Brexit Exposes Eurozone’s Weak Spot: Italy’s Banks
Posted by hkarner - 5. Juli 2016
Source: The Wall Street Journal By SIMON NIXON
The U.K. vote to leave has made an already serious Italian banking crisis worse, Simon Nixon writes
The markets may have taken Brexit in their stride for now but it would be complacent to assume the worst of the shock has passed. Investors may also be betting that the U.K.’s political crisis will prove short-lived with the cautious Home Secretary Theresa May now the front-runner to be the next Conservative leader and prime minister. It will take time to assess the damage from what Bank of England Gov. Mark Carney has dubbed the U.K.’s “economic post-traumatic stress disorder.” Meanwhile, the full extent of the Brexit shock will depend less on what happens in the U.K. than on its impact on the eurozone, whose weakest link is the Italian banking system.
Brexit has made what was already a serious Italian banking crisis worse. Italian banks are sitting on a combined €360 billion ($401 billion) of bad debts, equivalent to about a quarter of gross domestic product. This includes €200 billion of loans to borrowers now judged insolvent, which banks have on average written down to 45% of their nominal value but which the market appears to value at closer to 20% of their nominal value, which implies the system is short of around €40 billion of capital. Now thanks to Brexit, the market fears that hole may be even larger. Lower Italian growth forecasts point to higher loan losses while falling government bond yields increases pressure on bank margins. Shares in many Italian banks slumped by more than 30% after the Brexit vote and some now trade on multiples of as little as 0.1 times net book value, according to Morgan Stanley estimates, raising doubts about their ability to raise capital from the market.
Italian policy makers are to blame for allowing the crisis to become so serious. For years, they let the situation drift in the expectation that the bad-debt problem would resolve itself through a combination of economic recovery and the substantial collateral cushion that banks claimed was underpinning the bad loans. This approach may also have been driven by political expediency: Many banks struggled to raise capital due to opaque governance structures while the government’s own precarious financial position, with debt of 135% of GDP, raised questions about its ability to backstop a major recapitalization program.
However, the economy never fully recovered and bank efforts to recover their collateral were frustrated by a weak judicial system. Instead, undercapitalized banks were reluctant to lend and overextended companies unwilling to borrow, leading to a prolonged slump.
Now Rome must clean up this mess under far more challenging circumstances. Under new EU rules that came into force in January, no public money can be used to support failed banks until private-sector creditors accounting for 8% of the bank’s liabilities have been bailed in. A bank-backed private-sector fund, Atlante, recently established to facilitate bank rescues, has already been forced to use half its capital to buy shares in two lenders after their attempts to raise equity from the markets attracted zero interest.
If Italy is forced to stick to the rules, it could face multiple bank failures, which could mean heavy losses for many ordinary retail savers, who own up to €250 billion of bank bonds. When the Bank of Italy imposed losses on €750 million of junior debt as part of the rescue of four small lenders in December, it prompted a furious political backlash. A similar backlash now could make it all but impossible for Prime Minister Matteo Renzi to win a referendum promised for later this year on the constitutional overhauls that have been the centerpiece of his administration. If he loses, he has vowed to quit.
Mr. Renzi last week tried to persuade fellow eurozone leaders to use the Brexit crisis as cover to suspend the bail-in rules for six months to allow his government to put in place a €40 billion government-funded rescue program. But they rebuffed this, fearing that suspending rules agreed upon only two years ago would damage the currency bloc’s credibility.
Eurozone leaders did at least throw Rome one lifeline, allowing it to guarantee debt issued by Italy’s banks if necessary. That should reassure depositors and investors that the banks will have continued access to cheap ECB funding facilities, thereby removing liquidity risks and reducing the risk bank runs. But Rome has clearly been told it will have to deal with its banking-system solvency issues on its own.
The stakes for Europe could hardly be higher. The EU’s legitimacy largely rests on its claim to provide common solutions to common problems. In Italy that legitimacy was already in question amid accusations that the eurozone has failed to find a solution to the common problem of growth and that it treated the common problem of irregular migration as a purely Italian problem for years until refugees started arriving in Germany.
If Italian savers in due course conclude that they are being forced to bear substantial losses as a result of the EU’s failure to recognize the common challenges posed by Brexit, the damage to the EU’s legitimacy may be irreparable. And Italy’s banking crisis could yet become a financial, economic and political crisis for the whole of Europe.