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Gavekal-logoBlame the British. In the wake of the UK’s Brexit vote, investors fearful of spreading contagion have woken abruptly to the slow-burn banking crisis in Italy. It should have been news to no one that Italy’s banks are sitting on non-performing loans with a face value of EUR360bn, 18% of their total loan books, and that their capital position is supported largely by a very generous valuation of those loans’ collateral. Yet with the sector index down -30% since the UK vote, Italian banks are suddenly front and center in investors’ minds as the next source of European uncertainty.

Restructuring and recapitalization are badly needed to get credit flowing again in order to support the recovery of Italy’s ailing economy. The trouble for Prime Minister Matteo Renzi is that the private sector isn’t interested in putting up the capital and the government’s freedom to act is constrained by new EU rules imposing strict limits on state aid to the banking sector. This leaves him with few options to resolve the crisis:

1) Follow the rules: the Eurozone’s new rules, which came into full force at the beginning of this year, prohibit state aid to troubled banks until at least 8% of existing liabilities have been “bailed in”. For many of Italy’s 1,400 banks, that would mean wiping out not only their existing shareholders but also many of their own depositors to whom they have sold EUR173bn of subordinated bank debt. After the political outcry that followed last year’s bail-in of 100,000 retail investors in four small banks that is a step the Italian government is not prepared to contemplate. A bail-in now on a wider scale would stoke rising popular discontent, greatly reducing Renzi’s chances of carrying October’s referendum on constitutional reform—a referendum which is fast turning into a vote of confidence in Italy’s membership of the eurozone (see The Overlooked Risk In Italy and The Italian Problem).

2) Break all the rules: the extreme option would be for Renzi to disregard the EU rules entirely and proceed to a unilateral state bail-out of the Italian banking system. This could or could not mean the nationalization of stricken banks, but would likely involve setting up a publicly-capitalized “bad bank” which would issue bonds to commercial banks, using the proceeds to buy their bad assets at a price close to the 40% of face value at which they are currently carried on the banks’ books. The bad banks’ bonds would be backed by a government guarantee to ensure they have a low-risk weighting, so freeing bank capital to allow lending to resume. Such a drastic course of action is highly improbable; it would completely undermine the eurozone’s banking union. Moreover, it is doubtful whether Renzi has the domestic political heft to ensure its success.

3) Cut an EU-sponsored deal: a unilateral bail-out in defiance of EU regulations may not be a realistic option, but it is a powerful implied threat with which Renzi may well be able to secure a partial waiver of the restrictions on state aid. Article 32 of the EU’s banking rules allows in exceptional circumstances for “extraordinary public financial support” of banks deemed at risk of failure. With the European Banking Authority scheduled to publish the results of stress tests on Italy’s 10 or so largest banks on July 29, failure in the tests—highly likely if the appraisal is fully objective—would throw up a handy opportunity to plead just such exceptional circumstances. In return for pledges of restructuring and widespread banking sector consolidation, the EU authorities could allow Rome to inject “precautionary and temporary” capital into troubled banks, averting the immediate crisis without bailing in retail bond-holders.

This is the option that Renzi is pursuing at the moment. So far European politicians have poured cold water on the idea. However, given the danger of inaction and the unattractiveness of Renzi’s other options ahead of October’s referendum, some form of this solution remains likely. The big question will be the extent of the permitted capital injections. If they cover just one or two of the most troubled banks—notably Banca Monte Dei Paschi Di Siena, which has a 35% NPL ratio—the market’s immediate jitters may be calmed, but the dead weight of bad loans hampering Italy’s banking system and economy will not be lifted.

The unpalatable truth is that even Italy’s strongest banks have NPL ratios of 16% or more and inadequate provisioning that leaves them short of capital by some €40bn. Anything that falls far short of a full-scale recapitalization and restructuring plan encompassing Italy’s 10 largest banks, which hold close to 80% of the system’s NPLs, is unlikely either to alleviate public fears of bail-ins, ahead of the upcoming referendum, or to restart the credit creation process and restore Italy’s animal spirits. In short, failure to tackle Italy’s banking crisis head-on with an EU-sponsored bailout which acknowledges that “temporary” capital will likely prop the Italian banking system for much of the next 10 years, would risk amplifying the political and economic forces working to fragment the eurozone. With so much at stake, a little bending of the EU’s new banking rules is a small price to pay.

[Source: Reproduce by kind permission of Gavekal Research - by Nick Andrews & Tom Holland - July 8, 2016]


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