I last discussed the vulnerabilities in the Italian banking system in our April 12, 2016 blog post (“Strengthening the Global Banking System’s Weakest Link“), where I asserted that–given its global inter-connectivity today–the world’s financial system can only be as strong as its weakest link. Typically, a liquidity or solvency issue can linger on indefinitely, simply due to the absence of external shocks or because the overall global economy is doing well. In the case of the current NPL issues with the Italian banking system, an effort in January to encourage sales of NPLs by providing government-backed guarantees unfortunately attracted investors’ attention to Italian banks’ NPL issues. When we last covered this issue three months ago, Italian banking stocks were “only” down 20% YTD; today, they are collectively down by 55% YTD.
The vulnerability of the Italian banking system–and by extension, that of the Western European banking system–has come under increased scrutiny over the last several months, exacerbated by: 1) the unexpected, ongoing deflationary malaise in much of the developed world; the May 2016 Italian inflation reading was -0.3% year-over-year, worse than market expectations of -0.2%. June 2016 Italian inflation is expected to hit -0.4% year-over-year, resulting in six straight months of deflationary readings, 2) the dramatic flattening and downshift of the Western European yield curve; globally, nearly US$12 trillion of government bonds now have negative yields, and 3) an unexpected vote for “Brexit,” equivalent to a negative growth shock within the EU, as well as heightened political and economic uncertainty.
The Italian banking system in particular is saddled with 360 billion euros of NPLs, equivalent to about one-third of all of the Euro Zone’s NPLs. Moreover–as efforts since January have demonstrated–a concerted sales effort in NPLs in Europe is not a simple task. Firstly, EU rules explicitly ban the use of government-backed guarantees to cushion NPL losses. Secondly, the average restructuring period for Italian bad loans is an abnormally long 8 years; a quarter of cases take 12 years. Finally, the European market for NPLs is small and underdeveloped relative to the overall stock of NPLs in the banking system. In other words, the market for selling Italian NPLs is relatively small, and is almost non-existent without government-backed guarantees (e.g. A proposal by Apollo to purchase 3.5 billion euros of NPLs held by Italian bank Carige back in March made no progress). Italy’s NPL issues are especially concerning given the lack of core profitability of the Italian banking system (see Figure 1 below).
Figure 1: Return on Regulatory Capital of European Banks by Country – June 2015 (source: EBA, Goldman Sachs)
It is generally agreed upon that an Italian government-led recapitalization of 40 billion euros into some of Italy’s largest banks (Unicredit, BMPS, and Intesa, for example) would be adequate to resolve the Italian NPL issue, as long as Euro area growth re-accelerates; at the very least, the immediate probability of a Euro-wide banking contagion would be reduced by an order of magnitude. There are two real obstacles to this “happy scenario,” however: 1) the EU, backed by Germany, is resistant to any Italian government-led efforts to recapitalize the banks at no cost to Italian bank debt holders, as this directly goes against EU rules. Any attempt to “bail-in” Italian banks would increase contagion risks among all of EU banks as both depositors and debt holders will likely take their capital and flee to either the U.S. or other safe haven asset classes, such as gold, and 2) Italian Prime Minster Matteo Renzi has promised to resign if he loses the constitutional referendum to be held in October. Recent opinion polls suggest Renzi’s campaign will fall short; this will likely lead to significant Italian and EU-wide instability given the surge of the populist Five Star Movement in recent opinion polls. Seen in this light, the fragility of the Italian banking system is an ongoing cause for concern.