Inside Italy's circle of NPL hell
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Inside Italy's circle of NPL hell

The bad-debt crisis killing some of Italy's biggest banks looks likely to get worse before it gets any better. That has frightening implications, not just for the country, but for the rest of Europe as well. In the following features, Louise Bowman and Dominic O'Neill investigate the options left to political and financial leaders from Rome to Frankfurt, and reveal the depth of the problems they face in Italy's bad-debt heartlands.



Illustration: Robert Venables



Italy NPL main-160x186

Inside Italy’s bad-debt heartlands


Italy: Too big to bail



Italy: ECB’s first merger brings more worry

Introduction: Europe haunted by Italy’s bank crisis

A private-sector solution to Italian banks’ bad-debt problems could be impossible to find. What would that mean for the European Union’s recently constructed pan-regional resolution regime?

By Louise Bowman

Italy stands at a crossroads: the direction it chooses to take will have a profound impact, not just on its own banks, but potentially the entire construct of European banking-sector resolution. Make the wrong choice and the spillover from a new Mediterranean banking crisis could make Greece’s problems of five years ago look almost irrelevant; and it could lead to a full-blown political, as well as financial, crisis in the EU.

“The market can easily allow the banking sector to go on for a couple of years but the problem is the 11% of performing loans that are sub-standard [‘incagli’ loans],” insists Gennaro Pucci, chief investment officer at PVE Capital in London. “The problems will keep mounting and mounting. Doing nothing to fix this is the worst possible solution. If they can find a way to kick the can down the road, they will.”

Could Italy simply bail out its banks and be damned? 

Some believe that the situation in Italy is so severe that this is the tipping point when pressure for state aid is such that EU rules could simply be ignored. 

“Look at the consequences of ignoring state-aid rules: in situations of emergency there is not much of a stick that the EU can deploy,” reckons Etay Katz, partner at Allen & Overy. “The sanctions are not strong. The alternative is a calamity: multiple resolution of multiple institutions and potentially a sovereign crisis.”

The extent of the problems facing Italy’s banks is examined in-depth in features in the following features (see right). ‘Inside Italy’s bad-debt heartlands’ goes to the cause of Italian banks’ problems, the companies they have lent to, and asks if the problems might be worse than public figures show; ‘Too big to bail’ looks at how mounting NPLs have led Italian banks into a capital crisis, one which the ECB may be exacerbating; and ‘ECB’s first merger brings more worry’ questions whether or not consolidation is the answer for the country’s banking sector.

Italy hell Merkel-300

Italy’s government, led by prime minister Matteo Renzi, faces two realistic paths: it can attempt to recapitalize its banking system in compliance with the Bank Recovery and Resolution Directive by securitizing its bad-debt mountain and raising capital through rights issues and/or bailing in investors. Alternatively, it can focus on finding a way round the rules that will allow funding to be funnelled into its banks while being acceptable to Brussels. A third, or nuclear, option is simply to ignore EU rules.

So far, it is going with option one. Aside from the already announced restructuring of Monte dei Paschi di Siena, this strategy will trigger the splitting of banks up and down the country into good and bad institutions, with the assets of the latter being hived off into securitization special purpose vehicles. 

As the senior notes issued by these bad bank SPVs will carry the guarantee of the Italian sovereign, they will be eligible collateral for the European Central Bank. This is where the structuring gymnastics of the scheme enter the realms of the surreal: under pressure from the ECB, the Italian banks securitize their NPLs, and the senior notes of those transactions could end up in the hands of… the ECB. 

“Investors buying the senior tranches of securitizations can repo the bonds with the ECB as they will carry the guarantee of the Italian government,” confirms Pucci. 

When Euromoney asks if this is effectively state aid, he does not hesitate: “Absolutely.”

This does not get around the problem of finding subordinated and junior investors, given the finite resources of the Atlante rescue fund, however. Many of the distressed debt buyers that have been focusing on NPL portfolios will now turn their attention to acquiring equity in the good banks instead. 

We are not in a bail-in scenario. The EU either has to relax its principles or go after innocent retail investors who bought these bonds bona fide - Michael Immordino, White & Case

The extent of losses at the bad banks raises the thorny issue of bail-in and what this means in Italy, where one third of bank bonds are in the hands of retail investors.

“We are not in a bail-in scenario,” insists Michael Immordino, partner at White & Case in London. While pointing out that the general principles of BRRD are right, he summarises a stark choice: “The EU either has to relax its principles or go after innocent retail investors who bought these bonds bona fide.” 

Bailing in institutional investors ahead of retail investors is an attractive solution for governments anxious to avoid a political backlash, and it is allowed under the EU’s BRRD. 

“BRRD gives scope to discriminate between investors in extreme circumstances,” Katz explains. “If there are very good reasons to create discrimination on a justified basis between institutional and retail investors, this is possible. It will not have affected the insolvency hierarchy.” 

However, in Italy’s case there are simply so many retail bondholders that bailing in the institutions first may not even be enough to cushion the blow. 

When subordinated investors in four small regional banks were bailed in last November, one pensioner committed suicide, so the consequences of doing this should not be underestimated. The Italian Banking Association (ABI) has argued strongly against the retroactive nature of bail-in, a risk retail investors were clearly not aware of when they originally bought the bonds because it didn’t exist. The ABI also maintains that the prospect of bailing in depositors is contrary to Article 47 of the Italian constitution, which protects savers. 

The real fear here is that of a bank run. “Imagine what would have happened in the UK with Northern Rock if the UK government was prevented from stepping in and had said they would bail in depositors,” exclaims Giovanni Sabatini, general manager of the ABI. “There would have been a systemic crisis.”

However, even if investors could successfully claim to have been mis-sold the bonds, the prospect of compensation will not be sufficient to mitigate the impact that any bail-in would have on confidence. 

There is a certain irony in the Italian authorities now claiming these bonds were mis-sold when there were strong incentives in place for the public to buy them. 

“All retail programmes were signed off by the Consob [Italy’s SEC], so it is difficult for them now to argue that investors were mis-sold,” muses Immordino. Any compensation that is on offer would also have to comply with BRRD so would only be effective for retail investors if there is sufficient capital beneath them to reach the 8% threshold. 

“You can compensate bailed-in retail investors,” confirms Katz. “You have to have exhausted the 8% of liabilities without involving retail investors. In principle this is possible, but you need the right conditions. And you need forbearance from the ECB to be able to do this.”


Everyone that Euromoney spoke to for this series of articles anticipates that some form of state aid will have to be fudged if Italy’s banking problems are ever to be fixed. A private-sector solution is simply not possible, given the magnitude of the problem. 

“The holy grail [of BRRD] is a non-public sector resolution where multiple institutions are failing,” says Katz. “Can this work? Personally I am not sure that the case for this has been convincingly made.”

Before the announcement of the MPS deal in July, speculation was rife that Italy would use a precautionary recapitalization to inject state support into its banks without breaching BRRD. Under Article 32 of BRRD “an injection of own funds…is permitted to remedy a serious disturbance in the economy of a member state”. If this is deemed to be the case then temporary public financial support that is justified to preserve financial stability generally will not trigger bail-in of senior lenders to the bank. 

Speculation that the precautionary route might be taken abated after the JPMorgan-led deal was announced, but there is little doubt that such an option will have to be reconsidered once more. “We may not have heard the last of the attempt to cross the line of EU state aid,” says Justin Sulger, head of credit at asset manager AnaCap, an active buyer of Italian NPLs. 

“There are provisions for precautionary recapitalization within BRRD, but they are extremely narrow as they operate without triggering resolution,” says Katz. “State aid mustn’t go to cover actual losses. Whilst there is a Greek precedent now, it appears very difficult to meet that requirement.” 

Everybody now recognises that you can’t build confidence in regulatory implementation when it is applied piecemeal - Tim Skeet, Icma

BRRD’s rocky first year has been a sobering reminder of the problems inherent in trying to apply post-crisis regulation to institutions still labouring under pre-crisis problems. 

“Everybody now recognises that you can’t build confidence in regulatory implementation when it is applied piecemeal,” says Tim Skeet, chairman of the bail-in committee at the International Capital Market Association (Icma). “NPLs are a legacy issue that is proving very difficult to deal with. The regulators are working hard to ensure that the application of the regulation is consistent. We have to show a measure of understanding. Whenever you set new rules there is a transitional phase. It is challenging. The conundrum is how you apply inflexible rules to legacy situations.”

Raoul Ruparel, co-director and head of economic research at think tank Open Europe, believes that the escalation of Italy’s NPL crisis will change the pace of regulatory implementation in Europe. 

“It is very important to clear up problems now when you look at what is coming down the line: plans for the single deposit scheme and expanding banking union,” he tells Euromoney. “The regulators have signalled that they have learned from this – progress on banking union will be slower and more piecemeal than people were expecting.” 

It seems incredible that it has taken a banking system as dysfunctional as Italy’s to bring the inconsistencies of applying BRRD across Europe to a head. But as Renzi continues desperately to keep all his banking plates spinning in the air, it can only be a matter of time before one of them falls with a crash. 

And then the battle over who gets to pick up the bill will get very messy. 

“This goes beyond the finances of Italy. We need to rebalance the rights of bank stakeholders across the board,” says Skeet. “The regulators are trying to micromanage a macro issue while ignoring that rights and obligations of stakeholders need to be reset. They urgently need to find a mechanism for recapitalization that everyone can agree on.”

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