Italy’s best solution: private interest with a side of public bailout

Headquarters of Monte dei Paschi di Siena, the oldest surviving bank in the world. Photo: Pablo Saludes Rodil (CC BY-NC 2.0)
Headquarters of Monte dei Paschi di Siena, the oldest surviving bank in the world. Photo: Pablo Saludes Rodil (CC BY-NC 2.0)
Headquarters of Monte dei Paschi di Siena (Italy), third biggest bank in Italy and the oldest surviving bank in the world. Photo: <a href="">Pablo Saludes Rodil</a> (CC BY-NC 2.0)
Headquarters of Monte dei Paschi di Siena (Italy), the oldest surviving bank in the world. Photo: Pablo Saludes Rodil (CC BY-NC 2.0)

If the United Kingdom’s vote to leave the European Union was the entree, let Italy’s spoiled banking system be the bitter dessert. Shares of Italian banks plummeted after the June 23 Brexit vote and have fallen 57% since this time last year.

At the center of Italy’s bank problem is a €360 billion collection of non-performing loans (NPLs), some 18% of total loans made by Italian banks. A proper removal of NPLs from their balance sheets would require Italian banks to incur major losses which are typically covered by capital that those banks do not have and cannot raise thanks in part to low interest rates and falling share prices. Estimates suggest that the entire Italian banking system is undercapitalized by €30 billion or more.

High NPL levels slow a bank’s willingness to lend as it is forced to keep more and more capital on hand to cover bad loans. As banks lend less and their bad loans pile up, investors become less willing to finance banks, which increases the banks’ cost of capital and further limits their ability to lend in what becomes a vicious negative feedback loop.

Adding to the problem in Italy is a centuries-old, community banking culture which makes recovering and/or writing off NPLs much more difficult – a loan is more than a loan when the banker knows the face behind it. Italian bankruptcy laws make recovering collateral in NPL recoveries arduous, a problem when two-thirds of all Italian loans are secured by some kind of guarantee or collateral. This, combined with poor incentives for banks to write-off NPLs, a prolonged drop in property prices, and a slow economy have contributed to Italy’s NPL problem. Similar stories were written in Spain and Portugal.

The deep hole banks have dug for themselves gets deeper with delay. Italian Prime Minister Matteo Renzi should push through a quick, short-run state recapitalization of the banking sector and focus on a longer-run restructuring of the country’s banking system. Given the severity of Italy’s situation, a bailout should come before a bail-in.

State funds are necessary because the private sector will not fund a recapitalization of the banking system alone (the troubled Banca Monte dei Paschi di Siena has been up for sale since 2014, with no buyer interest), though some private equity interest exists. For example, KKR, an American private equity firm, recently invested capital in Greek banks struggling with underperformance and exposure to NPLs and has expressed a continued interest in Italy. Atlante is an Italian private equity fund, funded largely by Italian banks, with an available €1.5 billion which can be used to recapitalize a portion of the struggling domestic banking sector.

More, the Italian government has recently proposed a kind of government guarantee on positions taken in securitized NPL markets. The guarantee, which covers senior notes of securitized NPLs removed from banks’ balance sheets, makes the securities more attractive and more valuable, calming investor concerns and lessening bank losses. The move is a significant step in establishing a securitization market specifically aimed at slimming Italy’s bloated NPL problem.

A traditional government bailout can cover remaining capital shortfalls. Article 107 of the Treaty on the Functioning of the European Union should justify Italy’s use of public funds if one considers the Brexit vote and the subsequent market disturbances “exceptional occurrences”. A combination of private and public funds may attract more private investors and raise all ships, calming uncertainty. Similar approaches have been successful in Portugal where NPL ratios are crushing banks’ balance sheets and profitability.

Longer run changes to the Italian banking sector should include the consolidation of non-core assets, particularly the excessive number of bank branches; the overhaul of inefficient legal procedures, particularly with respect to bankruptcy and collateral-recovery procedures; more stringent assessments of banks’ balance sheets and measures to encourage NPL write-offs and sales; and the potential refinancing of recoverable NPLs. The shorter and longer run tools Italy has at hand should be employed quickly to keep this (currently) manageable banking problem from spiraling out of control.

Yet, new EU regulations, which require a bank “bail-in” (bank bondholders and un-insured depositors take a direct hit in the process of resuscitating a failing bank, oftentimes through debt-to-equity swaps) before any kind of publically funded “bailout”, complicate things. A bail-in, considering the fact that some €185-€200 billion worth of bank bonds are held by retail investors in Italy, would only depress already low investor confidence, leading to more capital pressures on banks and possibly, in a worse-case scenario, triggering a bank run as depositors fear that their deposits would be among those hit first. Lending would slow along with growth. Many argue that the economic crisis in Cyprus in 2013 was made worse by a bail-in, and all kinds of complications arose when Portugal insisted on bailing in Novo Banco bondholders in 2015. A bail-in in Italy today would only make a bad situation worse, potentially sparking an Italian and even European recession, and to what end?

Others argue a bail-in is appropriate if retail bondholders are compensated for being mis-sold bank bonds. Assuming such an option is even legal in Italy, how and who would determine which bonds were in fact “mis-sold”, or which investors are “retail” investors? Applying unequal treatment to bond holders is recipe for disaster – and lawsuits – as it was in Portugal, where bailed-in Novo Banco bondholders have cried discrimination. Such measures would worsen uncertainty and set a bad precedent for the future.

Arguments against an Italian bailout are well taken: EU credibility as a law-abiding union would be threatened; it would set the stage for other countries to follow in Italy’s footsteps; it would acquit an irresponsible banking sector and instead hold taxpayers accountable. But in a period when economies are at stake and EU skepticism is high, this is hardly the time to be teaching Italy a lesson. Allowing an Italian bailout is the lesser of two evils. A bailout has its costs, but the costs of enforcing a bail-in are more destructive and far-reaching.

The EU has the option to either enforce nascent regulation on a crippled Italy or to be pragmatic in allowing an exception of a state bailout. Pragmatism, especially when so much is at stake, should come before punishment.