Italy’s Banking Crisis by  Kaisa Stucke, CFA, Confulence Investment Management

On January 1, 2016, the EU implemented a new bank restructuring directive. The new and stricter rules are aimed at forcing private stock, bond and deposit holders to accept losses before public funds would be used in a bank restructuring. Although all EU countries are affected by these new rules, Italy remains of particular concern due to the number of distressed loans in the country. The Italian banking index is down almost 20% in 2016 due to concerns over nonperforming loans in the country’s banking system and the limited protection that private investors will receive under the new directive.

This week, we will look at the overall health of Italy’s banking system as well as the nonperforming loan problem in the country. We will explore the various issues affecting Italy and the EU with regard to finding a solution for Italy’s troubled banking system. Nonperforming Loans Nonperforming loans (NPLs) are loans that debtors are not paying off as agreed upon, but which have not yet been written off by the banks. All countries’ banking systems have some level of NPLs. The chart below shows NPLs as a percentage of total gross loans for various countries. In 2014, Italy’s (red line) ratio stood at 17.3%. The Eurozone average (dark gray line) was 6.8% in the same year and Germany’s ratio was 2.3% (light gray line). By comparison, the U.S. ratio was 1.9% in 2014 (not shown on the chart).

Some sources peg the 2015 level for Italy at 18.0%.



Italy's Banking Crisis
Italy’s Banking Crisis

Another measure of NPLs is the ratio of NPLs to GDP. Italy does not have the highest ratio of NPLs to GDP in the Eurozone. In fact, Cyprus, Greece and Ireland all have worse ratios than Italy. However, Italy represents an outsized risk due to its large size. It is the third largest economy in the Eurozone, after Germany and France, and the eighth largest economy worldwide. Thus, while smaller European countries may have worse NPL ratios, the relative size of “bailout” funds for those countries pales in comparison to what would be needed in Italy. This makes a banking crisis in Italy much more serious than a crisis in any other smaller European country. The BRRD The EU Bank Recovery and Resolution Directive (“BRRD”), which became effective at the beginning of this year, requires that shareholders, bond holders and even large depositors bear the costs of a bank restructuring before government funds will be used to bail out the failing institution. This mechanism is informally called a “bail-in,” with stakeholders  providing the funding as opposed to a “bailout” which uses public funding. In the case of a business failure, it is not uncommon to require shareholders to lose money. Even certain classes of bond holders usually lose some, if not all, of their investment. The approach, which was first used during the Cyprus bank failures in 2012-2013, will require losses from all subordinated debt holders as well as accounts with balances over €100,000. Smaller deposits would still be excluded from the bail-ins. Background on Italy’s Markets The Italian bond market enjoyed a period of falling yields in anticipation of the euro’s introduction. Financial markets interpreted the euro to mean that all Eurozone countries’ credit qualities would converge and ultimately would be guaranteed by the single monetary union. The chart below shows Italian 10-year Treasury yields. After falling in the late-1990s into the creation of the Eurozone on January 1, 2000, yields remained stable and low until the Eurozone crisis in 2009 when it became clear that not all credits were created equal within the Eurozone. However, the subsequent easy monetary policy by the European Central Bank (ECB) as well as the effects of the central bank’s asset-purchase program lowered yields to historically low levels.

Italy's Banking Crisis
Italy’s Banking Crisis

The chart below shows the Italian stock index over the same time period. Stocks have experienced greater volatility as the underlying economic growth has remained constrained.

Italy's Banking Crisis
Italy’s Banking Crisis

Following the Eurozone crisis, Italian banks avoided an EU-backed bail-out.

However, as a result, the country’s banks hold a disproportionate level of NPLs, especially when compared to banks in countries that were able to remove NPLs from their balance sheets through a bail-out (e.g., Spain, Ireland).

The Italian Small-Scale Bank Rescue

In November 2015, the Italian government restructured four small banks. Implemented ahead of the new Eurozone “bail-in” directive, the restructuring pushed losses onto not only stock and bond holders but also absorbed deposit accounts that were larger than €100,000 before using government funds. The bank rescue was relatively small at €250 mn, but it gathered public attention after a pensioner committed suicide as a result of losing his life’s savings in the restructuring. It appears that he owned the bank’s bonds, believing them to be low-risk assets. A complicating twist to the Italian bank situation is that the banks often sold their subordinated bonds to retail investors as a substitute for deposits, and depositors mistook them for safe

investments. As a result, many Italian retail investors are overexposed to the banking system bonds. Consequently, the Italian government has initiated a case-by-case resolution to help “irregular bond purchasers” who bought the bonds without understanding the risks involved. This policy is likely to fail due to the difficulty in applying for it in practice, the increasing popular opinion demanding a “blanket” guarantee to retail clients and the EU opposition to guarantees.

Italy’s Banking Crisis – Bad Bank

Italy has not been able to create a “bad bank” where it could accumulate the nonperforming loans. Spain and Ireland were able to help their banking systems by creating bad banks during the 2011-2012 bail-out crises. However, Italy has encountered recent opposition from the EU as the creditor nations are now more reluctant to bail out other countries’ banks. During the 2011-2012 Eurozone crisis, the monetary union was more open to providing support for countries that officially sought a bail-out, while current regulations oppose the use of “state aid” to bail out private banks. The use of EU funds to bail out banks has been virtually eliminated under the new BRRD rules. Additionally, under the new rules, each large depositor is liable for knowing the underlying health of the bank. In reality, it will be hard for retail investors to know this so it would mean that depositors should diversify their risks by opening several smaller accounts in various banks or move their money across the borders to other European countries. For example, neighboring Spanish banks were restructured via Eurozone bail-outs in 2012, thus reducing bad debts and currently

leaving them in a healthier financial position than Italian banks. In this banking environment, the possibility of bank runs will be increased as depositors grow increasingly nervous about the safety of their savings. Similar to the U.S. bank runs of 1907, rumors can feed panic, which can lead to bank runs that ruin even healthy banks. In addition, if a bank is forced

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