Italy: Too big to bail

Louise Bowman
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Every proposed scheme for sorting out Italy’s bad debt problems has its own shortcomings. And that’s before taking into account the fact that those problems could get worse. Pressure from the ECB is fanning the flames of the crisis. Fixing legacy problems could now require dramatic action.


Some problems are simply too big to ignore, no matter how hard you try. The Italian banks have tried very hard to ignore their non-performing loan problems for a very long time. Their €360 billion of bad debt is equivalent to one fifth of the country’s GDP, so it is hard to believe that turning a blind eye is going to work for much longer.

The European Central Bank certainly doesn’t seem to think so, and when it decided to write to the worst culprit of them all – Monte dei Paschi di Siena (MPS) – in July to demand that something be done, it lit a fire under a festering problem that is now large enough to undo the years of painstaking work that has gone into establishing a harmonised regime for bank resolution across Europe, the Bank Recovery and Resolution Directive (BRRD).

This is because their mountain of bad debts is preventing many banks from rebuilding their capital to levels that will satisfy their EU overlords. In a recent research paper entitled 'Capital shortfalls of European banks since the start of banking union’, academics Viral Acharya, Diane Pierret and Sascha Steffen calculate that Italian banks have a combined capital shortfall of €97 billion in a stressed scenario, which corresponds to about 6% of GDP. 

"The market is nervous about Italian banks, and rightly so," says Gennaro Pucci, chief investment officer at PVE Capital in London, which bought €565 million worth of Italian NPLs between 2014 and 2016. "There are such a large number of losses in the system. When the numbers are this significant, you can’t just hope that it will go away." 

The number of total gross NPLs in Italy has increased by 160% since 2009; bad loans now represent 18% of all outstanding loans in the system, according to Citi. In 2009, just 8% of outstanding loans were bad. 'Sofferenze’ loans, the worst performing category of NPLs, account for 60% of the total.

Its NPLs have made Italy the conduit for the market’s nervousness about European banks: UniCredit’s share price has tumbled from €6.45 in April 2015 to €2.40 today, while MPS has been all but wiped out – falling from €9.45 to €0.24 over the same period. This is despite the fact that the Italian banks’ capital levels are not actually the worst in the region. According to Acharya, Pierret and Steffen’s research, capital shortfalls as a percentage of GDP in the banking sectors of Germany, Spain and the UK are all worse than those for Italy. 

Despite this, it is Italy that has been the focus of attention. "Italy is a wealthy country and was not as overdeveloped as Spain or Ireland. There is also a high savings rate. These positives may have allowed for a certain amount of complacency," says Raoul Ruparel, co-director and head of economic research at think tank Open Europe. 

Plans to establish a bad bank before the implementation of BRRD on January 1 proved fruitless, so the system needs to be fixed within the new stricter regulations. "If Italy had set up a bad bank at the same time as Spain or Ireland, they would have had to take bailout with conditions, and there weren’t many European leaders pushing for Italy to take a bailout at the time," Ruparel recalls. "It is easy to criticise now."

Gennaro Pucci, founder of PVE Capital
Gennaro Pucci, chief investment officer at PVE Capital

Pucci believes that the intense focus on the €200 billion of sofferenze loans is masking looming problems elsewhere in the system as well. Loans that are currently performing but are classed as unlikely to pay, known as 'incagli’ loans, also present a dangerous threat to stability. According to Citi, in the third quarter of 2015 gross sofferenze accounted for 11% of banks’ loans.

Pucci says that they hold the same amount again as incagli loans that are likely to go bad. 

"The market is focusing on €40 billion of losses in the system, but if you include incagli, or loans that are unlikely to be repaid, the figure increases to around €100 billion," he says. "When incagli are taken into account, the Texas ratio [a measure of bad loans as a proportion of capital reserves] of all small and medium-sized banks in Italy is over 100, and the large banks are dangerously close to 100."

A Texas ratio of more than 100% indicates that action on capital is urgently needed. MPS has a Texas ratio of 145%. Intesa Sanpaolo has a ratio of 85%, UniCredit 95%, Banco Popolare 135% and UBI Banca 110%. The risk is, therefore, that the market is woefully underestimating how many incagli loans will become sofferenze loans. 

Urgent fix

The system urgently needs to be fixed before this happens. After lengthy negotiations, the Italian government revealed its €120 billion guarantee plan for securitized NPLs in February this year (Guaranzia sulla Cartolarizzazione delle Sofferenze, or GACS). The scheme was launched on April 15 and will run for 18 months, enabling banks to purchase a government guarantee for the senior notes of NPL securitizations, which will facilitate their sale to private investors. 

The scheme does not count as state aid because the banks pay the market price for the guarantee, which is calculated using a basket of single name CDS on Italian issuers based on the underlying rating of the debt instruments. The price is determined using the mid-price of the basket over the previous six months. Given how wildly Italian bank CDS have moved in recent months, predicting the price could be a tricky business. Nevertheless, the fact that the bank has to pay a market-based price for the guarantee is key to getting around EU rules.