- Brexit is just one of many challenges facing the EU
- Italy’s banking system is troubled by bad loans that also present liquidity risks that complicate the problem
- The European Banking Authority may have to bend yet again to contain the fallout for the financial system
Just as a new British government sets a course toward exiting the European Union, other challenges to the EU's structural and political integrity are heating up.
The topic of most immediate concern revolves around the potential that Italy’s troubled banks may need a bailout. Non-performing loans (NPLs) currently account for at least 18% of the total loan book at more than 360 billion euros. Putnam research estimates that the market clearing price to offload these bad loans is below 20 cents on the dollar, but they are being carried on balance sheets at a much higher valuation — approximately 50 cents on the dollar. Unlike the troubled loans held by Spanish and Irish banks, which were backed primarily by real estate, Italy’s loan books tend to be dominated by the assets of small and midsize businesses whose holdings and collateral are more difficult to value and less likely to find a buyer.
To make matters worse, the equity prices of Italy’s banks fell by between 20% and 30% in the aftermath of the Brexit vote, hitting the Core Tier 1 Capital Ratios, which makes it much more difficult for the banks to raise fresh external capital. In the beginning of this year, the European Commission’s BRRD (Bank Recovery and Resolution Directive) took full effect. The BRRD now requires any bank rescue to involve a hit to the bank’s creditors (including depositors) to help mitigate the cost to taxpayers. The fear, of course, is that when a particular bank is suspected of being in jeopardy, it could precipitate a run on the bank.
In the best outcome, the European Banking Authority this week will determine that some of the largest banks in Italy fail their stress tests. This determination would trigger a loophole in the BRRD, called Article 32, that allows state aid for banks at risk of failure. This would surely, once again, call into question the issue of just how cohesive the EU really is, if the one single crowning achievement to quasi-federalization — common banking system oversight — is unraveled for yet another “one-off” exception to the rules.
302295
For informational purposes only. Not an investment recommendation.
This material is provided for limited purposes. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Putnam product or strategy. References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice. The opinions expressed in this article represent the current, good-faith views of the author(s) at the time of publication. The views are provided for informational purposes only and are subject to change. This material does not take into account any investor’s particular investment objectives, strategies, tax status, or investment horizon. Investors should consult a financial advisor for advice suited to their individual financial needs. Putnam Investments cannot guarantee the accuracy or completeness of any statements or data contained in the article. Predictions, opinions, and other information contained in this article are subject to change. Any forward-looking statements speak only as of the date they are made, and Putnam assumes no duty to update them. Forward-looking statements are subject to numerous assumptions, risks, and uncertainties. Actual results could differ materially from those anticipated. Past performance is not a guarantee of future results. As with any investment, there is a potential for profit as well as the possibility of loss.
Diversification does not guarantee a profit or ensure against loss. It is possible to lose money in a diversified portfolio.
Consider these risks before investing: International investing involves certain risks, such as currency fluctuations, economic instability, and political developments. Investments in small and/or midsize companies increase the risk of greater price fluctuations. Bond investments are subject to interest-rate risk, which means the prices of the fund’s bond investments are likely to fall if interest rates rise. Bond investments also are subject to credit risk, which is the risk that the issuer of the bond may default on payment of interest or principal. Interest-rate risk is generally greater for longer-term bonds, and credit risk is generally greater for below-investment-grade bonds, which may be considered speculative. Unlike bonds, funds that invest in bonds have ongoing fees and expenses. Lower-rated bonds may offer higher yields in return for more risk. Funds that invest in government securities are not guaranteed. Mortgage-backed securities are subject to prepayment risk. Commodities involve the risks of changes in market, political, regulatory, and natural conditions. You can lose money by investing in a mutual fund.
Putnam Retail Management.