Why Italy’s banks could ignite a eurozone crisis

Why Italy’s banks could ignite a eurozone crisis. It wouldn’t be summer without Europe threatening to upend global financial markets. The looming threat this year comes from Italy and its long-suffering banking sector.

“As we trend into the second half of the year, the situation in Italy, and its spill over for the rest of Europe, will continue to be one of the biggest macro-political risks we are concerned about,” said Federico Santi, a London-based analyst at Eurasia Group, a risk consulting group, in a note.

The focus on Italy comes after the U.K. voted in late June to exit the European Union. In a worst-case scenario, analysts fear Italy’s bank problems could threaten the country’s membership in the eurozone.

In coming weeks, the situation has the potential to create at least near-term global market turmoil as financial and political risks collide. It also threatens to catch many investors, who had assumed the world’s banking woes were largely in check after the financial crisis, by surprise.

With that in mind, here’s a short guide to what you need to know about Italy’s banks.

What’s the problem?

Italy’s banks are neck-deep in nonperforming loans. Official data puts the total amount of nonperforming loans, or NPLs, at around 200 billion euros ($220.5 billion), or around 8% of total loans (see table above). But some analysts argue that another €160 billion worth of loans could soon be pushed into NPL status, according to Wells Fargo, which would put the NPL ratio at an “eye-popping” 15% of their loan portfolios.

Italian bank shares have been hammered. The focus has been on Siena-based Banca Monte dei Paschi BMPS, +1.77% or BMPS. Founded in 1472, BMPS is Italy’s third-largest bank by assets.

The European Central Bank earlier this month asked BMPS to cut its gross nonperforming loan exposure from €46.9 billion in 2015 to €14.6 billion by 2018.

That amplified worries about the solvency of BMPS and the Italian banking system, and heightened concerns about a potential showdown between the Italian government, headed by Prime Minister Matteo Renzi, and the European Commission, over new restrictions on government bailouts of the financial sector.

Results of a stress tests by the European Banking Authority due on July 29 are expected to shed more light on the capital needs of the Italian banking sector, potentially serving as a spark to renewed financial turmoil.

Shares of the world’s oldest lender have plunged 16% since the end of June and are down nearly 75% in the year to date. Other Italian banks have also suffered, leaving Milan’s FTSE MIB index I945, +0.25%  down nearly 22% year-to-date, lagging well behind European peers and the pan-European Stoxx 600 SXXP, -0.07% which is off 6.8% so far in 2016.

Weren’t the banks fixed after the financial crisis?

In a word, no. While Italy was widely praised for reforms in the wake of the crisis, most of the measures were relatively modest, wrote Ben May, lead eurozone economist at Oxford Economics, in a note.

In the end, Italy failed to restructure its banks in a meaningful way, May said. And the financial sector’s woes have only been exacerbated by persistently sluggish economic growth. Throw in low yields on Italian government bonds and falling interest rates, which weigh on interest income, and it is no surprise Italian banks are suffering.

Can’t Italy just bail out the banks?

Here’s the big rub. Under new European Union rules, bondholders must take a hit in the event of a public bank bailout. The rules are designed to prevent leaving taxpayers to foot the bill for bank rescues.

The problem is that around a third of bank bonds in Italy are held by household retail investors, noted Silvia Merler, affiliate fellow at Bruegel, a Brussels-based think tank, in a blog post. Merler explains how there may be wiggle room under convoluted EU rules. There’s also the possibility that bondholders could be compensated for being victims of “mis-selling” of the bonds in the first place, which could soften the blow, Merler and other observers say.

But such compensation, which was seen following the rescue of four smaller banks last December, would still require a lengthy arbitration process and may only partially offset the loss to bondholders, Santi said.

The situation presents a difficult dilemma for Renzi. A taxpayer bailout will irritate voters, while failing to protect bondholders also would risk a backlash.

That would empower the so-called euroskeptic 5 Star Movement, founded by comedian Beppe Grillo, ahead of an October constitutional referendum. If the referendum on Renzi’s reform agenda fails, he has vowed to step down.

So what happens?

The Financial Times on Wednesday reported that Italy is weighing a “private sector” solution to rescue chronically troubled BMPS in an end-run around EU bailout curbs. According to the report, Italy is exploring measures that would see bad loans bought up at favorable rates with money from private and state-backed institutions, including an existing privately backed bailout fund called Atlante.

It isn’t clear how such a plan would be received in Brussels. European officials are seen as reluctant to back off on the new rules but are equally afraid of sparking a political crisis that could bring down Renzi and threaten an anti-euro backlash in the eurozone’s third-largest economy.

“There’s too much at stake in Italy—politically and financially—for policy makers to fail to agree on a sensible plan to recapitalize Italian banks while shielding the small retail investors who hold a significant portion of the country’s bank bonds,” wrote Nicholas Spiro, partner at Lauressa Advisory, in a Monday note.

Foreign exposure to Italian banks is relatively contained (see chart above), noted Jay Bryson, global chief economist at Wells Fargo Securities, in a note.

The bigger worry, analysts say, is that a backlash over a bailout leads voters to revolt, empowering the 5 Star Movement, which has called for a referendum on eurozone membership.

The prospect of a 5-Star led government likely would lead to a surge in bond yields, credit-rating downgrades, further economic slowing and added troubles for banks—a scenario that would likely require Italy to seek assistance from the eurozone, said May of Oxford Economics.

That could lead to a chain reaction, he said. Here’s one scenario:

As a result of all this, an Italian government led by the 5 Star Movement might plausibly go into negotiations with its Eurozone counterparts believing that it holds the trump card—namely the threat of a referendum on Eurozone membership. This would make it difficult for the Eurozone to play hardball with Italy or kick the can down the road. Policy makers would thus be left with the unenviable choice of either calling Italy’s bluff, and potentially sparking a regional or even global financial crisis, or fast-tracking integration plans and sanctioning greater burden-sharing. The electoral cycle in the region will further raise the stakes. While the French government might be happy to agree to greater burden-sharing, such a deal would be political suicide for Chancellor Merkel in the build up to the German federal elections in 2017.

The bottom line, May said, is that “Italy could be a ticking time bomb.”

 

Source: Market Watch

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