The wider implications of the Italian banking crisis

July 12, 2016


The Italian banking system is in trouble and there are big economic and poltical implications for the eurozone.

Italian banks are facing the same sort of problems that’ some American banks faced in 2008. They made a lot of loans to people who aren’t paying them back — a situation that’s been made worse by years of weak economic growth in Italy. Yesterday the IMF released an assesement of the Italian economy in which they said the country faces “two lost decades”, that any recovery in the Italian economy was likely to be “fragile and prolonged”, adding that the authorities faced a “monumental challenge”. “The recovery needs to be strengthened to reduce high unemployment faster and buffers need to be built, including by repairing strained bank balance sheets and decisively lowering the very high public debt.” Italy has an unemployment rate of 11% and a banking sector in crisis, with government debt second only to that of Greece.

Prime Minister Renzi is worried that the large qunatity of Non-Performing-Loans held by the Italian banks, rendering many of them technically insolvent, could lead to a collapse of several major banks, which could trigger a broader financial crisis in the country. So he wants to organise a government bailout of Italian banks, injecting $45 billion into the banks to provide the cushion they need to ride out a wave of loan defaults.

This is exactly the kind of bailout that the United States and many other countries undertook during the financial crisis back in 2008, but Renzi has a problem doing it for Italy -relatively new EU rules prohibit governments from doing this kind of no-strings-attached bailout. Under European law, a bank’s own creditors — investors in the banks’ bonds — must take losses before the government can spend taxpayer money shoring up the bank’s finances.

There was a wide spread view after 2008 that it wasn’t fair to make taxpayers pay billions of dollars to bail out a bank while people who made loans to risky banks get 100 cents on the dollar. It was also believed that large scale bail outs of banks deemed ’too big to fail’ created what is known as ‘moral hazard’, which is economist jargon for saying that if companies think they will be rescued if their risky behaviour causes a problem then they will just take more risks.

When the EU constructed its new regulations for bank rescues it argued that making creditors pay before taxpayers would create an incentive to do due diligence on a bank’s finances before lending it money, and that making creditors pay would make them more wary of lending to banks making reckless investments. That, in turn, would force banks to be more prudent, making future crises less likely. See “The EU’s banking union is a recipe for disaster”.

This argument assumes that a bank’s creditors are wealthy, sophisticated financial institutions that understand the risks they’re taking on. But in Italy, that assumption doesn’t necessarily hold because 45 percent of Italian bank debt is held by ordinary Italians. That means complying with the EU rules could mean some Italians lose a big chunk of their life savings.

The problem with the new banking resolution regulations that came into effect in January 2016 is that they are a complex and cumbersome framework of rigid rules that are written in such a way so as to make it very difficult for the cost of bank rescues to be spread amongst eurozone members. In other words the banking resolution framework is, like the eurozone regulatory system in general, based on mistrust and a desperate opposition to the pooling of any risks or costs. It is the antithesis of solidarity and cohesion.

With Italy’s non-performing loans at over 20 percent of GDP and the country’s public debt at over 130 percent of GDP, Prime Minister Matteo Renzi is running out of time. An EU-approved plan earlier this year to restructure the banks through the state-backed rescue fund Atlante has stalled. With only 4.25 billion euros ($4.8 billion), against potentially 360 billion euros of troubled loans, the rescue fund always looked absurdly too small; it has failed to attract sufficient private money. Should Italian depositors lose confidence in their banks, still a very real possibility, the chaos would not only risk a financial collapse in Italy, but would spread through the euro zone. Shares in troubled lender Banca Monte dei Paschi di Siena is down 20 percent this week, with Italy’s La Stampa newspaper reporting Tuesday that the government is considering a new rescue plan.

Renzi would like to aid the banks without forcing investors to share losses, something that would be politically explosive given that 45 percent of bank debt is held by ordinary Italians, but European Union state aid rules prevent that. He requested a six-month waiver of EU rules that require investors to be “bailed-in” for state aid to be given except in exceptional circumstances. Though Germany has objected, it has not closed the door entirely, no doubt recognising that the alternatives to the current government are grim. Renzi, who has stood up to the European Commission in the past over budget restrictions, is likely to choose to break the state-aid rules rather than risk a financial collapse and defeat in the October referendum.

Renzi got a taste of the potential backlash back in December, when the Italian government rescued four banks in accordance with EU rules. Creditors took losses in the process, and one of them was an Italian man who lost $110,000 he had invested in bonds issued by one of the bailed-out banks. The man killed himself, leaving a suicide note criticising his bank. His death provoked a storm in the Italian media.

The danger of contagion and pressure for a second wave of bank bail outs

The reasons the EU, and Merkel, might agree to bend the rules for Italy is the acute danger of contagion that an Italian banking crisis would pose. Contagion is a particularly acute problem in the Eurozone due to the so-called “doom loop” that exists between sovereigns and their banks, thanks in large part to the ECB’s tireless efforts to underpin both Europe’s biggest banks (by providing them with an endless supply of free money) and its bond markets (by doing “whatever it takes” to make European sovereign bonds virtually risk-free).

As a result, banks have been able to make a tidy margin by simply buying government bonds at officially zero risk. Another consequence, whether intended or not, has been to create a very dangerous relationship of mutual dependence between governments and banks. When banks invest heavily in government debt, they become dependent on the government’s good performance, which is clearly not a given, especially in the Eurozone. Meanwhile, the governments depend on the banks to continue purchasing their debt, which for the moment is a given. However, if either one falters, the consequences can be dire for both.

Despite pressure from fiscally hawkish Eurozone countries such as Germany, the Netherlands, and Finland to put an end to the doom loop by removing the risk-free status of certain sovereign bonds, to the barely concealed horror of Italian and Spanish politicians and bankers, recent figures from Standard & Poor’s show that banks across the EU have been investing more heavily than ever in government debt, increasing their exposure to €791 billion. The total amount that international banks have lent to Italy alone is €550 billion.

The country’s whose banks are most exposed to Italian sovereign debt (apart from Italy itself) is France, the total exposure of French banks to Italian debt exceeds €250 billion. That’s triple the amount of exposure of the second most exposed European nation, Germany, whose banks hold €83.2 billion worth of Italian bonds. The already deeply distressed Deutsche Bank alone has over €11.76 billion worth of Italian bonds on its books. The other banking sectors most at risk of contagion are Spain (€44.6 billion), the U.S. (€42.3 billion) the UK (€29.77 billion) and Japan (€27.6 billion).

Eurozone bankers, sitting on top of piles of non-performing loans, have grown increasingly restless as the ECB negative interest rate policies have eaten into their already razor thin margins, the pressure has mounted from the German led hawks bloc to downgrade risk-free status of some sovereign bonds.

“The whole banking market is under pressure,” former ECB executive board member Lorenzo Bini Smaghi told Bloomberg. “We adopted rules on public money; these rules must be assessed in a market that has a potential crisis to decide whether some suspension needs to be applied.”

What the bankers want is another huge bail out with public money. Smaghi, besides being a former central banker, is also the current chairman of Société Générale, one of France’s biggest banks, presumably heavily exposed to Italian banks and sovereign debt, and as such a large potential beneficiary of a massive taxpayer-funded bailout of Italian banks. David Folkerts-Landau, Chief Economist at Deutsche Bank – whose shareholders have gotten crushed and whose bondholders are getting restless – picked up the baton and told the Welt am Sonntag that a US TARP-like European bank bailout of €150 billion was needed to “recapitalise the banks.” This is code for using taxpayer money to bail out bondholders and stockholders.

A renewed financial crisis, or the only thing that might avert it which is a massive bank bailout with public money, could easily become a major political issue in the crucial Dutch, French and German elections next year. For that reason some sort of deal on the Italian bank bailout seems probable. But the European banking system is still very weak and continuing economic stagnation combined with zero or negative interest rates means the banks are not going to recover anytime soon.

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