Cloudy Sky over Italian Banks
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Cloudy Sky over Italian Banks 

Since the Brexit vote, the attention of financial markets has turned to Italy, due to significant weaknesses in its banking sector and related concerns about a renewed bank-sovereign risk feedback loop. The new EU rules on state support for banking resolution might need to be "tweaked" to reduce the risk of renewed financial turbulence in the Eurozone.

The Brexit vote in the UK has raised concerns about further economic fragmentation in the Eurozone. With a referendum on constitutional reform looming in Italy in late October or early November and the reformist Prime Minister Matteo Renzi having tied his political future to its outcome, the focus has turned to Italy, whose banking sector is under substantial pressure due to non-performing loans (NPLs).

Short-term Liquidity Support after Brexit – Not the Required Solution

Following Brexit, Italian banks were among the most negatively affected, with share prices falling by an average 40 percent across the board. The European Commission authorized Italy and other member states to use government guarantees to create a EUR 150 billion liquidity support program for the banks. Italian banks do not, however, need liquidity – they need capital in order to offset the losses stemming from an increase in NPL coverage.

Italian Banking System: Large, Too Fragmented and Weak

How great is the risk of a more serious crisis developing? Credit Suisse's International Wealth Management team believes that the risk is non negligible, but this can be avoided providing the EU's rules on bank resolution are applied flexibly. That said, the Italian banking system looks structurally weak:

  • It is highly fragmented, consisting of approximately 654 banks. The two largest banking groups in Italy, Unicredit and Intesa Sanpaolo, have market shares of only approximately 10 percent each. Meanwhile, the banking sector is large, with total assets equivalent to approximately 250 percent of Italian GDP.
  • Gross NPLs are very high: They were EUR 360 billion at the end of Q4 2015, amounting to 18 percent of total banking system loans. The bulk of NPLs comes from lending to the corporate sector, where almost 30 percent of loans are non-performing.
  • Italian banks' profitability recovered somewhat last year, benefitting from the cyclical recovery, but it remains below the European average. Going forward, we expect profitability to remain constrained until a definitive solution to the non-performing loans issue is found.

Compromising on a Solution

A major concern for markets is the bank-sovereign risk feedback loop, in which undercapitalized banks holding large amounts of government debt come under pressure, while sovereign bonds sell off because of concerns that it would be too costly for the government to rescue the banks. It has been widely estimated in the media that a c. EUR 40 billion capital injection would be needed by Italian banks to clean up their balance sheets. This equates to approximately 2.5 percent of Italian GDP. Despite the country's relatively weak economic performance, the Italian economy is seen as being sufficiently resilient to absorb such a capital injection, which would not likely trigger the sovereign crisis that we saw in 2011.

Such an intervention by the Italian government however would run afoul of new Banking and Recovery Resolutions Directives (BRRD) introduced in January 2016, which forbid bail-outs without first imposing losses on equity and bond investors of banks, also widely known as "bail-in". The problem with a "bail-in" of credit investors, as foreseen by BRRD however, is that it would probably equate to "political suicide" for the EU friendly Italian prime minister Matteo Renzi, given that bank bonds in Italy are widely held by retail investors.

Failure to find a definitive solution to the Italian NPL problem could result in a prolonged underperformance by the Italian economy, with the wider European banking sector remaining susceptible to market concerns over possible contagion risks.

"Tweaking" EU Banking Union Rules

To escape this dilemma, the creation of a second bank recapitalization fund that would be privately capitalized is being considered. However, there is a high chance that this would only serve to postpone the problem. Other solutions being considered include compensation from the Italian government for any losses suffered by retail investors, and even a partial bail-in of institutional investors only. These would subordinate institutional investors and protect retail investors, but could face considerable legal challenges.

According to Credit Suisse's International Wealth Management team, the ongoing negotiations between the Italian government and the European Commission are likely to yield a solution that avoids a financial crisis, while conforming with the EU's rules. The BRRD provides some flexibility in that regard, allowing for the provision of extraordinary public support.

Initiatives to Strengthen Banking System Will Probably Only Help over the Longer Term

Since mid-2015, the Renzi government has launched various initiatives to strengthen the banks, but their impact will likely be moderate and only show an effect over time:

  • Facilitation of insolvency procedures: In August 2015, the Italian government amended the Bankruptcy Law and the Civil Procedure Code with the aim of facilitating insolvency procedures and property foreclosures. According to estimates by the Banca d'Italia, those amendments could result in a halving of the length of the processes which now average more than 6 years (for bankruptcy processes) and 7 years (for judicial foreclosures) respectively. Besides, the reform should promote higher recovery rates for creditors, boost the value of NPLs and spur the development of a private market for NPLs.
  • Inception of state guarantees on the securitization of non-performing loans could potentially help banks to clean up their balance sheets, but there are substantial doubts about whether it will really work. In the end, banks would have to recognize substantial losses when securitizing NPLs, given their book values still significantly exceed potential market values.
  • Inception of privately funded "Atlante" bank recapitalization fund: In April, Italian officials and financial firms announced the creation of a EUR 4.25 billion fund named Atlante, which between May and June acted as a buyer of last resort for two smaller Italian banks that had struggled to raise equity in the capital markets. Following these two actions the fund has c. EUR 1.75 billion left, which will be used to buy junior tranches of securitized bad loans. While potentially helping to reduce funding stress for several Italian banks in the short run, the fund will be unable to improve the Italian banking system meaningfully. First, its size is small compared to the amount of NPLs. Second, it mainly redistributes risk within the system, transferring it from weaker to stronger banks.