Italy's bank troubles challenge EU

Jason R. Vaillancourt, CFA, Global Macro Strategist

Jason R. Vaillancourt, CFA, Global Macro Strategist
Co-Head of Global Asset Allocation, 07/28/16

  • 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.

"To make matters worse, the equity prices of Italy’s banks fell by between 20% and 30% in the aftermath of the Brexit vote."

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.