Blog Post

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: Date: December 2, 2016 Topic: European Macroeconomics & Governance

On Sunday, Italians vote in a referendum to decide whether an amendment to the Constitution proposed by the government should be implemented or not. The vote is not about any financial or economic issue, but its timing and its potential implication for political stability are such that a negative outcome could trigger some financial instability.

Italian banks are still bearing the burden of a significant load of non-performing loans (NPLs). We have discussed the issue of NPLs in the Italian banking sector several times before (see e.g. here and here), and there is not much new on this front. As of September 2016, the Bank of Italy was reporting that the total of bad debts in the system was €198.9bn, down from €200bn in August. Table 1 shows updated 2016Q3 gross NPL ratios for some of the biggest Italian banks, showing that the situation is diversified. While some initiatives (such as the guarantee scheme GACS) have been taken recently, these will likely take time to bear fruit.

The elephant in the room is obviously Monte dei Paschi di Siena (MPS), with its 35% NPL ratio, and a capital raise operation looming at the end of the month. I have discussed the specific problematics of a potential MPS resolution here – particularly highlighting the point that 65% of MPS’ total outstanding subordinated debt is held by retail savers, making a bail-in focussed resolution within the BRRD framework potentially very painful. Back in July 2016, I had argued that the best solution for MPS would have been a precautionary recapitalisation with burden sharing for junior debt, protection of senior creditors and a credible reimbursement scheme for those who were wronged due to unlawful practices which should have been better prevented.

The choice was different, specifically to go for a disposal operation on NPLs which hinges on a capital raise of €5bn from private investors. The fear of a potential political backlash from a bail-in of subordinated retail debtholders possibly played a role in this decision, in view of the planned referendum. The fact that the capital increase was scheduled for December 2016 – after the referendum – is probably further evidence in support of that. But this choice now puts the bank in a very difficult and uncertain situation, for a number of reasons.

To put things in perspective let’s first note that a capital increase of €5bn is big in itself: it  amounts to almost 10 times the value of the bank’s current market capitalisation (which is around €600m). To this, the bank is adding a €4.3bn debt-to-equity swap offer, which will run from 28 November until 2 December The bank reportedly communicated to Consob – the Italian public authority responsible for regulating the Italian financial markets – that it expected a take-up of this offer for about €1bn, 25% of the total.

A second problem is timing. The operation is supposed to be initiated right after the referendum, and this has become risky, in view of the uncertainty mounting on the outcome of the vote. Opinion polls now point increasingly to a victory of the NO camp. If this were to happen – especially if NO were to win by a significant margin – the Prime Minister would likely resign and the opposition parties would be strengthened. After amendment of some aspects of the new electoral law – which was drafted in tandem with the constitutional amendment on which Italians are voting – new elections would be held.

The potential consequences of such a situation for financial stability are twofold. First, there would be a transition period that could drag on for a long time. All parties would likely try to pull the amendment of the electoral law in a direction that benefits their electoral prospects. During this period any reform effort would essentially be frozen, and in a country like Italy this is hardly good news.

Second, the outcome of the ensuing elections – with a strengthened 5 Star Movement and possibly a comeback of the centre-right – would heighten political and economic uncertainty. For starters, the idea of a referendum on Italy’s membership of the EU or Euro would probably be central to the 5 Star Movement’s campaign and possibly for the Northern League as well. Contrary to what many seem to believe, such a referendum is not something that can happen overnight. Article 75 of the Italian Constitution in fact states that the ratification of international treaties cannot be subject of a referendum. The Constitution can be amended – we are seeing it now – but it requires gathering a considerable majority in the Parliament and in the country.

Yet, the fact remains that this would be a complicated and uncertain situation, and in this context investors’ interest in the MPS operation could evaporate (and the success of the NPL dismissal operation with it). Attracting foreign capital in politically uncertain circumstances could be already difficult, and the prospect of a potential surge of the 5 Star Movement could complicate things even further, as the prevalent opinion among its members is that MPS shoudl be nationalised. The bank is reported to have communicated to Consob that there is “no plan B” under study. And admittedly it is hard to see what alternative option would be there, aside from the one discussed this summer.

So the solution to the MPS issue may in fact be back to the option that was available but not taken six months ago, although this “tactical” delay would not be inconsequential. Uncertainty may in fact create spillover effects on other Italian banks, whose NPL situation is also not yet resolved and who are part of a strongly interconnected system. As a matter of fact, interconnection has increased further recently, due to ventures such as the bank-funded Atlas fund that has been acting as a underwriter of last resort in the capital raises of several troubled small banks and that we have discussed at length here. Incidentally, one of the early proponents of the Atlas fund has recently admitted that in hindsight it would have been better not to participate.

So, in conclusion, almost six months after the most recently released ECB’s stress tests, the situation of the Italian banking system looks still very uncertain. In the case of a NO victory in the referendum, the success of the planned recapitalisation of MPS is at risk. At that point, the solution to the MPS problem may – somewhat ironically – be back to the one that was available six months ago. But this time there would be the downside of having to take action in a context of heightened political and economic uncertainty. This could create significant spillovers for the rest of the banking system. For now, all we can do is wait until Sunday, and see.


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

Podcast

Podcast

Director’s Cut: What risk does Italy’s new government pose to the euro area?

In this Director’s Cut of ‘The Sound of Economics’ podcast, Guntram Wolff discusses with Bruegel senior fellow Francesco Papadia the potential consequences of Italy’s new coalition government – both for Italy itself, and for the euro area as a whole.

By: The Sound of Economics Topic: European Macroeconomics & Governance Date: May 25, 2018
Read article More on this topic More by this author

Opinion

The upheaval Italy needs

While Italy remains without a new government, it would be foolish to believe that a country where anti-system parties won 55% of the popular vote will continue to behave as if nothing had happened. But political upheavals sometime provide a unique opportunity for addressing seemingly intractable problems. After its political upheaval, Italy now needs an economic one.

By: Jean Pisani-Ferry Topic: European Macroeconomics & Governance Date: April 30, 2018
Read article More on this topic

Blog Post

Italy’s pension spending: Implications of an ageing population

The Italian debate on the pension system predominantly focuses on short-term aspects, neglecting relevant longer-term fundamentals. Based on long-term economic and demographic projections, this blog post calls for more awareness about the balance of risks that lie ahead.

By: Francesco Chiacchio and Simone Tagliapietra Topic: European Macroeconomics & Governance Date: April 26, 2018
Read article More on this topic More by this author

Opinion

Europe needs a strong Italy

Europe needs to have its Italian voice. A stable government is required not only to pursue domestic policies and remain fiscally prudent but also to negotiate on euro-area reform, priorities in the EU budget and intensifying competition in global trade.

By: Guntram B. Wolff Topic: European Macroeconomics & Governance Date: March 20, 2018
Read article More on this topic More by this author

Blog Post

Clouds are forming over Italy’s elections

While the prospect of a gridlock reassured investors about the short-term risk of an anti-establishment government, Italy still needs a profound economic shake-up and is in no position to afford months or years of dormant governments.

By: Alessio Terzi Topic: European Macroeconomics & Governance Date: February 28, 2018
Read article More on this topic More by this author

Blog Post

The Italian elections

Italy goes to the polls on March 4, with a new electoral law that is largely viewed as unable to deliver a stable government. We review recent opinions and expectations,  as well as economists’ assessment of the cost/coverage of parties’ economic promises. 

By: Silvia Merler Topic: European Macroeconomics & Governance Date: February 26, 2018
Read article More on this topic More by this author

Opinion

Beyond border control, migrant integration policies must be revived

Border control and burden-sharing of refugees is just one aspect of immigration policies. Greater financial inclusion and the tailoring of regulations to refugees' specific needs would benefit not only the refugees themselves, but also native citizens.

By: Zsolt Darvas Topic: European Macroeconomics & Governance Date: February 23, 2018
Read article More on this topic More by this author

Blog Post

The financial side of the productivity slowdown

Scholars have devoted much research to the “productivity puzzle” that has emerged after the crisis, and some are investigating the role of financial frictions and capital allocation in relation to this phenomenon.

By: Silvia Merler Topic: Global Economics & Governance Date: January 22, 2018
Read article More on this topic More by this author

Blog Post

Italian economic growth and the Euro

While the Euro has frequently been blamed for the poor growth performance of Italy over the years, a long-term analysis shows deteriorating growth before the introduction of the Euro. Additionally, Italy has shown worse performance than other euro-periphery countries, such as Spain, implying deeper structural reasons for Italy’s economic malaise.

By: Francesco Papadia Topic: European Macroeconomics & Governance Date: July 26, 2017
Read article More on this topic More by this author

Blog Post

A tangled tale of bank liquidation in Venice

What can we learn about the Italian banking sector from the decision to liquidate Veneto Banca and Banca Popolare di Vicenza? Silvia Merler sees a tendency for Italy to let politics outweigh economics.

By: Silvia Merler Topic: Finance & Financial Regulation Date: June 26, 2017
Read article More on this topic More by this author

Podcast

Podcast

How will Europe's banking system respond to future challenges?

After the financial crisis, the EU has taken measures to create conditions for a safer banking sector. One of the key measures to do that is the creation of the banking union. How successful has the implementation of the new framework been so far? How will issues in the Italian banking sector be addressed? And how will Brexit change the European banking sector?

By: The Sound of Economics Topic: Finance & Financial Regulation Date: May 5, 2017
Read article More on this topic More by this author

Blog Post

Italian banks: not quiet on the eastern front

Italian banks are back in the spotlight. After MPS failed to raise enough capital from private investors earlier this year, Banco Popolare di Vicenza (BPVI) and Veneto Banca take centre stage. The story of these two banks epitomises the strategy of delayed reform that has been so characteristic of the Italian banking crisis.

By: Silvia Merler Topic: Finance & Financial Regulation Date: March 31, 2017
Load more posts