Fra JP Morgan
The banking sector has represented one of the main sources of turbulence for European equities since the beginning of this year. European banks are facing a tough environment created by the unprecedented phenomenon of negative yields and the UK electorate’s decision to leave the European Union (EU).
From its current position at the epicentre of the crisis, Italy must now address the ongoing structural challenges that have driven up its stock of non-performing loans (NPLs).
Structural dynamics
- Italy’s banking system did not experience a real estate or credit bubble during the last crisis, unlike those of many of its European counterparts. However, its current problems stem from its high lending exposure to small and mid-undercapitalised companies, which represent the core of the Italy’s industrial sector.
- The prolonged period of crisis has put these companies under pressure, ramping up defaults and adversely affecting the quality of credit portfolios.
- The stock of NPLs reached EUR 360 billion at the end of 2015, with a coverage ratio of 45.5%. Net of provisions, NPLs account for 10.8% of total loans.1
Recent history
- Spain and Ireland were forced into international bailout programmes in a bid to create a safer financial system in Europe, while Germany also recapitalised its network of public saving banks. However, Italy benefited from no such support.
- Previous Italian governments have tended to avoid situations that could have increased the perception of risk at a time when the country’s credibility was already low.
What happened in 2016
- Prime Minister Matteo Renzi and his coalition have been strongly committed to reform, modernising Italy’s networks of cooperative banks (Banche Popolari) and mutual banks (Banche di Credito Cooperativo).
- In 2016, Italy implemented the bail-in rules, designed to eliminate the inextricable links between sovereign risks and the solidity of banks, and to avoid channelling public money into rescue programmes, as happened in the previous crisis.
- The new bail-in scheme was used for the first time this year to rescue four regional small banks. But the scheme had a significant adverse impact on Italy’s retail investors, which often have high exposure to senior and subordinated bonds issued by banks.
- The Italian government then introduced a State-backed scheme (GACS) to enable Italian banks to securitise NPLs under an agreement with Europe that does not count as State aid.
- A privately owned fund, Atlante, was also launched to help Italian banks to sell part of their stock of NPLs and to carry out capital increases.
Limitations of the proposed measures
- While some NPLs were sold, the true value of these assets in Italian banks’ portfolios remains unclear.
- On 29 July, the European Banking Authority will release the results of a new round of stress tests. While Italy’s banking system faces no systemic risk, some of its banks could still be in deficit, creating the need for a fresh round of recapitalisations.
- Under such a scenario, the Atlante fund has some limitations. The fund is financed by big private banks that are not available to pump unlimited amount of liquidity into this vehicle at the risk of a deterioration in their own solidity and credit rating.
- Greater involvement by Cassa Depositi e Prestiti, the only public shareholder of Atlante, could be considered as public aid, thereby breaking the bail-in rules.
Possible solutions and caveats
- Prime Minister Renzi is starting negotiations with Europe to reach a compromise on using public funds to refund Italian banks.
- Such an agreement could prove very positive for markets and for the Italian system, as well as avoiding a new source of turmoil in Europe. However, it could also create a political backlash, especially in those EU countries that are currently experiencing anti-Brussels sentiment.
- Conversely, failure to reach an agreement could create a crisis of confidence in the banking sector and heavy losses for investors. If this happens, the Italy’s constitutional referendum in October could bring down Renzi’s government, leading to political instability and a delay in the reform process that he has been committed to for so long.
Investment implications
- The European banking sector was one of the main sources of turbulence for European markets year to date.
- Italy is at the epicentre of the crisis, but current valuations for Italian banks are already very depressed, incorporating the risk of lower equity values or the need for further capital increases.
- The challenges of solving Italy’s problems could constitute a new political test for Europe, particularly in the wake of Brexit.
- An agreement between Italy and Europe on the use of public funds for recapitalisations could help avoid further market turmoil, but it could also feed more anti-Europe sentiment.
- If no agreement is reached, both Italy and Europe could face a new source of risk—and a fresh period of market volatility.
