Hi traders it's Nicholas Puri here. With many people considering 2016 to be an annus horribilis,
it is safe to assume that there is a high level of uncertainty in the air as we head
into the New Year.
Political fragmentation appears to be the flavour of the moment, with Brexit and Trump's
election victory taking centre stage. However, despite the situations in the UK and US attracting
the bulk of the attention this year, the most immediate cause for concern lies firmly in
the hands of Italy.
If political division is currently in vogue, the Italians are certainly no strangers to
this; with the recent referendum and subsequent government reshuffle clearly showing unrest
is not absent in the Mediterranean. However, the most pressing concern goes beyond political
tensions and even beyond the weak and fragile growth seen in the economy. The biggest area
of alarm is with the severely troubled banking sector.
With the domino effect of negative financial events in recent years turning most of the
financial world into hardened cynics, one may roll their eyes and argue that the Eurozone
thrives on having its 'problem child' of the hour. In this case, Italy is just taking its
turn to step into the role once again, until the buck gets passed onto the next unfortunate
nation in line.
However, when we consider the level of apprehension that was present earlier in the year when
issues at global financial powerhouses such as Deutsche Bank reared their ugly head once
again, it becomes important to understand the situation in Italy, which has the potential
to be the smaller lead domino in a much more widespread financial downfall.
In this video, which is based on an article we recently published on SeekingAlpha.com
we will discuss the key issues causing the Italian banking crisis and what the potential
solutions and obstacles could be.
This is... Understanding the Italian Banking Crisis - The New Lead Domino?
The stress tests administered by the ECB on July 29 exposed the Italian banking sector
as being amongst the most fragile in Europe. The key areas of concern for this weakness
were the asset quality, which is seen as very poor, combined with the under par economic
outlook.
Taking a closer look at the issue of poor asset quality, it becomes clear that although
there are many problems, chief amongst those is the situation of non-performing loans (NPLs).
When you dissect the NPL data, it is evident that the main culprit for the issue stems
back to the financial crisis that hit the economy in 2008.
This is shown by approximately half of the total gross NPLs being loans collateralised
by real estate. From this, around 80% were issued to SME and corporate clients, with
Lazio and Lombardy (where Rome and Milan are situated respectively) being the key regions
with the highest NPL share.
At present, NPLs in the Italian banking sector amount to around €200 billion, which is
the equivalent of 8% of the total loan portfolio. However, some analysts believe this figure
understates the reality, since it does not include a further €160 billion which could
potentially join the pool, therefore increasing the actual portion to 15%.
A recent research by Goldman Sachs further highlights the dire situation of the current
loan book, with estimates showing the standard market price for 'past due' loans at 21 cents
and the standard market price for 'unlikely to pay' loans at 54 cents. A white paper by
PIMCO estimated that selling all NPL assets at these market rates would lead to a capital
depletion of around €40 billion, which along with other factors makes holding onto these
assets rational at present and justifies the Italian banks in doing so.
If the poor quality of assets being held by Italian banks was not already enough of a
destabilising factor, the issue has been further compounded by other economic measures being
imposed.
In particular, the sharp decline in interest rates has been an area of difficulty for Italian
banks, with it severely affecting their current and expected future profitability. When rates
are falling, the value of fixed-income securities on a bank's balance sheet goes up, leading
to higher profits. This is one of the tenets of the ECB's decision regarding rates, as
specified in a paper they released this year. However, this has not necessarily been the
case in Italian banking.
Not only must they endure the short-term interest rates being in negative territory at present,
but they have also been hit by the yield on Italian bonds. The 10-year Italian government
bond has plunged to an all-time low, which has therefore impacted not only a large portion
of their fixed-income securities holdings, but their overall holdings in general. As
Italian banks own more than €400 billion of Italian government bonds, this accounts
for around 10 percent of their total assets.
As we have observed in the years following the financial crisis and the actions taken
by central banks around the world, solving deep issues in the banking sector is no straight
forward task. The current Italian banking crisis is no different; presenting a myriad
of catch-22 situations and restrictions that are proving extremely difficult to resolve.
Measures taken so far have not proven to be impactful and a grand solution is still yet
to be agreed. The situation is currently changing by the day, as discussions continue about
whether a bailout of Monte dei Paschi di Siena, Italy's third largest bank, will be possible.
Therefore, while we can discuss the current potential solutions and measures taken thus
far, it is important to note the fast-changing landscape.
From the stress tests mentioned earlier that were undertaken on 51 EU banks, Monte dei
Paschi was found to be the weakest. The bank holds around €50 billion in bad loans, which
makes up about 30% of its total assets.
At the end of July, the Atlante fund signed a memorandum of understanding to buy the mezzanine
notes of the securitised bad loan portfolio of Monte dei Paschi for €1.6 billion. The
Atlante fund is a private equity fund which was set up by the Italian government this
year, with the sole purpose of recapitalising Italian banks and purchasing NPLs.
The fund was able to raise €5 billion from 67 investors and will be managed by Quaestio
Capital Management. It is important to note that Atlante has been funded predominantly
by capital from other Italian banks, which makes it vulnerable to becoming a vehicle
for further contagion.
Although Monte dei Paschi is the main focus at present, Italy's largest bank Unicredit
is also in a dire situation. The bank is planning to raise €13 billion in capital to boost
its reserves, which is expected to be launched by February 2017. They are also attempting
to dispose of €18 billion in bad loans to two new businesses. Monte dei Paschi had also
attempted a capital raise of €5 billion but was unsuccessful in doing so.
There are also other small, regional banks that are in a critical position and will likely
need assistance in the near future. This has already been the case for four troubled local
banks that were rescued by the Atlante fund. The sale of these banks is still on-going.
The Italian government has authorised the use of taxpayer funds to bailout close to
insolvency banks. Nevertheless, the biggest obstacle to a full government bailout so far
has been the political disputes within the EU. Germany was very public about its discontent
regarding this potential solution and the ECB have been on a similar page with this.
However, it seems progress is being made in this regard and a favourable outcome is looking
more likely by the day.
If this solution goes ahead, there will be two potential measures available:
A government guarantee on senior debt, which would ensure the medium and long term debt
issuing capability. Directly claiming a stake in the banks' equity
to prevent a default from taking place.
Unfortunately, a government bailout of close to insolvency banks is likely to have negative
electoral repercussions as well, despite the main beneficiaries being small entities with
strong links to the local communities. In addition to this, even if a taxpayer bailout
does take place, bondholders would still fail to be protected.
On the other hand, a bail-in solution, agreed within the EU context in case of banks' insolvency,
may unfortunately also prove to be a tough pill to swallow.
Firstly, the system which governs Italian banks, which is mostly accountable to the
political system rather than the markets or private investors, is likely to offer resistance
to the implementation of the bail-in solution.
Additionally, the bail-in would significantly change the ownership structure and could encourage
considerable opposition amongst the banks' investors as well as the electorate. This
would lead to political opposition parties using the situation to bolster their propaganda
during election time.
Given that the capital required to restructure the banks' debt is in the ballpark of €30
billion, this is a sizeable problem and one that is unlikely to fade away overnight even
if a bailout or bail-in solution is agreed.
When you consider the fragmented and uncertain political landscape in place, as well as the
unfavourable economic outlook, there is unlikely to be a large appetite from foreign institutional
investors to have any sort of involvement.
The question, as with most government and central bank endeavours to fix disastrous
economic situations in recent years, is whether this is an ultimate solution or simply delaying
the inevitable. For now, we can rest assured that whatever measure takes place, it will
curtail the risks for now that this situation could be the lead domino in a full European
banking crisis. But with that being said, how long will it be until the next and potentially
greater systemic risk elsewhere unfolds?