Understanding The Italian Banking Crisis, A New Lead Domino?

by: Nicholas Puri (PuriCassar)


Summary

- Non-performing loans have become the key area of concern for Italian banking, originating from the financial crisis in 2008.

- Further economic measures have compounded the issues for Italian banks, leading to an untenable situation.

- Potential solutions have been attempted, without great success. A wider solution is being discussed, although this is not without its own obstacles and restrictions.

- Will the contagion spread from Italian banking and become the lead domino in a larger scale banking crisis?
 
 
With many people considering 2016 to be an annus horribilis, it is safe to assume that there is a high level of uncertainty in the air as we head into the New Year. Political fragmentation appears to be the flavour of the moment, with Brexit and Trump's election victory taking centre stage. However, despite the situations in the UK and US attracting the bulk of the attention this year, the most immediate cause for concern lies firmly in the hands of Italy.
 
If political division is currently in vogue, the Italians are certainly no strangers to this; with the recent referendum and subsequent government reshuffle clearly showing unrest is not absent in the Mediterranean. However, the most pressing concern goes beyond political tensions and even beyond the weak and fragile growth seen in the economy. The biggest area of alarm is with the severely troubled banking sector.
 
With the domino effect of negative financial events in recent years turning most of the financial world into hardened cynics, one may roll their eyes and argue that the Eurozone thrives on having its 'problem child' of the hour. In this case, Italy is just taking its turn to step into the role once again, until the buck gets passed onto the next unfortunate nation in line.
 
However, when we consider the level of apprehension that was present earlier in the year when issues at global financial powerhouses such as Deutsche Bank (NYSE:DB) reared their ugly head once again, it becomes important to understand the situation in Italy, which has the potential to be the smaller lead domino in a much more widespread financial downfall.
Non-Performing Loans
 
The stress tests administered by the ECB on July 29 exposed the Italian banking sector as being amongst the most fragile in Europe. The key areas of concern for this weakness were the asset quality, which is seen as very poor, combined with the under par economic outlook.
 
Taking a closer look at the issue of poor asset quality, it becomes clear that although there are many problems, chief amongst those is the situation of non-performing loans (NPLs).
 
When you dissect the NPL data, it is evident that the main culprit for the issue stems back to the financial crisis that hit the economy in 2008. This is shown by approximately half of the total gross NPLs being loans collateralised by real estate. From this, around 80% were issued to SME and corporate clients, with Lazio and Lombardy (where Rome and Milan are situated respectively) being the key regions with the highest NPL share.
 
At present, NPLs in the Italian banking sector amount to around €200 billion, which is the equivalent of 8% of the total loan portfolio. However, some analysts believe this figure understates the reality, since it does not include a further €160 billion which could potentially join the pool, therefore increasing the actual portion to 15%.
 
A recent research by Goldman Sachs (NYSE:GS) further highlights the dire situation of the current loan book, with estimates showing the standard market price for 'past due' loans at 21 cents and the standard market price for 'unlikely to pay' loans at 54 cents. A white paper by PIMCO estimated that selling all NPL assets at these market rates would lead to a capital depletion of around €40 billion, which along with other factors makes holding onto these assets rational at present and justifies the Italian banks in doing so.
 
Economic conditions further compounding the issue
 
If the poor quality of assets being held by Italian banks was not already enough of a destabilising factor, the issue has been further compounded by other economic measures being imposed.

In particular, the sharp decline in interest rates has been an area of difficulty for Italian banks, with it severely affecting their current and expected future profitability. When rates are falling, the value of fixed-income securities on a bank's balance sheet goes up, leading to higher profits.

This is one of the tenets of the ECB's decision regarding rates, as specified in a paper they released this year. However, this has not necessarily been the case in Italian banking.
 
Not only must they endure the short-term interest rates being in negative territory at present, but they have also been hit by the yield on Italian bonds. The 10-year Italian government bond has plunged to an all-time low, which has therefore impacted not only a large portion of their fixed-income securities holdings, but their overall holdings in general. As Italian banks own more than €400 billion of Italian government bonds, this accounts for around 10 percent of their total assets.
 
Finding a solution to this growing problema
 
As we have observed in the years following the financial crisis and the actions taken by central banks around the world, solving deep issues in the banking sector is no straight forward task.
 
The current Italian banking crisis is no different; presenting a myriad of catch-22 situations and restrictions that are proving extremely difficult to resolve.
 
Measures taken so far have not proven to be impactful and a grand solution is yet to be agreed. The situation is currently changing by the day, as discussions continue about whether a bailout of Monte dei Paschi di Siena (OTCPK:BMDPD), Italy's third largest bank, will be possible.
 
Therefore, while we can discuss the current potential solutions and measures taken thus far, it is important to note the fast-changing landscape.
 
From the stress tests mentioned earlier that were undertaken on 51 EU banks, Monte dei Paschi was found to be the weakest. The bank holds around €50 billion in bad loans, which makes up about 30% of its total assets.

At the end of July, the Atlante fund signed a memorandum of understanding to buy the mezzanine notes of the securitised bad loan portfolio of Monte dei Paschi for €1.6 billion. The Atlante fund is a private equity fund which was set up by the Italian government this year, with the sole purpose of recapitalising Italian banks and purchasing NPLs. The fund was able to raise €5 billion from 67 investors and will be managed by Quaestio Capital Management. It is important to note that Atlante has been funded predominantly by capital from other Italian banks, which makes it vulnerable to becoming a vehicle for further contagion.
 
Although Monte dei Paschi is the main focus at present, Italy's largest bank Unicredit (OTCPK:UNCFF) is also in a dire situation. The bank is planning to raise €13 billion in capital to boost its reserves, which is expected to be launched by February 2017. They are also attempting to dispose of €18 billion in bad loans to two new businesses. Monte dei Paschi had also attempted a capital raise of €5 billion, but was unsuccessful in doing so.
 
There are also other small, regional banks that are in a critical position and will likely need assistance in the near future. This has already been the case for four troubled local banks that were rescued by the Atlante fund. The sale of these banks is still on-going.
 
Bailout or bail-in?
 
The Italian government has authorised the use of taxpayer funds to bailout close to insolvency banks. Nevertheless, the biggest obstacle to a full government bailout so far has been the political disputes within the EU. Germany was very public about its discontent regarding this potential solution, and the ECB have been on a similar page with this. However, it seems progress is being made in this regard and a favourable outcome is looking more likely by the day.
 
If this solution goes ahead, there will be two potential measures available:
 
A government guarantee on senior debt, which would ensure the medium and long-term debt issuing capability, directly claiming a stake in the banks' equity to prevent a default from taking place.

Unfortunately, a government bailout of close to insolvency banks is likely to have negative electoral repercussions as well, despite the main beneficiaries being small entities with strong links to the local communities. In addition to this, even if a taxpayer bailout does take place, bondholders would still fail to be protected.
 
On the other hand, a bail-in solution, agreed within the EU context in case of banks' insolvency, may unfortunately also prove to be a tough pill to swallow.
 
Firstly, the system which governs Italian banks, which is mostly accountable to the political system rather than the markets or private investors, is likely to offer resistance to the implementation of the bail-in solution.
 
Additionally, the bail-in would significantly change the ownership structure and could encourage considerable opposition amongst the banks' investors as well as the electorate. This would lead to political opposition parties using the situation to bolster their propaganda during election time.
 
Will this be the end to the saga?
 
Given that the capital required to restructure the banks' debt is in the ballpark of €30 billion, this is a sizeable problem and one that is unlikely to fade away overnight even if a bailout or bail-in solution is agreed.
 
When you consider the fragmented and uncertain political landscape in place, as well as the unfavourable economic outlook, there is unlikely to be a large appetite from foreign institutional investors to have any sort of involvement.
 
The question, as with most government and central bank endeavours to fix disastrous economic situations in recent years, is whether this is an ultimate solution or simply delaying the inevitable. For now, we can be rest assured that whatever measure takes place, it will curtail the risks for now that this situation could be the lead domino in a full European banking crisis.

But with that being said, how long will it be until the next and potentially greater systemic risk elsewhere unfolds?

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