Our Opinion: 2016
Italy’s failing banks worry Euro-zone
The possibility of banking collapses in Italy is concerning many European leaders. Such a collapse will lead to yet another Eurozone crisis, and a wider banking crisis for those countries with high exposure to Italian bank debt.
Italy’s banks are in deep trouble, weighed down by €360bn of bad debt (non-performing loans), equivalent to 20% of Italy’s GDP, and about 18% of all the banks’ loans. Shares in the sector have slumped this year as investors began to price in the risk of banking collapses. One of the worst affected has been Monte dei Paschi di Siena, the world’s oldest bank. The sell-off has gathered pace since the shock of the Brexit vote on 23 June caused investors to re-evaluate the risks facing European assets.
Italian banks are fundamentally vulnerable because of Italy’s terrible economic performance over the past decade (the economy is still 8% smaller than it was pre-crisis). This has left the banking sector exposed to years of bad debts from failing businesses.
The International Monetary Fund (IMF) recently warned that Italy was unlikely to grow its economy back to pre- crisis size until the mid-2020s, implying nearly two lost decades. High taxes, an inefficient public sector and civil service wage rises that have outstripped productivity gains for years, had all contributed to one oft the lowest growth rates among advanced economies over the last 30 years.
Brexit-related uncertainty is expected to drag down the economy over the next two years, with growth in GDP of 1% or less. The IMF added that public debt, at 133% of GDP, left policymakers very little room to cope with shocks.
All this implies that banks face a situation that will get worse, not better, without intervention. Which leads to another key reason for the exceptional weakness of Italy’s banks – its weak and often short-lived governments have spent years avoiding decisive action to tackle their festering problems. After the global financial crisis, governments in the UK and the US in particular undertook a major recapitalisation of their banking sectors from 2008- 2010.
Italy chose not to. It also failed – unlike Spain – to take the opportunity to set up a bad bank in 2012 at the height of the euro-zone crisis, and has preferred to kick the can down the road ever since. But as a senior Italian banker told the Financial Times recently: “You think you are kicking the can down the road, but suddenly the road turns uphill and the can comes back and hits you in the face.”
At the end of 2015, the rules governing what euro-zone governments can do to help struggling banks changed dramatically, giving them much less scope to come to the rescue. Specifically, under the European Union’s new “bank resolution and recovery” directive, which came into effect at the start of 2016, governments are prohibited from using public money to recapitalise banks without first forcing huge losses onto private investors – both shareholders and bondholders. On the face of it, this provision – that 8% of existing liabilities must be “bailed in” by investors before the banks can be “bailed out” by the public purse – seems fair, especially where those investors are wealthy institutions that can take the losses on the chin. But the situation in Italy is very different.
The Italian banks’ creditors include millions of ordinary Italians, who
own around €200bn of bank bonds eligible to be bailed in. For many of Italy’s 1,400 banks, a ‘bail in’ would wipe out not just shareholders, but also ordinary depositors who have been sold €173bn worth of questionable bank debt (“subordinated” loans – ie, bonds that are a lower priority for repayment in the event of bankruptcy). In other words, bailing out its banks in line with euro-zone rules looks politically impossible for Italy, especially after a ‘bail in’ of four small banks last year hit 100,000 retail investors, causing widespread street protests and even suicide.
So what is likely to happen?
Italian bank stocks rallied recently on the hope (boosted by positive noises from Angela Merkel and the IMF) that the EU and Italy will come up with a fudge that allows both sides to save face, and facilitates some form of limited or initial bail out. Either way, time is of the essence.
In just over two months, Prime Minister Matteo Renzi’s government faces a referendum on constitutional reform, which is likely to be a de-facto vote of confidence in Italy’s membership of the euro-zone. Any bail out that turns Italians further against the political establishments in Rome and Brussels would seriously damage Renzi’s chances of winning it – and deliver yet another blow to a Europe already reeling from Brexit.
4th August 2016