What’s the matter with Italy’s banking sector?

Let's take a brief step away from the UK today.

The fallout from Brexit is going to be with us for a while, so it's good to catch up with the rest of the world occasionally.

And right now, one thing stands out as worrying people more than most hell, they've even made the cover of The Economist.

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It's the Italian banking sector

What's the problem with Italian banks?

What the Italian banks need is to raise a load of money, so that they can start recognising these bad debts, writing them off, and start lending again.

Trouble is, no one wants to fund them. One look at their share prices demonstrates why they can't raise new money in the market.

So the obvious answer is for the government to step in. It's happened in plenty of other places. Indeed, it's pretty much the accepted playbook for resolving a banking crisis.

And the reality is that the banks don't need a ridiculous amount of money (not by today's standards, at least). According to FT Alphaville, JP Morgan reckons that the Italian banking system needs around €40bn to recapitalise it. In the context of Italy's current low cost of borrowing (madness, yes, but that's where we are), this is "manageable".

However, it's not that simple. Because Italy is part of the eurozone, and as with every financial issue in the eurozone, this is ultimately about the politics.

So what's the big problem? Basically, the eurozone introduced new banking regulations last year. These are designed to go some way towards tackling the moral hazard that created the banking crisis in the first place. And what they do is, they prevent government bailouts from happening, without some bank stakeholders being wiped out first.

As JP Morgan outlines: "Any government funding is conditional on pre-emptive burden sharing, which amounts to wiping out / haircutting private investors' stakes in the banks' capital" ie shareholders and bondholders pay first.

This is perfectly reasonable, of course. Some might even suggest that it's capitalism at work. And if we were talking about the retail sector, for example, the question wouldn't even arise. But we're not talking about shops here. Shops are allowed to go bust. We're talking about banks.

And the really big problem with the Italian banks is who the bondholders are. You see, this isn't some big faceless institution that's holding on to these bonds. It's your average Italian in the street. Voters, in other words.

Wipe them out, and as JP Morgan put it: "the likely burden sharing of retail-held bonds would send shock waves across the domestic depositor base". As a result, "if dealt according to the rules, the problems of the Italian banking sector could easily morph into a domestic banking crisis".

Four small banks were dealt with according to the rules in November, and the political fallout involved widespread protests, and the suicide of one saver.

Let this happen on a wider scale potentially affected bank bonds account for roughly 5% of Italian household financial assets and political chaos (in an already fragile system) would ensue. Lending would dry up. Already weak economic growth would falter. And you'd have "a potential to unleash a broader euro area banking crisis through contagion".

So what's the answer? As always with political problems: fudge.

There are no rules

The whole period of the EU's existence has been one long negotiation. Almost every country has broken at least one of the sacrosanct rules on deficits, for example.

So the idea that a systemic banking crisis will be allowed to happen because Europe's politicians can't get it together to find a way to allow Italy to bend the rules (and a relatively new set of rules, at that) stretches credulity.

Expect to see a solution worked out that at the very least, ensures that domestic bondholders are spared.

What does it mean for investors? I wouldn't be queuing up to stick my money in Italian banks. But what I will say is that I think talk of "Lehman Brothers" part II etc is misplaced. The next world-shattering crisis is not going to be the same shape as the most recent one.

The banking crisis rulebook has already been written. Banks get into trouble. Someone (usually the taxpayer) pays for it. The central bank prints the money needed. There are some hairy moments, but the overall strategy is clear.

And this, of course, is exactly what will lie at the root of the next crisis. The actions taken to save the banks today and "stimulate" the economy in the meantime will be what causes the next big disaster.

The illusion that money printing has no consequences is already encouraging policymakers towards ever more dramatic interventions, as I discussed in yesterday's Money Morning. If the continued collapse in bond yields is telling us anything, it's this.

My colleague Tim Price often debates the monetary endgame in his London Investment Alert if you don't already subscribe, you can find out more about it here [LINK].