Italy’s broken banks – the spectre haunting Europe

Italian banks are on the brink of collapse and EU rules make bail-outs seem politically impossible. Will they fall and who will they take down with them? Simon Wilson reports.

Why the worry over Italian banks?

A spectre is haunting Europe the spectre of banking collapses in Italy, which could lead to renewed crisis in the eurozone, and a wider banking crisis affecting other countries with high exposure to Italian bank debt. Italy's banks are in deep trouble, weighed down by €360bn of bad debt ("non-performing loans" in the jargon), equivalent to a fifth of Italy's GDP (and about 18% of all the banks' loans).

Shares in the sector have slumped this year as investors began to price in the risk of banking collapses. One of the worst affected has been Monte dei Paschi di Siena, the world's oldest bank. The sell-off has gathered pace since the shock of the Brexit vote on 23 June caused investors to reevaluate the risks facing European assets.

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Why are the banks so vulnerable?

Most fundamentally because of Italy's terrible economic performance over the past decade (the economy is still 8% smaller than it was pre-crisis). This has left the banking sector exposed to years of bad debts from failing businesses. This week the International Monetary Fund (IMF) warned that Italy was unlikely to grow its economy back to pre-crisis size until the mid-2020s, implying "nearly two lost decades".

The IMF's latest economic health check found that high taxes, an "inefficient public sector" and civil service wage growth that had for years outstripped productivity gains, had all contributed to one of the lowest productivity growth rates among advanced economies over the last 30 years. Brexit-related uncertainty is expected to drag down the economy over the next two years, with growth in GDP of 1% or less. The IMF added that public debt, at 133% of GDP, left policymakers "very little room to cope with shocks".

What does all that imply?

The banks face a situation that will get worse, not better, without intervention. Which leads to another key reason for the exceptional weakness of Italy's banks its weak and often short-lived governments have spent years avoiding decisive action to tackle their festering problems. After the global financial crisis, governments in the UK and the US in particular undertook a major recapitalisation of their banking sectors from 2008-2010. Italy, where the banks at that point appeared stronger, chose not to.

It also failed unlike Spain to take the opportunity to set up a bad bank in 2012 at the height of the eurozone crisis, and has preferred to kick the can down the road ever since. But as a senior Italian banker told the Financial Times recently: "You think you are kicking the can down the road, but suddenly the road turns uphill and the can comes back and hits you in the face."

So what can Rome do now?

Here we come to the third big reason why investors are fearful. At the end of 2015, the rules governing what eurozone governments can do to help struggling banks changed dramatically, giving them much less scope to come to the rescue. Specifically, under the European Union's new "bank resolution and recovery" directive, which came into effect at the start of 2016, governments are prohibited from using public money to recapitalise banks without first forcing huge losses onto private investors both shareholders and bondholders.

On the face of it, this provision that 8% of existing liabilities must be "bailed in" by investors before the banks can be "bailed out" by the public purse seems fair, especially where those investors are wealthy institutions that can take the losses on the chin. But the situation in Italy is very different.

How so?

The Italian banks' creditors include millions of ordinary Italians, who own around €200bn of bank bonds eligible to be bailed in. For many of Italy's 1,400 banks, a bail in would wipe out not just shareholders, but also ordinary depositors who have been sold €173bn worth of questionable bank debt ("subordinated" loans ie, bonds that are a lower priority for repayment in the event of bankruptcy).

In other words, bailing out its banks in line with eurozone rules looks politically impossible for Italy, especially after a bail in of four small banks last year hit 100,000 retail investors, caused widespread street protests, and resulted in at least one suicide by a ruined saver.

So what will happen?

Italian bank stocks rallied this week on the hope (boosted by positive noises from Angela Merkel and the IMF) that the EU and Italy will come up with a fudge that allows both sides to save face, and facilitates some form of limited or initial bail out. Either way, time is of the essence. In three months' time, Prime Minister Matteo Renzi's government faces a referendum on constitutional reform, which, analysts say, is likely to be a de-facto vote of confidence in Italy's membership of the eurozone, particularly given the growing popularity of the populist Five Star Movement.

Any bail out that turns Italians further against the political establishments in Rome and Brussels would seriously damage Renzi's chances of winning it and deliver yet another blow to a Europe already reeling from Brexit.

Who is most exposed?

Italy's nascent banking crisis risks political as well aseconomic turmoil in Italy itself. But there is also, crucially,a serious risk of contagion, with the potential to unleash abroader eurozone banking crisis. Most exposed, by somedistance, are the French. According to figures fromDie Welt, the total exposure of French banks to Italian debtexceeds €250bn.

That's three times as much as the second mostexposed European nation, Germany, whose bankshold €83.2bn-worth of Italian bonds (Deutsche Bank alonehas more than €11.76bn, increasing the fears over thatbank's long-term stability). The other banking sectors mostat risk of contagion are Spain (€44.6 bn), America (€42.3bn),the UK (€29.77 bn) and Japan (€27.6 bn).