The Banking Crisis in Italy—Bigger than Brexit?
Italy is suffering from both a banking crisis and a political crisis (EuroIntelligence). Italian banks are the focus of attention because of their €360 billion in bad loans, the risk of a bank run, a freeze and/or collapse of the banking sector, and collapsing stock prices (see Tyler Cowen in Marginal Revolution).
The referendum on constitutional reform in October will be a key test for the looming political crisis, i.e., the fall of the PD and rise of the Five Star Movement. Erik Nielsen (UniCredit) downplays the downside political scenario as “more of the same”, notably because the Italian constitution (appropriately) prevents big inter-generational decisions to be made by simple majority in a referendum. Though a successful referendum will bring much better governance, with a constitutional reform that restrict the Senate’s powers to constitutional amendments and EU matters and downsize it; and a reform in the degree of autonomy of regions. A new electoral law (the Italicum) reinforces the majority premium to the largest single party. Both radically reforming governance by virtually eliminating the possibility of gridlock in return for handing substantial powers to the biggest party. Corruption scandals, pointing to the government, are weakening the PD.
The difficult mechanics of a banking rescue—Luigi Zingales (hat-tip EuroIntelligence) argues that banks cannot lend because they are insufficiently capitalized to support the weight of €200bn in nonperforming loans and a further €160bn of past due loans. Banks don't want to raise new capital because that would massively dilute existing shareholders, and so they choose extend-and-pretend, in hopes that economic recovery will rescue them—but have faced a 7-year recession instead. The most pressing issue is with Monte dei Paschi di Siena (MPS) (see EuroIntelligence), expected to fail the stress tests and to need to shed up to €10bn in gross NPLs over the next three years.
David Keohane (FT Alphaville) explains how the new banking regulation (the BRRD) prevents a government sponsored systemic solution, and requires pre-emptive burden sharing, an extremely risky approach—arguing that applying European rules could result in a full banking crisis. For JP Morgan’s Marco Protopapa there is sufficient wriggle room for systemic risk to avoid a full blown bail-in approach; especially as Italy’s fiscal contingent liabilities are limited, according to the IMF (VoxEU). Given the relatively small financial commitments, the main hurdles are political (German intransigeance).
The need for a “market operation.” Given the limits imposed by State aid regulations in the EU, the Italian government needs to resort to a market operation. EuroIntelligence reports that this could be expanding the Atlante fund into a new rescue fund (Giasone) with fresh capital, contributed by the public bank CDP and SGA with some new private investors. The sale of the NPLs to this new fund will result in losses to MPS, which could raise new capital with a bond issue using the just approved €150bn "liquidity" guarantee (approved by the EC). The overarching objective is to avoid a bail-in at any cost. Otherwise there will be no alternative to a public recapitalization (as noted by Bank of Italy governor Ignazio Visco, on Bloomberg). The BRRD envisages a recapitalisation after a failed stress test only in case the bank remains solvent.
The call for a systemic exemption. As the market continues to be illiquid, the Italian government has turned to seeking a systemic solution and continues to push for a "systemic risk" exception to the bank recovery and resolution directive BRRD, based on the shock of Brexit. Italy is aiming at building a political consensus with the European Commission, first on a bailout of Monte dei Paschi di Siena (MPS), and eventually on a broader recapitalization of the whole sector. Philip Hildebrand agrees with Renzi that governments should be allowed by European authorities to intervene in their banking systems to fix structural issues, with a TARP-like solution.
Stress tests, precautionary recapitalization and bail-in. The European Commission offered a precautionary recapitalization if MPS fails the EBA stress tests. The plan would also require a bail-in of subordinated creditors in the form of a debt-to-equity swap—with the government reluctant to do so for institutional investors, notably because the precedent of Novo Banco shows that discriminating against institutional investors can have negative consequences for sovereign debt spreads. The Commission accepts the possibility that the Italian government may compensate retail investors for their losses though it is unclear what the level of compensation will be given that the price of both equity and subordinated debt of MPS has collapsed. A debt-for-equity swap could protect small investors, following the Greek model (EuroIntelligence), while at the same time respecting the principles of the “bail-in” – as long as a lock-in period prevents share-selling immediately after conversion.
The issue of a eurozone fiscal backstop and the German insistence on dealing with "legacy assets" first comes back because of high levels of public debt and tightened European fiscal rules, lead back to the (EuroIntelligence).
The Importance of the Banking Union
The importance of the BU is even greater after Brexit, according to Reza Moghadam (hat-tip EuroIntelligence). He proposes to set up a European Asset Management Company, funded by all eurozone governments, with the task of buying up the stock of €900bn in non-performing loans from ECB-supervised banks, with losses would be borne by shareholders or other interested parties, in accordance with BRRD rules. The aim being to reestablish confidence in the banking sector. Deutsche Bank’s chief economist David Folkerts-Landau called for a €150 billion public rescue of European banks to recapitalize European banks. For Folkerts-Landau, the bank bailout is so urgent that it should permit Europe to violate the bail-in rules of the new Banking Directive, which are politically unfeasible and would create a bank run.
A reminder that Deutsche Bank is a core risk for Europe, according to Tyler Durden (Zero Hedge), notably because of its derivatives positions with a notional value of €52 trillion. The DB shares recently reached record-setting low (Visual Capitalist's Jeff Desjardins), 8% of its peak price in May 2007 (Tyler Durden at ZeroHedge).
