The Italian Bail-In: the making of a banking crisis

Warren Buffet once said “You never know who’s swimming naked until the tide goes out”. The dry humour quip applies very well to the personal finances of Italians that have just realized they have been dipping naked. After all, the “financial literacy rate” in our country is one of the lowest in Europe: as a recent work by S&P stated, more than 63% of Italians don’t possess basic knowledge of finance and don’ t know how to properly understand its tools. It turns out that in many cases they are not totally conscious on the financial instruments they deal with and given that more than 40% of the bonds they have subscribed has been emitted by Banks, in the light of well-known recent developments, there has never been to feel easy. Plus, add together some suspected criminal conducts by the management of the financial institutions involved, inadequate supervision of surveillance authorities, a protracted recession and a sneaky inflation that is not showing up, and there you have it: a huge amount of debt that is going to never be paid. Sum up and one would have easily thought that the Italian banking system, with its stakeholders and clients, was destined to live tough times soon. Unfortunately, one would have been right. Within just the first 25 days of 2016, the FTSE Italia all shares bank Index, as reported in the graph below, lost 21,8%.

One of the primary causes of this volatility in the stock market is the uncertainty on the actual nature and amount of the assets of the banks, which causes the recent spread of sales. This takes relevance in a world where shareholders might be often asked to chip in for new increases of a bank’s capital (some others might follow Veneto Banca and Popolare di Vicenza) and where bondholders and depositors over €100.000 might face deep losses in the most serious cases. The most important leading figures of ECB, Italian government and ABI were forced to assure about the solidity of the banking system (just a few small banks are not), but concerns remain.

What are the worries about? The volume of non-performing loans (NPLs) in Italy is immense: they are thought to be €350 billion, more than 20% of GDP. The NPLs are unproductive assets for the bank. In other words, they are loans that are either in default or close to. This is a huge problem for the institute itself, affected by a loss in the assets in its portfolio, and for businesses, given that the banks are unable to extend new credit in an effort to shore up their balance sheets. The events regarding Cariferrara, Carichieti, Banca Etruria and Banca Marche, which deposits together count 1% of the total in Italy, showed dramatic additional and largely debated consequences also on junior bondholders that have been sacrificed to help saving the banks. For instance Banca Etruria owns 32% of NPLs (€2.88 billions) on the total of loans (€6.77 billions), truly not an enviable record. The urgency of the issue was also underlined by a selling off on the shares of Monte dei Paschi di Siena (MPS), Italy’s third biggest lender. In absolute values, the three biggest Italian banks Unicredit, Intesa Sanpaolo and MPS have collected more than a half of the total amount of NPLs, but they seems to be well covered by their capitalization and reserves. Mario Draghi few days ago mentioned a report examined by the European Banking Authority in 2014 that indicated that four Italian banks, including MPS, needed to strengthen their capital. Since then they all have raised capital to safe levels. UBI Banca has the lowest coverage rate right now.

So what are the true reasons behind the blasts of the four Banks, now put under Bank of Italy’s receivership? Beyond the high-priced acquisition of other local banks, event that characterized Banca Etruria above all, the deciding factor is precisely the amount of NPLs in their portfolios. How come so many? The causes are several: first of all, seven years of recession have killed the industrial production, especially the small businesses of the country. The austerity policies have probably not helped to inject more liquidity in the system, which instead has been drained away. Secondly, banks have had clear difficulties selecting credit-worthy businesses and have struggled supporting their development during time. Simultaneously, enquiries are being conducted over the mala gestio of the management responsible for the financial disarray of the four local banks. As it happened in the past, it might be possible that some criminal activities have been carried out, but only the judiciary will verify it though. On the other hand it’s not easy to get rid of these bad debts: banks are not willing to sell them because of the fear that these unpleasant circumstances characterising their balance sheets will be otherwise notified to the public. The management generally tends to be less transparent if the supervision on the solidity of the bank is weak. After all, given the great reliance of the real economy on the financial institutions in Italy, there has always been a great sense of trust among the public. The risk of a loss of the savings or of the returns on investments in bonds or shares has always been cancelled through rebalancing and incorporations. The banks have always been distinguished only through the interest rates they apply or by the geographic proximity. No perception of risk means no need of control to prevent risky events. Italians just realised that Banks might fail too.

Anyway, the government was already thinking to rationalise the banking system before any bankruptcy, requiring the big mutual banks (Popolari) to turn themselves into joint stock companies. Sorting out the bad loans, and in general the big amount of public and private debt that characterises the country, would have been easier with a little help from the inflation (in fact, since most debts is fixed in nominal terms, higher inflation erodes its real value) that, despite the several attempts made by the ECB through the QEs, struggles to show up, also because of low (sometimes negative) interest rates. Finally, a solution to avoid the bankruptcy of the four banks in Italy came up in December with the Decreto Salva Banche, that considered the creation of one bad bank, where the bad loans would flow into. The procedure is worth €3.6 billions, covered by the Fondo di Risoluzione, created with respect to European regulation and made up by all Italian banks contribution. The Italian government is not putting up any money directly, although the Cassa Depositi e Prestiti (CDP), a public development bank, is involved in case the fund is not sufficient. Regrettably, even though the operation saved the employees, the account holders and senior bondholders, it ruined thousands of savers, in particular 130.000 shareholders and 10.500 junior bondholders. This Bail-in reminds of few rare precedents. For instance the resolution of Cyprus Crisis in 2013, where the banks, in trouble because of Greek bonds, have been saved sacrificing depositors and bondholders, or the nationalisation of SNS Bank in Holland. From the 1st of January 2016, after the enactment of the EU Bank Recovery and Resolution Directive (BRRD), approved by Italian parliament, the involvement of depositors over €100.000 and any bondholder is expected. Despite the set up of a solidarity fund to reimburse the damaged bondholders, through unclear arbitral procedures, puzzlement remains on EU management of the banking crises.