Worse than Brexit: how Italian banks can destroy the economy of Europe

The office of Credit Suisse in Milan

After the decline of the hype surrounding Brexit to the forefront of the economic agenda of Europe suddenly came another problem — the hole for hundreds of billions of euros in the financial sector of Italy, the fourth largest economy in the EU and eighth in the world. It threatens not only to destabilize the political situation in Italy itself, but also undermine the entire banking sector of Europe, experts warn. The burden of bailing out Italian banks may have to separate private investors and lenders, but Prime Minister Matteo Renzi is politically unacceptable. The negotiations of the Rome and Brussels about the options of rehabilitation of the financial sector has not yet yielded results.

The origins of the crisis

The volume of bad loans on the balance sheets of Italian banks, the IMF estimates of €360 billion — 18% of the total loan portfolio. This is three times more than the average for the Euro area (6%) and comparable with levels of bad debt in Albania and Burundi. The dire situation of the financial sector of Italy — the result of a three-year recession and decades of economic stagnation, concludes the FT. In addition to bad loans to Italian banks face a series of problems: chronically low yield amid record low interest rates, insufficient capitalization and high costs. Systemic risk also comes from the excessive amount of government bonds in the portfolios of Italian banks, wrote in April to Bloomberg. More than 10% of assets Italian banks accounted for government bonds of various countries, twice the average of the Eurozone — it strengthens the link between Bank and sovereign risk.

Unfortunately, Italy lost time in the recovery of its financial system, writes the FT. The government held a large-scale recapitalization in 2008-2010, when this was done by other countries in Europe and the United States, they have not created a Bank of problem assets following the example of Spain, which took the decision in 2012, and did not have time to support their banks before 1 January 2016 when the Eurozone earned a Single mechanism (Single Resolution Mechanism — SRM) requiring that the burden of bailing out troubled institutions were shared by the depositors and holders of Bank bonds.

This year, the supervision of financial sector of Italy passed to the European Central Bank (ECB), and on 29 July the European banking authority (EBA) will announce the results of stress tests designed to identify the depth of the problems in the sector. According to Matteo Renzi, who became Prime Minister in February 2014, today he’s got a problem in 2013, declined to decide the previous leadership.

Deals Rome

For the first time the government talk about aid to the financial sector at the end of June, after Brexit provoked sales of the shares of Italian banks: only two days after the British referendum leading banks in Italy, Intesa Sanpaolo Banka MPS, Mediobana and UniCredit lost a third of its market value. In response, authorities began to consider the possibility of recapitalization of financial institutions by €40 billion, wrote The Wall Street Journal.

Italy insists that the recapitalization of its banks in the framework of the European rules of financial recovery of credit institutions, told Bloomberg this month informed sources. These standards allow to support the banks when, for example, stress tests reveal that those experiencing a shortage of capital.

The Chairman of the Central Bank of Italy, Ignazio visco admits the possibility of state intervention, as Finance Minister pier Carlo Padoan says the government develops measures to support banks that would be based on market approaches. Last week, he said that all authorities are discussing measures will be based on the principle of “maximum protection of investors.”

“Visco says the obvious, but the markets will calm only safe plan,” Bloomberg commented on the actions of the authorities Jacopo Ceccatelli, CEO of the Milan brokerage company Marzotto SIM SpA. — I am worried that a decision on Monte Paschi, which is at the forefront of this crisis will be found, and a comprehensive plan for the entire sector and does not appear. According to Catelli, the risk that the collapse of one Bank in the financial sector of the country will trigger a Domino effect, increase.

According to analysts and experts, €200 billion of the €360 billion of problem loans — loans for which debtors are insolvent. To portfolio bad debt returned to fair value, requires write-off of €30-40 billion of these assets, estimated by the WSJ. The FT estimates the amount of required write-downs of €85 billion.

Expert evaluations

The statements of the Central Bank of the country about what the regulator expects from financial institutions reducing the amount of bad loans on their balance sheets, have alarmed markets, wrote July 12 Bank of America Merrill Lynch. The rush to write off bad debts and to increase capital threatens to damage the real economy and, paradoxically, thereby to provoke a new rise in bad debts, says the Bank.

The EU may initiate a program of “open aid to banks”, which is essentially equivalent to running [in 2008] bailout of troubled assets (TARP), under which the U.S. government bought the shares of the largest U.S. banks, said Jim Millstein, the former head of the restructuring program of the U.S. Treasury. Attempts to protect taxpayers from Bank losses and to transfer all the burden of their salvation on the investors threatened to trigger a Domino effect in the financial sector”. “Thus, you burden those who invest their money in the economy”, — concluded Millstein.

The Objections Of Brussels

Brussels insists that in saving the banks first participated investors and private holders of their bonds (so-called bail-in), after which will assist the European stability mechanism (ESM). Rome opposes, reported Bloomberg sources familiar with the discussions.

Commenting on the talks with Rome, the Minister of Finance of the Netherlands Jeroen Deysselblum, concurrently holding a post of the head of the Eurogroup (group of Eurozone Finance Ministers), stated that “the rules state the obvious: investors and owners of banks have to suffer losses, just as they made a profit in the fat years.” He was supported by German Finance Minister Wolfgang Schaeuble: “the European standards of the [Bank rescue] was established after the lesson that we learned after the financial and banking crisis, the Minister said, referring to the existing bail-in. According to him, at the time, all were unanimous in saying that we cannot allow banks to earn huge profits, and the burden of risk fell on the shoulders of taxpayers.

To solve the problems of the financial sector, the Italian authorities intend to create a toxic Bank, where it is proposed to transfer troubled assets with a nominal value of €50 billion, announced on 16 July, the Sunday Telegraph, without citing a specific source. The newspaper notes that the plan may not like Brussels, because in the scheme it is proposed to use taxpayers ‘ money.

The Dilemma For Renzi

The banking sector crisis poses a dilemma to Prime Minister Renzi. If he moves to Brussels, the losses incurred by ordinary Italians, who had invested in Bank bonds, hoping that in terms of reliability, they are comparable with Bank deposits and yield even surpass them. It is unpopular and may cost the Prime Minister his job — indeed, among voters are the holders of the securities, Bloomberg reported. According to the Agency, now in the hands of investors are bonds of Italian banks more than €180 billion, the aggregate capitalization of the financial sector is less than €60 billion, were evaluated July 5, Bloomberg Intelligence analyst Scott Makewhat.

In the autumn — in October or November — in Italy will be initiated by Renzi referendum on constitutional reforms to improve the efficiency of the political system of the country. According to FT, Renzi risks nothing less than David Cameron in Britain, as voters consider the referendum as an opportunity to Express trust or distrust of the government in the middle of his term. In the last municipal elections in the country party, Renzi has already pushed competitors. In June, at the election of the mayor of Rome, won by Virginia Raja, candidate of the opposition five star Movement” in favour of a referendum on the country’s withdrawal from the Eurozone.

Renzi unlike the Greeks not asking for money. He asks of the possibility of tricky accounting maneuver that will increase the national debt of Italy and make Italian banks “zombie banks”, with even greater exposure (exposure, the amount of potential risk to Italian government bonds, explains RBC managing Director of Arbat Capital, Alexander Orlov. “The most serious risk carry of Italian government bonds — if the price starts to fall, the entire banking system is reset almost instantly; they are the key liquid asset has already been mortgaged several times in the ECB,” says Orlov. — The more government debt of Italy and the greater exposure of Italian banks to government bonds, the greater the risk that sooner or later the banking system will collapse and nothing will be able to save her”.

The German authorities insist on bringing to the rescue of the Italian banks depositors, but politically it will be impossible to do — increase the risk of regime change in Italy. Renzi can use this fact to put pressure on Merkel to refer to the term Italexit after the October referendum if Germany, the informal leader of Europe, will not agree to the terms of Rome.

Bail-in in Europe

In the Eurozone, the mechanism of bail-in is effective from 1 January 2016. According to the Directive on restructuring and bankruptcy of banks, approved by the European Parliament in may 2014, the burden of saving the credit institution must be passed on to the shareholders and creditors of financial organizations.

According to provided document the procedure first are obligations to shareholders (capital), then capital will be converted obligations to the bondholders and, finally, large deposits over €100 thousand Contributions for a smaller amount must remain intact, as they are guaranteed by the state. The Directive also establishes that the authorities can connect to Bank restructuring, only after the participation in his salvation will take its shareholders and creditors.

The Domino effect

The problems of Italian banks not only can destabilize the political situation in Italy, but to blow up the entire financial sector of Europe. “If we take Brexit, sanctions against Spain and Portugal for violation of financial discipline and problems in the banking sector of Italy (and other EU countries), the last question is the main agenda of Europe in the next six months, said Bloomberg, Larry Hateway, Board member of the international asset management Group Gam. — The use of the mechanisms of rescue of banks in the European banking Union can not only destabilize the political situation in Italy, but also destabilize the banking sector in the major EU economies, including France and Italy.”

Agree with him chief economist at Deutsche Bank David Folkerts-Landau. In his opinion, Europe urgently needs assistance Fund by €150 billion to recapitalize the troubled banks, especially Italian. “Europe is seriously ill, and she needs to quickly solve its problems, otherwise there’ll be a catastrophe,” — said Folkerts-Landau in an interview with Welt am Sonntag. According to the economist, the recurrence of the financial crisis of 2008 is not worth waiting, because now banks are much more stable and have more capital.” However, ahead of the financial sector are slow and the long period spiral fall.”

The banking crisis in Italy could spread to the rest of Europe, said in an interview with Bloomberg, the Chairman of the Board of Directors of Societe Generale and a former ECB Board member Lorenzo Bini Smaghi. In his opinion, it is necessary to revise the pan-European restrictions on the provision of state aid to banks (restrictions on the use of taxpayers ‘ money) to prevent a larger crisis.