
"Monte dei Paschi is an existential question for the ECB, a matter to act for its own credibility," said Karel Lannoo, chief executive of Brussels think tank CEPS. "We are two years into the SSM, and the Monte dei Paschi question has been known for five to six years."
Nicolas Veron, a research fellow at economic think tank Bruegel in Brussels and the Peterson Institute in Washington, said the ECB has been slow to act until now because it was building up capacity as a supervisor.
"I would have preferred them to be more forceful earlier. They have taken a risk in terms of their reputation. This delay has not gone unnoticed, but in fairness, it has to be asked if they had the capacity to do things more quickly," Veron said.
Successive Italian governments failed to tackle the issue, which became a political taboo this year when new European rules came into force banning state bailouts unless private investors take losses first.
The fall of Renzi this week following a resounding defeat in a referendum on constitutional change is seen by some commentators as bringing the country's banking crisis to a head, thus forcing the ECB's hand.
President Sergio Mattarella began consulting political leaders on Thursday to seek a consensus to back a government. Without that, he will have to dissolve parliament and call early elections.
ECB officials hope an interim government, ideally including economy minister Pier Carlo Padoan, would take the unpopular decision to inject capital into Monte dei Paschi, negotiating a way to compensate savers with the European Commission.
The precautionary recapitalisation model could also be used for other struggling lenders in Italy. This could lure private investors back into the sector and allow the banks to sell down their bad loans more quickly, an objective for the ECB.
Monte dei Paschi was the only Italian bank to come short under an adverse scenario in the pan-European stress test of large lenders this year.
(editing by David Stamp)