Are Italy’s Banks A ‘Doom-Loop’ Risk That Could Bury The Eurozone? by [email protected]

Eight years after the global financial crisis, Italy’s economy remains weak and the country’s banks have a very high rate of shaky – or under-performing — loans at about 18%. That compares with rates of 5% in France and 1.5% in the United Kingdom. Since Italy is the third-largest economy in the European Union, a breakout of loan defaults or a run on bank deposits could quickly spread eurozone-wide, where many banks have been struggling, in part because of record-low interest rates cutting profit margins. What’s more, companies in Europe depend on bank loans far more than in the U.S., so struggling banks can mean that even successful companies face a credit squeeze.

This has led to fears of a “doom loop,” where the potential failure of Italy’s banking system might require a state rescue at a time when the country is already heavily indebted at around 135% of GDP. And that is complicated by the fact that, as of January, new regulations require European banks to bail-in shareholders and bondholders – use their holdings to recapitalize a troubled bank — before any taxpayer-funded bailout can occur. Yet in Italy, many bondholders are actually small investors who were duped into buying bank bonds under the impression that they were as safe as insured deposits, explains Franklin Allen, an emeritus finance professor at Wharton and a finance professor at Imperial College in London. If small investors start to take a hit, it could spark a run on bank deposits and kick off a major crisis. In this [email protected] interview, he looks at the big picture regarding risky Italian banks, assesses the odds of significant problems breaking out, and considers how officials might avoid a major new financial crisis.

An edited transcript of the conversation appears below:

[email protected]: A new rule passed by the European Central Bank that takes effect next year calls for bank authorities to tap stockholders and bondholders for recapitalization before they would tap taxpayers for any bailout. This so-called “bail-in” is in contrast to what happened after the financial crisis when the U.S. bailed out its banks using taxpayer money. But many of the bondholders in Italy are small investors. They are similar to small depositors in the U.S. [and the small bondholders in Italy] thought that buying bonds would be a safe investment. These smaller holders may not be aware of the precarious financial position they are in because of these underperforming loans held by the Italian banks. Do you agree with this context? And what are the risks of these bondholders suddenly panicking, if they were to realize that the banks are in a fragile condition, and starting a run on deposits?

Franklin Allen: I agree completely that this is a very important issue and I think it’s off the radar screen of most people who aren’t involved in the financial sector. People in the financial sector realize that this is a potentially existential problem for the European Union. The reason is that Italian banks are very big and if they need to be bailed out by taxpayers, large amounts would be required. But the problem is that the Italian government is already heavily indebted, so there’s what people sometimes call “the doom loop” between banks and the sovereign. That’s the general background.

“These systemic problems can arise out of nowhere — or out of small beginnings — and take over very quickly…. This problem with the Italian banks has that potential….”

You laid out very well that under the new rules — the [European Union] Bank Recovery and Resolution Directive — the banks need to bail in shareholders and bondholders before they can get state funds. This is problematic because it seems as though many small investors were missold. In other words, they were not really told the truth about what they were buying. In many cases, they thought they were buying something that was equivalent to insured deposits. But these subordinated and other kinds of debt are not like that. They have the potential to be bailed in.

I think everybody agrees that it’s fine to bail in the shareholders, but it’s problematic to bail in these small bondholders. Politically, this represents a big problem for Italian Prime Minister Matteo Renzi’s government. There was a case at the end of last year where four small banks were bailed in and the same problem occurred there in that many didn’t realize what they had. There was a tragic case of a retired pensioner who lost his life savings and was so distraught that they committed suicide. This obtained quite a lot of publicity, as you would expect.

But I think you’re right, there are still many people who don’t fully understand what they’re holding. It seems that if there are bail-ins, the Italian government is going to recompense the small savers who have this kind of debt. But we get back to this problem of, can they afford to do that? And who exactly will get compensated? Will they go back and compensate the people in the banks that had the bail-ins last year? How far will it go?

[email protected]: If that were to escalate up, if they weren’t able to contain it on a local level, then you start to open up all of the things that people have worried about for the last several years since the last financial crisis, which is this whole idea of systemic risk. This could spread to other banks in Europe that are facing some lean times and would have difficulties dealing with big challenges. One in particular is Deutsche Bank. Could you talk about the risk of systemic contagion and Deutsche Bank, in particular?

Allen: In Italy itself, there are a number of banks that have problems. Banca Monte dei Paschi di Siena, which is the oldest bank in the world dating back to the 15th century, has been bailed out twice already but is still on the ropes. The first question is, what will happen to them? They are the No. 3 bank in Italy, so they’re significant. They’re not huge in a global sense. The bank that is globally important in Italy is UniCredit, and it has operations in many other parts of Europe and the rest of the world. They have had a big drop in their equity price since the beginning of the year. This represents the fact that people are worried about these issues that you’ve talked about, the nonperforming loans and how the government will deal with them if they get into trouble.

I think if there is a meltdown, particularly if it spreads to UniCredit, then other banks in Europe will also face problems. I think Deutsche Bank has potential to have problems. The nature of their business is such that the very low interest rates and the fact that there isn’t much different between long-term rates and short-term rates is problematic for them because of their business model. So, there is likely to be some contagion.

Once it starts, it’s very difficult to stop because I don’t think people understand what’s going on, and they are going to be quite surprised by these new bail-in rules. That

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