Italy’s banks: Rules – made to be broken?

The Italian banking sector has been gripped by financial stress over the course of 2016. Market concerns are not new. Italy has a large non-performing loans (NPLs) problem, amounting to a full €360 billion last year. This reflects a legacy of weak growth and inadequate prudential management. On a positive note, NPLs growth has slowed markedly alongside a long-awaited recovery in the real economy.

However, the stock remains acute and some banks are struggling to address this burden. Italian NPLs are difficult to value, with long recovery times and uncertainty over collateral values depressing any secondary market for this debt. Furthermore, bank profitability has been dampened by a range of headwinds including provisioning, weak
loan growth and squeezed net interest margins. This makes it more difficult for banks to boost capital positions through retained earnings and work out NPL problems organically.

The Renzi government has moved to try and address the NPL issue by shortening procedures for credit recovery, providing government-guarantees on senior tranches of securitised NPLs and launching a privately funded recapitalisation fund – Atlante. However, these measures have proved insufficient to quell market disquiet, increasing the pressure for a more definitive solution to Italy’s bank issues.

The government has clearly been exploring its options on this front. Reports have suggested that a direct capital intervention is being considered for those banks in greatest need of support. Indeed, a €40 billion injection was rumoured, which at around 2% of GDP would not be too fiscally onerous. However, EU rules continue to provide a barrier to direct action.

In particular the newly implemented Bank Recovery and Resolution Directive (BRRD) prohibits any public money being spent before at least 8% of banks liabilities are bailed in. The BRRD forms a cornerstone of the banking union in the Eurozone, with the bail-in mechanism seen as a means of breaking the link between banks and sovereigns. However, Renzi is extremely reluctant to go down this route. Italian households are large holders of bank securities, which had benefitted from favourable tax treatment. This puts the government between a rock and a hard place – inject public capital and damage the credibility of banking union or push loses onto Italian households, which would be politically disastrous.

As is so often the case in Europe, there may be a compromise to be had. An ideal solution would be to increase the Atlante fund, although it is not clear that the government will be able to obtain sufficient private contributions. If public money is required then state aid rules and the BRRD both allow for exceptions. One route might be a precautionary recapitalisation in which governments can intervene to support ailing banks under certain conditions, although this may still involve some bail-in. Another option might be a reimbursement of affected savers after a bail-in, with this policy having been used following the resolution of four small banks last year. None of these policies are ideal and they would require the cooperation of Italian and European policymakers. However, a failure to address Italy’s NPLs challenge in a cooperative way risks dealing a severe blow to either EU banking regulations or Italian political stability.

James McCann European economist at Standard Life Investments

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