by John Browne, Euro Pacific Capital:
On December 7, 2016, Italy’s Prime Minister Matteo Renzi resigned following defeat in a national referendum, that he had supported, that would have changed the country’s parliamentary system. The development, which represents just the latest sign of anti-EU sentiment spreading throughout Europe, was felt acutely by Italy’s troubled banking sector. In particular, the Banca Monte dei Paschi di Siena (MdP) has been teetering on the brink of collapse and now may stand as a case study that may be encountered by other EU member nations.
The advent of the euro currency allowed Eurozone member countries, even those with poor financial health like Italy, to borrow at far lower ‘Germanic’ interest rates than their respective national credit ratings would have allowed. In turn, national borrowers were able to tap into the vast sums of liquidity created under central bank quantitative easing (QE) programs at astonishingly low, and sometimes negative, interest rates. Predictably this has led to a massive misallocation of capital, and billions in potentially non-performing loans.
The problem for Italian banks became particularly acute when the fall of the Renzi government raised the possibility that a new Government could seek to lead Italy out of the Union and bring back the lira to Italy. With the return of its own currency, future Italian governments could devalue at will in order to pay the country’smounting debts. If faced with the possibility that their euro-denominated deposits could be transformed into shrinking lira deposits some could be convinced to transfer funds into German banks where they would face no such peril (EU laws present no obstacles to cross-border banking). This is a clear recipe for a banking default.
According to a 2016 IMF working paper (WP16135), Italian bank nonperforming loans had tripled since the crisis of 2008. It blamed “A combination of over-indebted corporates following the sharp crisis-related drop in output, banks generally low in capital buffers, a highly complex legal system of corporate restructuring and insolvency, lengthy judicial processes and a tax system that until recently discouraged NPL write-offs … .” On September 13th, Bloomberg estimated Italy’s nonperforming loans at $394 billion through March or 16.1 percent of Europe’s total, based on data from the European Central Bank (ECB).
Furthermore, a relative lack of economic opportunity and a massive increase in inward migration has caused a marked increase in emigration from Italy, particularly among young males. The recently released OECD 2016 International Migration Outlook recognizes that, “The public is losing faith in the capacity of governments to manage migration.” Italian emigration more than doubled between 2010 and 2014. This contributed to an erosion of the bank deposit base.
Italy is one of the world’s most indebted nations with debts estimated in 2015 at over $2.4 trillion or 130 percent of its GDP, about half of which is comprised of government spending. Therefore, Italy is not well placed to finance a potentially devastating and fast developing domestic banking crisis.
In the U.S. banking crisis of 2007/8, our government reacted quickly to a potential international financial meltdown by organizing the Troubled Asset Relief Program (TARP) to purchase ‘toxic’ assets from banks bailed-out with taxpayer funds. Politically, it was highly unpopular. In Europe’s case, influenced largely by Germany’s unwillingness to make its citizens liable for foreign banks, the EU and Eurozone chose to leave its banks unaided while toxic or non-performing loans continued to fester. The EU’s article 32 provides that equity and bondholders suffer financial loss before national governments are permitted to deploy taxpayer funds. It is a policy first developed by the EU, in conjunction with the IMF and ECB, in the rescue of Cypriot banks in 2015 when even certain large depositors’ funds were seized to make the banks whole. It was termed a ‘bail-in’.
MdP is a relatively small bank. As of June 30, 2016, its assets came in at just $182.9 billion, ranking the bank at only 121st largest internationally (www.relbanks.com). Regardless, the news of its potential collapse sent shock waves through Italy’s banking community. However, the crisis does not appear to be contained (as they never are). Italy’s second largest bank, UniCredit, S.p.A, with a deposit base of almost $1 trillion, has also come under intense scrutiny. But the larger bank was able to gain shareholder approval for a 10:1 reverse share split and a rights issue that raised some $13.8 billion of new capital. The combination met the demands of Article 32 of the EU Directive for a bail-in. It may have restored confidence sufficiently to ensure survival, for a time at least, without government intervention.
The case of Monte dei Paschi was very different. The bank had waited until December 21st to declare that it had sufficient liquidity to last only four months. The shareholders of Monte dei Paschi, by the close of 2016 had experienced a large fall in earnings per share (EPS) and an almost complete collapse in the share price for the year.
To make matters worse, like mortgage-backed securities that were distributed by Wall Street in the early 2000’s, junior bonds in Italian banks were sold to risk averse retail investors as ‘sound banking investments’. The degree to which rank and file investors are exposed to the bank has made the case a politically charged issue.
On December 21, 2016, Italy’s finance minister, Piercarlo Padoan, implored his Parliament for rescue funds. Posturing that the Italian banking system was “solid and healthy”, he nevertheless urged adoption of government restructuring plans so that banks could “… travel on their own legs, be profitable, and finance the economy.” Later that day, the Italian Parliament approved a bank bail-out package of $20.8 billion. However, Goldman Sachs had estimated earlier that almost $40 billion would be needed to ensure long term survival. (Financial Times, R. Sanderson, J. Politi, M. Arnold, 12/21/16) A London analyst had forecast even more.
The range and conflicting data surrounding the bank’s rescue make it unlikely the real amount necessary to halt the escalating Italian banking crisis is known or can be known any time soon. In today’s highly interconnected financial world, Italy’s banking problems are not restricted to Italy or even to the European Union. Estimates are that French, German, Japanese, Spanish, UK and U.S. banks are exposed to the debts of Italian banks approaching half a trillion dollars.
Important general elections are due this year in France, The Netherlands, Germany and, owing to the failed Italian referendum, in Italy. In addition, Brexit has set a precedent in the minds of the European public that it is possible to escape the clutches of the EU. Also, should the UK succeed in leaving, the EU will lose its second largest economy and financial contributor. Doubtless, this potential erosion of EU funding and the recently exposed possibility of democratic ‘revolution’ will act to focus the minds of the EU’s bureaucracy increasingly on finding a political solution to Italy’s banking woes.
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