Opinion

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: Date: October 27, 2016 Finance & Financial Regulation Tags & Topics

This op-ed was originally published on thecorner.eu.

thecorner-eu

Italian banks were among the worst performers in the 2014 ECB/EBA comprehensive assessment of banks’ balance sheets. Banca Monte dei Paschi di Siena, Banca Carige, Banca Popolare di Vicenza and Banca Popolare di Milano were found in need to raise respectively 2.1bn, 0.81bn, 0.22bn and 0.17bn, for a total of 3.31bn.

Casting worries about the health of Italian banks is an unresolved and sizable (360bn) burden of Non-Performing Loans (NPLs), 14% of which is made of more serious bad debts. 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. Worries about the increasing bad loans are in part responsible for the mediocre profitability of Italian banks over the last years, together with longer-lived factors, such as structurally high costs and inefficiencies.

Despite awareness of these problems, the Italian banking system avoided the deeper monitoring and restructuring process undertaken in Spain and other countries that where subject to EU/IMF financial financial assistance program. However, market pressure has been intensifying in 2016, due to concerns about how the NPL issue will play out in the future, under the new regime of the Bank Recovery and Resolution Directive (BRRD). BRRD aims at reducing the cost of bank rescues for taxpayers, especially problematic for states – like Italy – that have high public debt. But to do so, it requires sizable bail-in of bondholders. In the case of Italy, retail investors hold a large share of banks bonds with limited awareness of the risk and limited portfolio diversification.

The recent months have therefore been dense with events, starting from several episode of bank resolution in 2015, which unveiled the problem of retail bank bond-holdings. These early episodes, occurring before the entry into force of BRRD, were characterised by attempts to limit if not avoid completely the bail-in of retail junior bondholders.

In early 2016, a guarantee scheme on NPL and a bank-financed backstop fund (Atlante) were set up. These initiatives have as a common denominator the worry for the unresolved issues in the Italian banking system, as the entry into force of the new regime made it difficult if not impossible to implement “creative” solutions aimed at protecting bondholders.

The creation of a guarantee scheme on non-performing loans (GACS) could be a positive step to clean up Italian banks balance sheets, but it is not going to be more difficult than when Ireland and Spain adopted similar solutions. The idea in the Italian case is to reduce the balance sheet impact of NPLs write-downs by having the bad loans sold to special purpose vehicles (SPV), which would issue bonds to fund the purchase. To make the bonds appealing and cheaper to issue, Italy will offer a state guarantee on them, in the hope that this helps limit the balance sheet impact.

The banks will need to pay a fee for the guarantee, for it not to qualify as state aid. The fee will be increasing over time and calculated based on the guaranteed amount, and the price of the guarantee will be computed taking as reference the prices of credit default swaps (CDS) for issuers with a “comparable level of risk” to the guaranteed bonds.

Before the GACS guarantee can be activated on the senior tranches of securitized NPLs, 50% of the less senior tranches need to be placed with private investors. The market appeal of riskier tranches is low, and the market price could be very different from the value at which the NPLs are accounted for on banks’ balance sheets, which would translate into impairments and consume capital. Under these conditions, the guarantee scheme for Italian NPLs runs the risk of being ineffective, unless Italian banks pool their funds together and buy a significant part of the junior products themselves.

This is among the tasks that should be performed by a recently established fund named Atlas. The fund was set up in April 2016, with the mission to buy junior tranches of securitized NPLs and to “ensure the success of capital raising” of banks that face market difficulties, acting as a subscriber of last resort. This fund is problematic from two points of view. First, the effect of Atlas on investors’ confidence in the Italian banking system is probably low: ideally, a backstop should be reassuring enough for it never to be used, but Atlas ended up subscribing almost entirely the capital raises it participated in. Second, Atlas can significantly increase systemic risk in the longer term, because of its structure. The fund is mostly financed by Italian banks and by acting as a shareholder of last resort for banks that are not able to raise capital on the market, it accumulates risk onto the balance sheets of a banking system that is already very interconnected, and that retains areas of weakness.

Last but certainly not least in the order of importance, this summer brought the day of reckoning with the long-lived weakness of Banca Monte dei Paschi di Siena (MPS). MPS with 5bn of subordinated debt, 65% of which was sold to retail clients, well represents the complexity of enacting BBRD-style resolution in the Italian context. At the time of writing, the bank is expected to raise capital from the private sector and start a deep process of NPL clean-up, but doubts remain on whether it will succeed in raising enough capital on the market. If not, the issue of bail-in will re-surface, with potentially big political implications.

The Italian situation offers several important lessons. First, it shows that procrastinating the reform of the banking system is costly. While initially Italian banks were resilient, resilience soon turned into complacency and this complacency explains today’s situation and the increased complexity of the Italian solution compared to previous cases.

A second lesson concerns the approach to the new regime of bank recovery and resolution. While the date for entry into force of BRRD bail-in had long been known, Italy was not entirely prepared for it. After BRRD-bail-in entered into force in January 2016, making it impossible to envisage a public-only solution to banks’ problems, the Italian approach seems to be to avoid resolution as much as possible. The Atlas fund was set up to act as a shareholder of last resort and ensure that even banks that fail to raise capital are not resolved, yet this cannot be a long-term solution (as the MPS example clearly shows).

More generally, regardless of whether one thinks that keeping weak banks alive at all costs is a good idea, it is beyond doubts that the aim of EU-wide rules on bank recovery and resolution is to provide certainty on how banking problems will be dealt with. The single supervisory mechanism has so far worked well, despite occasional misjudgments, being effective, demanding and broadly fair. But it needs effective resolution practices to complement it. For now, the Italian approach to bank resolution has been an ad hoc one, which appears at odds with the aim of making progress towards a solid European Banking Union.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint.

Due to copyright agreements we ask that you kindly email request to republish opinions that have appeared in print to communication@bruegel.org.

View comments
Read about event

Upcoming Event

Feb
3
09:30

Tackling Europe’s non-performing loans crisis: restructuring debt, reviving growth

How can we connect the different initiatives for NPL resolution and identify an agenda that is shared between EU, national authorities and the private sector.

Speakers: Corso Bavagnoli, Iker Beraza, Arne Berggren, John Berrigan, Marco Buti, Vítor Constâncio, John Davison, Maria Demertzis, Sharon Donnery, Vítor Escária, Giorgio Gobbi, Piers Haben, Boštjan Jazbec, Gert-Jan Koopman, Alexander Lehmann, TJ Lim, Brendan McDonagh, Reza Moghadam, Emanuele Rosetti Zannoni, Dirk Schoenmaker, Carola Schuler, Julien Wallen, Thomas Wieser and Guntram B. Wolff Topic: European Macroeconomics & Governance, Finance & Financial Regulation Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article More on this topic

Blog Post

MariaDemertzis1 bw
DSC_0798
DSC_0787

The Italian Lira: the exchange rate and employment in the ERM

In the decades before Italy joined the Euro, the Lira was devalued many times relative to the Deutschmark. Were these re-alignments accompanied by long term improvements on the labour market? The data suggests this was not the case.

By: Maria Demertzis, Konstantinos Efstathiou and Fabio Matera Topic: European Macroeconomics & Governance Date: January 13, 2017
Read article More on this topic More by this author

Opinion

Nicolas Véron

ECB finally addressing Italian bank woes

Italy’s banking problem has been left unaddressed for too long. Similar to Japan in the 1990s, it is best understood as a combination of structural and cyclical factors.

By: Nicolas Véron Topic: Finance & Financial Regulation Date: January 4, 2017
Read article More on this topic More by this author

Blog Post

Silvia Merler

The strange case of the MPS capital shortfall

Italy's banking saga continues with the announcement that beleaguered MPS may need to find an additional €3bn. What exactly has changed, and what does it say about ECB decision making?

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

Blog Post

Silvia Merler

Socio-economic determinants of the Italian vote

The socio-economic factors driving the 'no' result from Italy's referendum differ from the Brexit vote. The Italian NO vote seems to have been driven by young voters, and mostly related to a sense of economic “malaise”. However, the Brexit vote appears to have been strongly driven by older voters and somewhat less educated ones.

By: Silvia Merler Topic: European Macroeconomics & Governance Date: December 12, 2016
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

Policy Contribution

pc-20-16_page_01European Parliament

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, European Parliament, Parliamentary Testimonies 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
Load more posts