The bailout of the Italian bank Monte Paschi provides a great illustration of why banks must provide transparency.

Driving the need for a bailout is the publicly acknowledge fact the bank is sitting on a pile of bad loans.  Bank regulators would like it to raise capital and then deal with these loans.

Originally, Monte Paschi tried to sell stock to private investors.  It hired JP Morgan to do so.  This failed for the predictable reason investors weren’t interested in blindly betting on the bank.  Because of opacity, investors don’t know how large this pile of bad loans is and cannot estimate how much the bank will eventually have to write off.

Subsequently, Monte Paschi turned to the taxpayers to raise capital in the form of a bailout.  Bloomberg reported on the machinations bank regulators are going through to make this possible.

When the European Central Bank declared Banca Monte dei Paschi di Siena SpA solvent last December, the first step toward a state-funded rescue, some members of the 19-nation Supervisory Board weren’t fully on board.

Confronted with what they saw as a political agreement to bail out the world’s oldest lender, dissenters went along with the consensus despite their concerns about the bank’s health…

Of course, if Monte Paschi provided exposure level transparency, there wouldn’t be any doubts about its health.  All market participants, including investors and regulators, could evaluate the bad debt and assess for themselves whether the bank is viable or not.

If it is viable, there is no need for a bailout.  The bank could simply retain earnings until it had rebuilt its book capital to what regulators require.

If it is not viable, the bank should be closed.

However, since the bank does not provide exposure level transparency, we see the bank regulators putting their credibility on the line to force through a bailout.

To make sense of the Monte Paschi debate, you have to start with a 2014 law known as the Bank Recovery and Resolution Directive, which sets out the EU’s bank-failure rules. The law assumes that if a firm needs “extraordinary public financial support,” this indicates that it’s failing and should be wound down. In that process, investors including senior bondholders can be forced to take losses.

An exception, known as a precautionary recapitalization, is allowed for solvent banks if a long list of conditions is met. As the name suggests, this tool isn’t intended to clear up a bank’s existing problems, such as Monte Paschi’s mountain of soured loans. This temporary aid is allowed to address a capital shortfall identified in a stress test.

Daniele Nouy, head of the ECB Supervisory Board, reiterated in an interview on Monday that Monte Paschi and other Italian banks in line for a bailout are “not insolvent, otherwise we would not be talking about precautionary recapitalization.”

Not everyone is convinced the bank, whose woes date back many years, qualifies for this special treatment.

Even if Monte Paschi gets this special treatment, how does anyone know in the absence of transparency if the bailout is large enough?  They don’t.

By providing this special treatment, bank regulators also run the risk of the market concluding Monte Paschi is Too Big to Fail.  This too would be avoidable if the bank provided exposure detail transparency.

Instead, to paraphrase Shakespeare, we are left watching: “oh what a tangled web regulators weave when first they practice to deceive.”