The most imminent financial crisis facing the European Union is not Brexit, but the collapse of the Italian banking sector. With an aggregate $400 billion of bad loans on the books, Italian banks have no money left to lend, and the crash in their stock prices have cut off their ability to raise capital. If a resolution to the crisis acceptable to all parties is not found soon, it could push Italy out of the EU.
How Are Bad Loans Formed?
Economic downturns will always result in more loans going bad than usual This was especially prevalent during the pan-European recession caused by the global financial crisis. It's no different in Italy. However, the recession hit Italy harder than some other countries. leading to a large number of bankruptcies.
The long-running downturn in the Italian construction and real estate sectors have piled far more bad debt onto the balance sheets of Italian banks than those of other countries. Construction and real estate loans account for 40% of all commercial non-performing loans. The Financial Time reports that on average, two-thirds of Italian bank loans are secured by personal guarantees or real estate collateral. In smaller banks, the proportion can be as much as three-quarters.
An overly-complex and lengthy bankruptcy process that usually lasts for years, and many bad loans couldn't be written off even if the banks wanted to. Many Italian banks dug themselves a deeper hole by playing fast and loose in the loan department in the years before the 2008 financial crisis.
Now all those loans have come home to roost.
The Italian Job
New bank bailout rules became effective in the EU this January. Inspired by the Cyprus crisis and the massive use of taxpayer money to rescue banks from their own risky behavior, these rules establish a "bail-in" procedure for all of the EU. Under the rules, known as BRRD, at least 8% of a failed bank's liabilities that be written off or converted into common shares of stock in the bank before public funds can be used for a bailout. This presents a huge problem for Italian Prime Minister Matteo Renzi, which can be traced back to how bank bonds were promoted to consumers.
Subordinated bank bonds were marketed to Italians, especially the elderly, as sort of a €1000 euro high-yield savings instrument. As a result, €200 billion in bank debt was purchased by retail investors. An earlier bail-in of four regional Italian banks wiped out subordinated bond holders and resulted in the suicide of a pensioner and mass protests in the streets.
The last thing in the world that Renzi, already losing popularity to Euroskeptic political opponents, wants to do is appear on national television and tell hundreds of thousands of citizens that their "safe" investments were just wiped out.
He requested €40 billion in EU assistance to help Italian banks immediately after the Brexit vote, but was promptly shot down. Renzi is now floating a plan for the EU to declare "exceptional circumstances of systemic stress" due to economic turmoil caused by the Brexit vote, and declare a six-month window to allow governments to waive EU bail-in rules.
The Italian banking crisis is also causing trouble for German Chancellor Andrea Merkel. She is facing falling poll numbers and opposition from inside her own party over what they saw as "giving in to the Greeks" during their most recent bailout. Agreeing to set aside EU bailout law that has only been in effect for six months would likely cost her her political career (not that she's keen on the idea in the first place.) Consensus in Germany and elsewhere in the EU is that the Italians got into this mess by themselves by ignoring long-standing weakness in their banking sector, so they have no one to blame but themselves.
Dutch Finance Minister Jeroen Dijsselbloem, chairman of the Eurogroup committee of the finance ministers of member states feels much the same way. Declaring that Italian banks were not really facing an immediate crisis, he told reporters “At a certain point, you need to take the losses, take precautionary measures, that will cost money, and the bank, or banks, are going to have to do it.”
Any recovery for Italian banks presents a "chicken and egg" problem. Economic recovery is stalling out because banks' balance sheet problems. Conversely, the banks need the economy to recover so they can make enough money to write off bad loans. The IMF recently reported that rebuilding Italy's banks was an "urgent" problem. It also stated that the Italian bank crisis has contributed to what it calls "two lost decades," estimating that Italy would not recover economically to pre-crisis levels until the 2020s at the earliest.
On the Brink
All these factors boil down to this:
- If the Italian banking system collapses, it will drag the rest of the EU down with it. The resulting destruction of the economy of Italy and the EU will mean the end of Renzi's career.
- If Renzi follows EU rules and bails in the failing banks, at least partially, mass protests will bring down his government and the Euroskeptic Five Star Movement will likely take power. One of Five Star's promises is to leave the euro common currency while remaining in the EU. They maintain that returning to the lira will allow Italy greater control over its economy, but blowback may push Italy out of the EU.
- If Renzi ignores EU banking rules and uses taxpayer money to bail out the banks, he will face some sort of EU sanctions, as well as widespread protests, with the same results as #2
- If Merkel agrees to let Italy break the new rules, she will be driven out of office, and will have fatally weakened the power of EU law.
The question now becomes: How many governments will lose power due to the Italian banking crisis, and how many member nations will be left afterward?
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