The imminent collapse of the Italian banking system has implications for the entire European Union. Should multiple Italian banks go under, they could drag their EU counterparts into a cascading "Lehman Moment." With so much shared risk, one failed bank could drag down others, who would drag down still more, until the whole EU financial sector lies in ruin.
The crisis has pitted the government of Italian Prime Minister Matteo Renzi against European Union financial regulators, who insist that Renzi abide by EU "bail-in" rules. This course of action would be political suicide for Renzi's government, already under assault by the rising popularity of the Euroskeptic 5 Star Movement political party.
Don't Blame It On The Brexit
Initially, the Italian government and bank officials tried to blame the impending meltdown of the country's financial sector on the market turmoil surrounding the Brexit vote, but Renzi later had to admit that the underlying problems have been festering for years. EU financial services commissioner Valdis Dombrovskis noted that the plunge in stock prices of Italian banks pre-dated the Brexit vote: "This is not a new development. It's something which is already happening since the beginning of the year."
While Brexit may not have been the cause of the Italian banking crisis, it has given the whole problem an extra turn of the screws. The EU-wide economic slowdown that has worsened since the Brexit vote has forced the European Central Bank to continue with negative interest rates.
Overwhelmed By Bad Loans
While all EU banks are struggling with a tepid economy and negative interest rates that crush already thin profits, Italian banks have a double share of misery. 17% of all loans held by Italian banks are bad. This is 10 times more than those of US banks. Bad loans held by US banks peaked at 5% at the height of the financial crisis, showing just how bad the Italian banking sector's problems are. This more than €360 billion ($401 billion) in bad debt is quadruple what it was in 2008, and is growing. It is also 25% of Italy's GDP. A commonly-used ratio of bad loans to capital reserves shows that the condition of major Italian banks are some of the worst in Europe.
Italian banks hold 1/3 of ALL bad loans in the EU. The banks have too much money tied up in bad loans to be able to lend, which means they can't make the profits they need to write off bad loans. It is no wonder that the Italian economy is in trouble. It also explains why the FTSE Italia All-Share banks index has plummeted by 55% since January.
Perhaps the worst off among major Italian banks is Banca Monte Dei Paschi Di Siena, whose stock has lost 45% of its value in ten days. This led financial regulators to ban short-selling the bank's stocks. MPS shares have lost 77% of their value this year. Already the recipient of two government bailouts, it still has over $55 billion in bad loans on the books, and is being pushed by the ECB to cut that by at least 20% by 2018.
A "Poisonous Cocktail"
The Daily Express quotes Michael Hewson, chief market analyst at CMC Markets UK, as saying "Now that Brexit is in rear view mirror it has shone a light in the significant problems in the European banking system. EU leaders are experiencing a “rabbit in the headlights” moment... You have a poisonous cocktail that has the potential to bring Europe’s banking system to its knees, and for now it would seem that policymakers have no idea as to what can be done to deal with it."
Old Folks In The Crosshairs
In Italy, Prime Minister Matteo Renzi is dealing with his own poisoned chalice. He plans to commit €40 billion in government funds to partially recapitalize some of the worse-off Italian banks, in defiance of EU rules. After being warned against the move by Merkel, Renzi said that he would not be “lectured by the school teacher".
Brian Jacobsen, chief portfolio strategist at Wells Fargo Funds, told CNBC "The bigger issue here [is] the fact that you have so many pensioners and depositors who have purchased some of the slightly higher-yielding securities issued by Italian banks, who by EU rules would effectively need to be wiped out before there could be a recapitalization."
Greek Crisis As Template
As Renzi threatens to trash the new EU bail in rules in order to save mom and pop investors, some experts have floated the idea of using the same mechanism used during last year's Greek financial crisis. Under this plan, the government would be allowed give money to failing banks in return for stocks, but the bank would have to sell assets and cut jobs. Bondholders of the bank would have their bonds turned into shares, which would reduce the bank's debts while giving the bondholders something in return.
Renzi is going to the mat against German Chancellor (and de facto EU ruler) Angela Merkel over the "bail in or bail out" question. Renzi knows that should he follow EU bail in rules, the country will erupt in violence. When he bailed-in four small failing lenders last year, mass protests followed. How much worse would bailing in the country's largest banks be?
Anti-EU sentiment has been growing in Italy. Perhaps the most visible sign of that is the rise of the Euroskeptic Five Star Movement. Five Star is now the most popular political party in Italy, riding the success of recently winning the mayor's race in Rome. Voices are already calling for an Italian referendum on leaving the EU -- "ItaLeave".
Renzi hopes to boost his flagging poll numbers by standing up to Merkel and the Brussels establishment to protect ordinary Italians against a bail in. Perhaps he should take a page from the platform of his political rivals, and pull Italy out of the common euro currency.
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