Blog Post

Bad banks and rude awakenings: Italian banks at a crossroads

Italian banks have recently come under market pressure, as investors seemed to have grown worried about the sector. This triggered a speed-up in the discussion between the Italian government and the European Commission about the creation of a “bad-bank”, on which a decision is reportedly due this week.

By: Date: January 26, 2016 European Macroeconomics & Governance Tags & Topics

Taking a step back, it is important to understand what could be behind the sudden change in market sentiment. Borrowing a literary expression, this is to some extent the chronicle of a death foretold. Italian banks have been very resilient to the first wave of financial crisis in 2008, due to the low exposure of Italian banks to US products and to the fact that there was no housing bubble that burst (contrary to what happened e.g. in Spain). But when the financial crisis turned into a euro sovereign banking crisis, things started to deteriorate for Italian banks, and they have really never improved much since then.

Figure 1

Source: own calculations based on data from Bank of Italy

SM_26_01_2016_11

As the economic situation worsened, bad loans accumulated on banks’ balance sheet, making it increasingly difficult for them to lend to the private sector and support the economic recovery. Bad loans have been growing constantly ever since 2008, and reached 200bn euro in September 2015. This is roughly equivalent to 9% of total loans, a level that was unseen since the late Nineties. About 71% of the total bad debts is made of loans to non-financial corporations, whereas 27% is constituted by loans to households, and the ratios are higher in the Southern and Islands regions – where the economic situation is worse – than in the North (see Table 1). At the bank level, the situation is mixed (Table 2). Non-performing Loans ratios range from about 14% for Unicredit to as much as 39.9% for Monte dei Paschi and coverage ratios also vary considerably across the individual institutions.

Table 1 – Bad debt by geographical area

Source: own calculations based on data from Bank of Italy

The existence of sizable and increasing bad loans in the Italian banking sector has been known for quite a long time (see e.g. here and here). What acted on market sentiment is probably a worry about how this could play out in the future, given that the new regime for bank recovery and resolution (the BRRD) has now entered into force.

The recent episodes of “creative” resolutions of four Italian banks have in fact highlighted a potentially very serious problem, i.e. that over the past years some Italian banks had been placing their subordinated debt with retail customers who were unaware of the true risk associated with these products.

Figure 2 shows that as of September 2015, Italian households were holding about 30% of the total bonds issued by Italian banks, slightly less than the 35% that was held by other Italian banks. The households’ share of total bank bonds used to be much higher (around 60%) until the mid-2000s. It declined to about 45% between 2005 and 2007, mostly substituted by increased foreign holdings, and it started to to decrease again in 2011, substituted this time by increased holdings of other Italian banks.

Figure 2 – holdings of Italian banks’ bonds, by sector (% total)

Source: own calculations based on data from Bank of Italy

SM_26_01_2016_1

The entry into force of the BRRD makes this a thorn in the side of the Italian government. BRRD aims at reducing the cost of bank rescues for taxpayers, which  would be especially problematic for states – like Italy – that have high public debt. But in order to do so, BRRD requires sizable bail-in of bondholders, which in the case of Italy can likely retail holders with limited awareness of the risk. The potential for political backlash is obviously large, and “creative” solutions like those implemented this fall to protect senior bondholders will hardly be possible under BRRD. Even if they were possible, it would be very difficult to engineer them, because of their cost. The operation that was carried out to resolve four banks in November without haircutting senior bondholders required the three biggest Italian banks to advance the money that were not in the resolution fund. And these were only 4 very tiny banks, making up for around 1% of Italian deposits in total.

These worries, and the resulting market stress, speeded up the talks between the Italian government and the European Commission about the creation of a bad bank. This could be a potentially important step to finally clean the Italian banks balance sheet, but it is probably not going to be miraculous and it is certainly not going to be as easy as it would have been in the past. According to Reuters, the plan that is being discussed aims at reducing the balance sheet impact of the necessary writedown by having the bad loans sold to special vehicles, which would issue bonds to fund the purchase. To make the bonds appealing and cheaper to issue, Italy would offer a state guarantee on them, with the underlying idea that the easier it is for the SPV to finance the purchase and the better the terms on which it can buy the loans from the banks, thus limiting the balance sheet impact.

But the implementation of this public-private scheme could be much more difficult today under the new regulatory framework than it was at the time when Spain and Ireland cleaned up their banking sectors. The point of contention is the the price at which the banks will be able to offload their bad loans to the vehicle. If this price is too low, than the writedown could have a sizable impact on banks’ balance sheet and it would not reassure the markets. Reuters reports that the selling price of the bad loans to the SPV could be between 20 and 30 percent. If we pick the average (25 percent), a very simple back of the envelope calculation suggest the existence of additional provision needs for the sector (see table 2). On the other hand, if the government guarantee were such that the selling price resulted too high compared to the market value of the loans, then the operation would be considered state aid.

Table 2 – selected indicators at individual bank level

Sources: banks’ reports

Table 1 Table 2

Last year, just after the release of the ECB stress test results, I wrote about some long-term structural issues – such as the low profitability of the Italian sector compared to e.g. the Spanish one, or the complex and opaque governance system. While having been know for a long time, these problem were at that time lying quietly below the surface waiting for their moment of recognition.

The final wake up call might have finally come on the 1st January 2016, when the Bank Recovery and Resolution Directive (BRRD) officially entered into force. Based on the management of recent resolution episodes, investors have probably realised that the Italian government will have troubles managing a change that could have potentially relevant social consequences of which the country had little awareness until a couple of months ago. Facing the long-lived issues in the Italian banking sector is now urgent, but Italy might have waited too long for it not to be painful.

 


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read article More on this topic More by this author

Blog Post

Silvia Merler

Financial implications of the Italian referendum

On Sunday, Italy will held a constitutional referendum whose implications for the political stability of the country are uncertain. Right after the referendum, Italy’s oldest and most troubled bank - Monte dei Paschi di Siena - is expected to complete a very important and sizable capital raise. Here we look at the situation and implications of this critical juncture.

By: Silvia Merler Topic: European Macroeconomics & Governance Date: December 2, 2016
Read article Download PDF More on this topic

Policy Contribution

pc-20-16_page_01

What impact does the ECB’s quantitative easing policy have on bank profitability?

This Policy Contribution shows that the effect of the ECB’s QE programme on bank profitability has not yet had a dramatically negative effect on bank operations.

By: Maria Demertzis and Guntram B. Wolff Topic: European Macroeconomics & Governance Date: November 30, 2016
Read article

Blog Post

Giuseppe Porcaro
hsbeziyq

Tweeting the Italian referendum: the hashtag war

We are monitoring an aggregate of twitter hashtags in the run up to the Italian Constitutional referendum of 4 December 2016.

By: Giuseppe Porcaro, Henrik Müller and Gerret von Nordheim Topic: European Macroeconomics & Governance Date: November 29, 2016
Read article More on this topic More by this author

Blog Post

sd-12177-_0028bea2-web

Can public support help Europe build distressed asset markets?

Distressed asset investors can relieve banks of their NPL overhang and offer valuable restructuring expertise, although banks will need to realise a further valuation loss. Regulators could do a lot to support the growth of this market.

By: Alexander Lehmann Topic: Finance & Financial Regulation Date: November 29, 2016
Read article More on this topic More by this author

Blog Post

Silvia Merler

The Italian referendum

What’s at stake: on 4 December, Italy will hold a referendum on a proposed constitutional reform approved by Parliament in April. The reform, which was designed in tandem with a new electoral law, aims to overcome Italy’s “perfect bicameralism” by changing the structure and role of the Italian Senate. It also changes the distribution of competences between the state and regions. After the shocks of Brexit and the US election, polls are now drifting towards a defeat of the government’s position in Italy.

By: Silvia Merler Topic: European Macroeconomics & Governance Date: November 28, 2016
Read article More on this topic More by this author

Blog Post

sd-12177-_0028bea2-web

Credit recovery in Spain: NPL resolution was essential, but success depended on broader sector reform

Growth in Spain again exceeded expectations this year, and bank deleveraging appears to have reached an end. Addressing non-performing loans was a precondition for recovery, and it required comprehensive financial sector reform.

By: Alexander Lehmann Topic: European Macroeconomics & Governance Date: November 21, 2016
Read article More on this topic More by this author

Blog Post

IMG_1985

Renzi is going all in on the Constitutional referendum: what are the (updated) odds?

Italians are being called to the ballot boxes on 4 December to either confirm or reject Constitutional amendments put forward by the government. Alessio Terzi constructed a probabilistic model based on poll data to assess the likelihood of such an event.

By: Alessio Terzi Topic: European Macroeconomics & Governance Date: November 17, 2016
Read article More on this topic More by this author

Blog Post

Schoenmaker pic

Stealing London’s financial crown would bring both benefits and responsibilities

After Brexit, several major cities across the EU27 are looking to take over London's financial activity. While there are plenty of benefits in hosting a major financial centre, it also comes with significant risks and responsibilities.

By: Dirk Schoenmaker Topic: Finance & Financial Regulation Date: November 17, 2016
Read article Download PDF More on this topic More by this author

External Publication

claeys-ref-2016

What role for the financial markets in Europe?

The European European financial system is too strongly bank-based. How can it be rebalanced to become favourable to growth and employment again? (This paper is only available in French).

By: Grégory Claeys Topic: Finance & Financial Regulation Date: November 16, 2016
Read article More on this topic More by this author

Opinion

Silvia Merler

An Italian take on banking crisis

The year 2016 has not been good to Italian banks. While resilient to the first wave of financial crisis in 2008, due to their low exposure to US sub-prime products and to the fact that Italy did not have a pre-crisis housing bubble, they have been suffering much from the euro sovereign crisis and the ensuing deteriorating economic conditions.

By: Silvia Merler Topic: Finance & Financial Regulation Date: October 27, 2016
Read article More on this topic More by this author

Opinion

Nicolas Véron

Breaking the vicious circle

Nicolas Véron argues that EU banking union can only be complete if the vast amounts of domestic sovereign debt held by many banks are reduced

By: Nicolas Véron Topic: Finance & Financial Regulation Date: October 21, 2016
Read article More on this topic More by this author

Blog Post

MariaDemertzis1 bw

A framework for thinking about bad loans

An important guiding principle in resolving non-performing loans (NPLs) should be to ensure that viable debt remains serviced, while non-viable debt gets resolved. We present here a framework to approach the issue.

By: Maria Demertzis Topic: Finance & Financial Regulation Date: October 18, 2016
Load more posts