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The problems of the Italian banking system have been public knowledge for quite some time, but since Brexit it seems that these problems have worsened with Italian banks having suffered a dramatic decline in their value on the stock market and the oldest bank in the world and Italy’s third-largest lender, the Banca Monte dei Paschi di Siena, facing serious troubles. As The Economist put it, "another, potentially more dangerous, financial menace looms on the other side of the Channel—as Italy’s wobbly lenders teeter on the brink of a banking crisis". This is a concern shared by other economic newspapers, such as the Financial Times or the Wall Street Journal , and world leading media.

The crisis began to emerge last fall with the bankruptcy of four small regional banks. With the partial implementation of the EU’s Bank Recovery and Resolution Directive or BRRD (commonly known as "bail-in"), shareholders and investors have incurred significant losses. Among these investors are many small savers, without specific knowledge in this type of financial instruments, who have repeatedly protested against these measures -one of them driven to suicide.

The BRRD allows the rescue of banking institutions provided that shareholders, investors and in extreme cases depositors pay their share of costs through a "bail-in" mechanism. In principle all deposits up to 100.000 euros are guaranteed, but it all depends on the severity of the situation. The Italian case is a bit more complicated. It is estimated that 200 billion euros in bonds issued by Italian banks are in the hands of small savers or retail investors -and not in the hands of major international banking institutions or private funds- since bonds have been perceived as both savings and investment products.

Furthermore, changes in the global economy are starting to affect Italian banks more than their competitors. It happened earlier this year with the problems of the Chinese economy and again after the British referendum. The Italian government, the Bank of Italy and the Italian Banking Association are in favour of suspending the operation of BRRD and using public funds to save the banks, but the EU -and especially Germany- is opposed to such a possibility.

The problems in the Italian banking system are hardly new and partly of Italian origin: antiquated leadership, collusion with politics, too many branches and employees for their size, too small and inefficient banks. But perhaps the most important and long-term problem is that the Italian financial institutions are carrying too many NPLs (Non-Performing Loans) affecting their balance sheets and lending ability.

These toxic loans are largely the product of the recent economic crisis that has resulted in a dramatic decline in the Italian GDP and GDP per capita, thus making debtors unable to manage their debt repayments. They are also the result of bad management on behalf of the banks: many loans that were granted to friends, family, political allies etc. would have never been approved by a strict and sound financial management. In addition, a substantial part of these toxic loans is in the hands of a relatively small number of debtors. It is estimated that about 18% (about 360 billion euros) of loans issued by Italian banks is highly unlikely to be repaid.

This significant amount of NPLs blocks the banks’ ability to issue new loans, which in turn causes serious negative consequences for economic activity. There are reasonable fears concerning the financial sturdiness of the weakest and most exposed of these problematic banks.

In trying to fix the problem, especially considering that the creation of Atlante, a multibillion-euro fund tasked to offload bad loans, has proven unable to restore confidence in the Italian banking system, there seem to be two solutions: either to increase the banks’ capital or to decrease the amount of NPLs.

The Italian government (along with the Italian Banking Association, the Italian Business Association “Confindustria” and the Bank of Italy) would like to combine the two solutions using public money -even more so considering that it has already been done in the case of the German banks at the beginning of the crisis or the case of the Irish and Spanish banks later on-. The question is how to proceed, given that Italy has adopted the BRRD in 2013.

Even if the Italian government was to convince the Germans not to strictly implement the fore-mentioned directive, not all problems would be eliminated. How to calculate the capital the banks need? That is to say, how to calculate the value of toxic loans that will not be repayed? Some estimate it at 40 billion euros. Also where will the resources for the recapitalization of troubled banks come from?

Thus far the European Commission has allowed Italy to supply as much as 150 billion euros in government liquidity guarantees to cope with its struggling banks’ liquidity needs until the end of the year.

However, as noted by Professor Alberto Bagnai, we are facing a systemic problem. The European Banking Authority (EBA) pointed out, since mid-2015, that the Banking Union meant a double incentive to place subordinated securities to non-professional investors. On the one hand, these securities can be used for the "bail-in" and therefore enter the capital requirements of banks as established in the BRRD. That is to say, banks can raise capital by turning for resources to their clients, who should be warned that their money can be used to rescue banks -that not often being the case-. Moreover, ECB’s policy of "Quantitative Easing" (QE) has prompted savers to the acquisition of more remunerative securities such as these, assuming -wrongly- that they would be safe since no-one informed them of the risks and because for many years savers had not lost money investing in institutions as closely monitored and supervised as banks.

But low interest rates, boosted by the euro (theoretically to relaunch the European economy, but in fact as a means to keep the euro zone united), have encouraged entrepreneurs to borrow too much and have led savers to excessive risk taking (as indicated by the EBA). Therefore, there has been a systemic risk, also pointed by the EBA, of which non-professional savers and investors have not been properly informed.

In short, the European Banking Union has been unable to guarantee that Italy can overcome the financial crisis in which it seems to sink. Italy provides us with yet another example of a major problem in the euro zone: the conflict between the Brussels-imposed rules and the national policies’ actual needs and demands. It is basically a problem of national sovereignty and therefore of democracy.

At the same time, it is the manifestation of a conflict between creditors (Germany) and debtors (Italy). Here we must take into account the political circumstances in both countries: Matteo Renzi faces a major challenge with the Italian referendum on constitutional reform this fall and Angela Merkel must face a federal election next year. In this context, it remains to be seen whether the German intransigence in the matter of using public funds continues or they come to some kind of agreement in order to overcome the serious situation of the Italian financial system.