Italy’s Plan for Banks Could Roil Europe

By PETER EAVIS
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The stock price of Banca Monte dei Paschi di Siena, one of Italy’s most troubled lenders, is down 80 percent in the last 12 months. Credit Stefano Rellandini/Reuters       

 
 
Even as Europe grapples with repercussions of Britain’s vote to leave the European Union, a dispute over tens of billions of dollars is also threatening to roil the region’s $16 trillion economy.
 
The Italian government, according to some estimates, needs to spend $45 billion to shore up its banks burdened with bad loans. Fears that European authorities will bar the government from providing that support are adding to the turbulence caused by “Brexit.”
 
It may seem difficult at first to understand how the lenders of a medium-size country, none of which are particularly large, or engage much in risky Wall Street activities, could be spreading fear through global financial markets.
 
But they are, and their problems reveal what can happen when well-intentioned regulations bump into reality. And this is creating tension among the leaders of Europe. The situation may drag through the summer, keeping investors around the world on edge.
 
So how bad could this get?
 
The steep declines in shares of Italian banks suggest that a storm is ahead. The stock price of Banca Monte dei Paschi di Siena, one of Italy’s most troubled lenders, is down 80 percent in the last 12 months. Its shares also trade at under 10 percent of its book value — a measure of its net worth — a sign that investors really think that the bank needs new capital. Also, when bank stocks sink that much, banks find it almost impossible to raise new capital in the markets.
The banks have already set aside significant reserves to absorb losses in these loans, effectively valuing them at 40 percent of their original value, according to some analyses. Investors appear to think that these loans are worth even less, however.
 
The theory is that the banks would now have to bite the bullet and value the loans at an even lower level. But this could produce losses, and some banking experts say €40 billion of support is needed to help the banks take those hits.
 
A simple response would be for the Italian government to hold its nose and plow that sum into the banks, roughly mimicking what the United States government did with its TARP spending in 2008.
 
But such a bailout may be illegal under relatively new European rules that aim to protect taxpayers and instead force investors in the banks to provide financial support in times of trouble. Investors lend money to banks by buying their debt securities. Under the anti-bailout rules, those securities would be forcibly turned from debt into new equity, which could absorb any new losses taken on the bad loans. Under such a so-called bail-in, the equity would in theory be worth less than the debt securities, leading to losses for investors who held the debt.
 
It sounds straightforward, but in Italy it is not.
 
Retail investors hold many of those debt securities. According to Bruegel, a research organization that specializes in European economic issues, families own about a third of Italian banks’ debt securities. Not only would bail-ins focus the pain on Italian households, the fear of losses might also prompt investors to stop lending to banks and lead depositors to withdraw their money. This would make a bad, but manageable, situation much worse.
 
Italy could try to focus the losses on institutional investors, but, as Silvia Merler, an affiliate fellow at Bruegel, has noted, picking winners and losers could only add to the confusion among investors in bank debt.
 
To try and avoid this sort of mess, Italy’s government is hoping that Europe’s leaders will let it put money into its banks. But there is considerable tension over the question, as shown by a sharp public exchange between Angela Merkel, Germany’s chancellor, and Matteo Renzi, Italy’s prime minister.
 
A compromise doesn’t look impossible, though.
 
Europe’s leaders, seeing the specifics of Italy’s problems and wary of the stresses caused by Brexit, may decide that it makes sense to give Italy a pass this one time.
 
And the rules provide ways to do that. There are, for instance, exemptions in Europe’s “state aid” rules that aim to force bail-ins. One kicks in if a bail in could have “disproportionate results.”
 
Dan Davies, senior research adviser at Frontline Analysts, says the Italian government could argue that forcing losses on retail investors would fall under that exception.
 
Yet even if Italy is not given a green light to directly bail out its banks, Luigi Zingales, a professor at the University of Chicago, has suggested that the Cassa Depositi e Prestiti, a large investment entity controlled by the Italian government, could provide the bailout funds. Mr. Zingales was a critic of TARP and says that investors in the bonds of United States banks should have been made to participate in bail-ins. But, because of the retail investors, and the potential for financial panic, he says, “you cannot do the same thing in Italy.”
 
So if Italy does bail out its banks, will they stop being a problem? Will they resurface as a destabilizing force two summers from now?
 
To stop that happening, analysts say that government support must come with a plan to overhaul the industry. Mr. Davies said that mergers would help, if done at valuations that make sense.
 
Alberto Gallo, head of macro strategies at Algebris Investments, a hedge fund, says that moves must be taken to make the industry much more efficient than it is.
 
“This injection would need to come with a restructuring of the system,” he said.

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