Concerns about the fallout from the Brexit referendum on June 23rd 2016 have cast a spotlight on a risk that had not received much attention prior, the Italian banking sector. Following the 2008 global financial crisis (GFC) banks across the U.S., U.K., Spain & Ireland were bailed out using taxpayer funds, and as Italian banks were not facing immediate collapse there was no need to recapitalize the lenders and therefore did not receive a bailout. Instead Italian banks waited for the economy to recover in order to improve their non-performing loans (NPL’s), and they are still waiting for this recovery.
Since then Europe’s banks have been likened to “zombie banks”, similar to those in Japan where a credit bubble burst in the early 1990’s led to two decades of sluggish growth. The idea behind a zombie bank is that they are burdened by non-performing loans and instead of collapsing are allowed to stay in business. However the holding of these non-performing loans prevents them from making the new loans necessary to recover.
In November 2015 four smaller Italian banks, Banca Popolare dell’Etruria, Banca delle Marche SpA, Cassa di Risparmio di Ferrara SpA and Cassa di Risparmio della Provincia di Chieti SpA, faced collapse and were bailed-in by their creditors being holders of the banks subordinated bonds when they were forced with losses as part of a restructuring. While these banks made up only around 1% of total bank deposits the implications of these operations were far more wide reaching. The issue with this is that around one third of Italian bank bondholders are private households, protests ensued with at least one reported suicide as a result of the losses. The problem faced by Italy is a large portion of private households were sold bank bonds as opposed to traditional deposits without fully comprehending the risk.
Source: http://bruegel.org/2015/08/now-you-see-it-now-you-dont/
In February larger lenders began to face similar issues regarding their non-performing loans, and on April 11th an Italian bank fund was announced named Atlas after the Titan in Greek mythology who was condemned by Zeus to eternally hold up the weight of the sky on his shoulders, an excellent metaphor for the fund supporting the banks. The goal of Atlas was to be a backstop as a buyer of last resort to ensure the success of capital raisings that had been requested by supervisory authorities to face market difficulties. The Atlas fund was funded through other banks, industry groups and insurers raising concerns about increasing systemic risk however it was a necessary measure in the short-term to avoid collapse. So far Atlas has failed to inspire the confidence it was intended to do.
A recent letter from the European Central Bank (ECB) who regulates the Italian banks, sparked the latest concerns when it sent a letter to the lender Banca Monte Paschi, one of the world’s oldest financial institutions, to offload more than €14 billion in non-performing loans over the next three years reducing the NPL’s to 20% of total loans.
Italian banks are estimated to hold around €360 billion in non-performing loans or around 21.94% of Italian GDP of which the banks face an estimated €40 billion shortfall equating to around 2.4% of Italian GDP. The government faces a very serious dilemma, bail-in reforms were agreed in 2014 under the Bank Recovery and Resolution Directive (BRRD) to remove the issue of “too big to fail” banks, the idea being that some of the burden of bank rescues was shifted away from the tax payer and onto the investors which Italy needs to abide by.
These NPL’s account for around 18% of total Italian bank loans according to data from the world bank highlighted on the chart below.
Source: http://data.worldbank.org/indicator/FB.AST.NPER.ZS?locations=IT
The situation is very different to the rest of Europe, although some periphery countries such as Spain and Greece do face some bad debt issues.
Source: FT.com
Clearly the Italy government is between a rock and a hard place, to force the bondholders to take some losses and face political upheaval in a time when Europe is facing issues over Brexit. A collapse in any bank has the potential to spread and see a run on the banks where depositors withdraw funds over fears of a similar collapse. While Italy is seeking help from Europe, circumnavigating the BRRD legislation looks unlikely given it was implemented for this very reason. They will also face a tough time against Germany who see any bailout as a further burden on their taxpayers.
How would a bail-in work? Once it has been determined an institution is failing or likely to fail authorities responsible for the resolution will try to manage the failure as orderly as possible with the aim of maintaining financial stability, ensuring continuity of critical economic functions and protecting insured deposits and public funds. During this process the claims or shareholders and unsecured creditors may be written down/or converted into equity to absorb the losses and to recapitalize the firm or its successor. Investors will have no say in these write downs and no court approval is needed and at least 8% of the banks liabilities must be wiped out before any taxpayer support can be provided.
Next the firm will undergo restructuring where additional changes are made to the structure and business model, including the winding down and disposal of certain business lines. Once the structuring is complete the firm will exit the resolution and continue its operations.
source: http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2015/q302.pdf
Bail-ins are a step in the right direction removing the burden from the taxpayer onto the investors, while they are not a silver bullet for “too big to fail” they are now an essential part of the toolkit. A bail-in will not be a remedy for contagion, given the interconnecting nature of the global financial system equity and debt is often held by another financial institution raising concerns they could also experience losses. This however is justified given how a bail-in is designed to work, investors need to be responsible in making their decisions, particularly professionals. Some concerns have been raised that bail-ins interfere with shareholder and creditor property rights, this is simply not true. Under the resolutions authorities can only use bail-ins when deemed necessary and in the public interest. Under these rules no creditor will be worse off following a bail-in than they would be had the whole firm been put into insolvency. In any case where a shareholder or creditor is worse off than they would have been they have the ability to seek financial compensation.
Italian Prime Minister Matteo Renzi is now looking to find a solution that will avoid such a bail-in forcing losses on private households. Any bail-in could spark an economic crisis within Italy and cause further headaches for Renzi who is holding a controversial referendum in October to reduce the number of Senate seats in the government in order to reduce political gridlock.
So what happens next? Italian authorities are continuing discussions with the European Commission over a number of possibilities, including the recent approval for Italy to guarantee up to €150 billion euros in liquidity until the end of 2016. Struggling banks including Banca Monte Paschi may also sell new convertible bonds to the government and well as a €3 billion injection from the Atlas fund. While there looks to be no immediate resolution I am confident the Italian government and EU will come to some type of agreement, meeting somewhere between the two solutions of a bail-in and bail-out in which the EU approves further aid that is short of what Italy is asking.
Originally published by rivkin.com.au