Economics

Just how serious is Italy's banking crisis?

€360bn of Italian bank loans are estimated to be “non-performing”

July 13, 2016
Dutch Finance Minister and chair of the eurogroup finance ministers Jeroen Dijsselbloem, left, speaks with Italian Minister for Economy and Finances Pier Carlo Padoan at the start of the Economic and Financial Affairs Council meeting at the EU Council bui
Dutch Finance Minister and chair of the eurogroup finance ministers Jeroen Dijsselbloem, left, speaks with Italian Minister for Economy and Finances Pier Carlo Padoan at the start of the Economic and Financial Affairs Council meeting at the EU Council bui
Read more: What will the Bank of England do?

Roughly €360bn of Italian bank loans (equal to about a fifth of annual GDP) are estimated to be “non-performing,” which means that borrowers are in breach of their original terms, either behind on interest payments or paying back the loan itself. Since the UK’s Brexit vote on 23rd June, shares in Italian banks have fallen by about a third. That unexpected vote led to a surge in distaste for risky assets, and Italian bank assets were clearly judged to be amongst the riskiest.

The non-performing assets of Italian banks are not the casino-like investments that we now see brought down other banks across Europe and the US in the 2008 financial crisis. They are, seemingly, regular loans to small and medium enterprises. The difficulties were not, therefore, caused by reckless banking innovation as happened in the UK.

Instead they are a result of the effects of slower than hoped for growth in the Italian economy over many years; a fragmented industrial structure (there are 600 independent lenders in the country’s banking sector); and the complex links between banks and local politics, which prevented central government from acting earlier.

Ironically, the problem has been aggravated, and is coming to a head almost precisely because of policy measures designed to respond to the last crisis.

For starters, banks across the western world are struggling because of the effects that very low or even negative central bank policy rates have on their profits. Loan rates are linked either contractually (via tracker rates) or through competitive pressure, to the policy rate, so they have fallen in Italy as the European Central Bank has cut rates to try to stimulate the eurozone economies in the aftermath of the last financial crisis. But rates offered to depositors and other funders cannot fall materially below zero. (People will hold cash rather than suffer negative rates). So margins are squeezed by monetary policy.

The government of Italian PM Matteo Renzi—pressure on whom is mounting in the build up to the country's coming constitutional referendum—is considering recapitalising the banks: giving the banks funds in return for an equity stake. But doing this would flout existing rules governing state aid to industry in the EU, and, should the banks’ health become a matter of solvency (it hasn’t yet), new rules governing the use of public funds arising out of the emergent banking union.

Those regulations were a response to the “doom loop” that threatened the very existence of the eurozone in 2012.

A recession which hits the value of bank loans, or a financial panic that causes their funding to evaporate, can cause markets to run from the sovereigns who they expect might try to stand behind those banks. (This is what happened in Ireland). Or a government that loses control of its finances can sink its own banks, which will typically be heavily invested in its government bonds, and that can aggravate government finances further. (That was what happened in Greece).

Preventing reflexive government injections of funds to support banks is supposed to help break the first part of this “loop” and avoid the associated fiscal “doom.”

As things stand, the Italian government would have to force some existing bond and equity holders in the banks to take a hit (to be “bailed in”) before providing funds itself. This is particularly unattractive for Italy because, unlike elsewhere, a lot of those bonds are held by retail investors—ordinary household savers—as opposed to professional investors. Wiping out the savings of such people is for the politically brave only.

These rules are part of a framework that is designed to protect the continuity of the euro itself. As we saw with Greece in 2015, if a government gets to the point where it cannot finance itself through bond finance, it may be forced out of the euro de facto as it resorts to printing a new domestic money.

But, paradoxically, the prospect of the inflexibly applied state aid/resolution rules may itself increase the risk of a rupture with the eurozone.

The impasse—and the prospect of a bail-in of retail investors—stokes the popularity of anti EU and anti-euro groups in Italian politics. And the uncertainty it creates depresses share prices (no-one wants bank shares if equity holders are about to be wiped out). The effect of that is that lending is further depressed in Italy, harming real activity, and feeding back negatively into government finances and bank balance sheets again, making a highly unlikely Italian exit fractionally more so.

Daniel Davies, senior research advisor at Frontline Analysts, is reported in the Financial Times’ Alphaville as suggesting one way out: if bailing in bondholders is thought likely to spark retail depositors to run from all banks, causing a problem for the banking system as a whole, government money could be pumped into the bank without a bail-in. Since one cannot obviously prove a hypothetical, there is inevitably scope for flexibility and disagreement over this.

Alternatively, it may be that funding could be given in a way that is pre-committed to be temporary, buying time for the government/central bank to restructure the most troubled banks.

Perhaps only €40bn is needed. Although Italian government debt has piled up to the tune of 125 per cent of GDP, this cost could easily be borne while the fracas itself has not affected yields on Italian bonds. And in the context of the eurozone as a whole, it is a tiny sum on which to break the euro, so we should expect some deal to be found.