Italian banks: fixing the hole

‘Are Italian banks more of an EU risk than Brexit?’ was the title of a video posted yesterday by Bloomberg. The plight of the country’s banks – in particular the 544-year old Monte dei Paschi di Siena – has been under increasing scrutiny ever since the shock result of the UK’s referendum on its membership of the European Union (EU) was announced early on June 24.

The resulting uncertainty has pushed the stock prices of many Italian banks from already depressed levels to record lows and increased their risk of default.

As the Financial Times recently noted, a developing crisis in the Italian banking sector stands in marked contrast to the near-meltdown in the industry globally less than eight years ago. When the UK government was forced to mount a state-backed rescue of Royal Bank of Scotland (RBS) in October 2008. Paschi di Siena’s executives were condescending in their attitude. A similar situation would not arise in Italy, they maintained, as Italian banks were more prudent and conservative than the UK and US peers. They had scrupulously avoided the subprime mortgage lending and derivatives that had felled other banks, while they remained rooted in their local communities.

However ever since the crisis Italy’s economy, the fourth-biggest in Europe, has struggled. Its poor record is exceeded only by that of Greece. Since 2008, it has undergone three recessions and lost nearly 10% of its gross domestic product (GDP), while youth unemployment had risen to over 44.2% by July 2015. Forecasts that growth this year would edge up to 1.2% from 0.8% in 2015 may now have to be revised downwards due to the fallout from Brexit.

At the same time Italy’s banking sector has accumulated €360bn of bad loans – or one fifth of the country’s GDP – and have provisioned for only 45% of the total. Paschi di Siena looks to be its most vulnerable member; it accounts for nearly €47bn of the bad loans total after several attempts to clean up its book of business failed and it is worth only one tenth of its book value. The European Central Bank (ECB) has now demanded more radical surgery and ordered it to reduce its debt burden over the next two years.

Murky outlook

This isn’t the only challenge facing Italy’s government. A recent paper issued by Standard Chartered’s research team on the global implications of Brexit noted: “In Italy, major opposition parties oppose EU membership, and prime minister [Matteo] Renzi’s authority has been challenged by recent defeats of his mayoral candidates in Rome and Berlin. There are questions now whether the constitutional referendum in October may be defeated.”

Renzi has been considering measures to shore up Paschi di Siena, along with the sector’s other weakest members. Unfortunately for him, Italy not only passed on the opportunity between 2008 and 2010 to shore up its banks, it also decided not to follow the lead of the Spanish government in 2012, which set up a ‘bad bank’ to take on delinquent loans. With private capital now pulling out and an existing bank-backed rescue fund to recapitalise the weakest lenders and buy bad loans largely exhausted, the obvious option would seem to be belatedlying follow in the path of countries such as the UK and Germany, which spent heavily to mount a state-backed bailout.

However, in the past three years the EU have tightened regulations so that bondholders are required to bear the brunt of losses before any state rescue is permissible. In Italy many of the bonds are held by retail investors. Renzi is keen to protect them, already bruised by last November’s rescue of four small banks when investors were hit and one committed suicide.

Complying with the EU rules and forcing this group to take a further, probably much larger financial hit would further undermine the Italian prime minister. Like his UK counterpart, David Cameron, Renzi has staked his premiership on winning a referendum – although in this case it is on proposed constitutional reform rather than EU membership and will be held this autumn.

But his request for the EU to sanction a taxpayer-funded rescue have so far received short shrift both from Brussels and also from German chancellor Angela Merkel, who is also mindful of the fact that Germany will be holding elections next year. The fear is that if the EU waters down the rules to suit Mr Renzi they will lose credibility. “We wrote the rules for the credit system,” said Merkel in response to Italy’s request. “We cannot change them every two years.”

A bigger problem

In turn, Renzi has suggested that Italy’s banks may not be alone in needing a bail-out. Earlier this month, at a press conference with Sweden’s prime minister Stefan Lofven, he commented: “If this non-performing loan problem is worth one, the question of derivatives at other banks – at big banks – is worth one hundred. This is the ratio: one to one hundred.”

One ‘big bank’ that he had particularly in mind was Germany’s Deutsche Bank, whose chief economist, David Folkerts-Landau, is calling on Brussels to authorise a €150bn recapitalisation of Europe’s banks. “Europe is seriously ill and needs to address very quickly the existing problems, or face an accident,” urges Folkerts-Landau. “Strictly adhering to the rules would cause greater harm than if they were suspended.”

Relaxing the rules would also help Deutsche Bank itself. Germany’s biggest lender has seen its share price slide by nearly 50% since the start of this year and, according to a study issued last month by the International Monetary Fund (IMF) “appears to be the most important net contributor to systemic risks in the global banking system, followed by HSBC and Credit Suisse.”

Renzi could yet be helped out if Italian officials and the European Commission (EC) are able to fudge a compromise solution that manages to avoid flouting the rules and also sparing Italian bank bondholders from major pain – not to mention a showdown between Brussels and an EU founder member so soon after the Brexit shock. This could be in the form of a “precautionary” recapitalisation.

With the results of stress tests of European banks, expected to expose Monte di Paschi’s fragility, due on July 29, the clock is ticking if Italy is to save its banking sector from collapse and Renzi to keep his job.

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