European Affairs

Spellman 1Italy’s overwhelming vote on Sunday (December 5) against an over-confident PM Matteo Renzi, left bankers scrambling to shore up the country’s third-largest lender and prevent other Italian banks from collapsing under both the staggering burden of unpaid debt (an estimated $393.47 billion, or €365 billion) and a weak, intransigent economy.  By Monday’s close in Europe’s markets, Italy’s bank stocks had fallen overall by two percent,[1]  a decline that was probably offset by widespread expectation of the “no” vote.

CHART:  Performance of Italian Bank Stocks, December 5, 2016 

Italian Banks1

Source:  Borsa Italiana.

After a bitter, months-long campaign, Italians rejected by 59.1 percent of the vote a referendum to overhaul the country’s political structure through constitutional reforms.  Under this proposal to rewrite 47 of the 68-year-old constitution’s 139 articles, the upper house Senate would have been cut from 315 seats to 95 and its powers reduced to largely a consultative role.  The lower house, the Chamber of Deputies (Camera dei deputati), would have had the authority to approve many bills without a Senate vote, the most contentious change.  The provinces – government units below regions – would have been abolished and their powers transferred to the regions and the central government in Rome. Streamlining government was another thrust, from ending a national council on the economy and labor to simplifying the election of judges for Italy’s highest court.  

 Italian Banks2
Source:  Ministry of the Interior, the Government of Italy. .  For the text of the referendum (in Italian), go to:

Political observers generally saw the poll results as a “no confidence” vote against Renzi, the self-styled “demolition man”, and mainstream politics.  Some feared the constitution’s balance of power would be overtaken by a more powerful prime minister.  But, above all, many questioned why Renzi expended his shrinking political capital on parochial issues and a thinly-veiled effort to bolster his office’s power — and giving all the opposing parties reason to coalesce and rally to defeat the referendum by exploiting “euro-scepticism” and anti-establishment populism.  (One Italian legislator called it a "completely unnecessary" mistake.)  This, especially when the once enormously popular Renzi was increasingly under fire for initiatives that failed to end what Italians see as an interminable economic malaise.[2]   Italian economic growth has barely improved over the past three years and remains one of Europe’s slowest to recover.
CHART:  Stagnation Continues after Global Financial Crisis in 2008
Italian Banks3
Source:  Edward Robinson, “Italian Banks Reel But Monti Has No Regrets for Avoiding Bailout.”  Bloomberg, August 9, 2016.
“The ‘no’ won is an incredibly clear way,” said the 41-year-old Prime Minister Matteo Renzi.  “I assume all the responsibility of the defeat…. I will greet my successor with a smile and a hug, whoever it might be."  He subsequently tendered his resignation to President Sergio Mattarella, who is expected to name a prime minister-designate as caretaker until national elections are held likely next year.[3]   Renzi and Mattarella agreed to postpone Renzi’s departure until the country’s budget is approved.[4]  
 Italian Banks4
For a country that apparently gave English the word “bank” from “banca,” the bench on which traders sat and made deals, the demise of the world’s oldest lender (founded in 1474), Banca Monte dei Paschi di Siena (MPS), seems unreal.  The Tuscan bank’s immediate fate rests on a $5.33-billion (€5 billion) recapitalization plan, which is now more difficult to secure by year-end after Sunday’s referendum vote.  
Meetings with a consortium of bankers and, separately, the Qatar Investment Authority are underway to secure capital by Friday, according to news reports.[5]   These talks center around a three-stage plan involving:  1) a voluntary bondholder debt-for-equity swap ($1.61 billion or €1.5 billion); 2) $1.08 billion (€1 billion) from Qatar’s sovereign wealth fund; and 3) an offering of new shares ($2.69 billion or €2.5 billion).[6]   The Financial Times reported, "People briefed on the situation said the political upheaval made it 'more difficult' to secure a €1 billion [$1.08 billion] investment from Qatar on which MPS's €5 billion capital-raising plan hinges.[7]”   Some observers see a state bailout, with one option being nationalization, as the inevitable rescue to be announced next week at the latest to avoid a politically unpopular forced “bail in,” in which MPS retail shareholders, bondholders and depositors would lose roughly $2.15 billion (€2 billion).[8]   Whatever the solution, there is general agreement that insolvency must be avoided to prevent a “contagion” effect on weak banks in Italy and throughout Europe.
CHART:  MPS Shares Fell Sharply since Year’s Start 
 Italian Banks5
 Source:  Wall Street Journal Data Market Group, December 5, 2016.
The bank’s situation is an extreme of the problems other Italian banks confront.  MPS is burdened with “non-performing loans,” which are estimated at $49.51 billion (€46 billion).  That debt resulted in MPS being ranked as the weakest of the 51 European institutions subjected to the annual assessment in stress tests by the European Banking Authority in July.[9]  

Other banks in Italy are worrisome, too, particularly the small ones, facing “significant asset quality challenges” and “low profitability,” as the IMF explained.  Non-performing loans account for about 18 percent of total loans.  While that level has stabilized, banks are pressed to build up adequate capital buffers to survive heavy losses in bad debts and improve earnings so they can expand credit to businesses.  Profitability is low compared to other EU banks, with the return on equity averaging 3.1 percent.  The number of bank branches per capita is the highest in Europe.
CHART:  European Bank Stocks Outpace Italians’ Performance   

Italian Banks6
Source:  James Mackintosh, “No Roman Holiday for Investors in Italy.”  Wall Street Journal, December 5, 2016.
CHART: Non-Performing Loans Rise Sharply
Italian Banks7
Source:  European Central Bank cited in:  Economist, “The Italian job.”  July 9, 2016. 
CHART:  Italian Bank Branches Highest Per Capita in Europe

Italian Banks8
Source:   IMF, Italy:  Selected Issues.  July 11, 2016. .  Also:  Andreas Jobst and Anke Weber, “Profitability and Balance Sheet Repair of Italian Banks.”  IMF, August 19, 2016. .   

Sustainable and strong growth is central to rebuilding Italian banks capital buffers and increasing profits, according to the International Monetary Fund.  “A bottom-up analysis of the 15 largest Italian banks suggests that restoring sustainable profitability depends heavily on the growth outlook. Many banks are expected to become more profitable as the economy recovers, but their capacity to lend depends on the size of their capital buffers. However, a number of smaller banks face substantial profitability pressures, highlighting the need to reduce the large stock of nonperforming loans and for further cost cutting and efficiency gains.[10]” 

Neither economic growth nor capital infusions are the total solutions.  Reforms are needed to break the pernicious downward cycle of bad loans.  This means overhauling the regulations governing insolvency, the judicial processes for handling litigation arising out of these loans, and the tax laws that accelerate write-offs.  Carrying the loans on the banks’ boards – perpetuated through a process of “evergreening,” in which the loans are rolled over in the hope they’ll eventually be repaid – must also be addressed.  All are highly unlikely for political and economic reasons at this hiatus for Rome.

Decisions reached over the next two weeks will be key to the outlook for Italy’s banks.  By Friday, a rescue is needed for MPS.  The day before, ECB President Mario Draghi may announce measures targeted at Italian banks.  Over the next few weeks, Unicredit, Italy’s largest, plans to seek more capital. Its success will be shaped by the MPS deal.  Indications may emerge soon over the new appointee to be Prime Minister and when national elections will be called next year.  Macro-economic trends will provide greater evidence of a Europe-wide recovery, fueled by the low euro and the U.S. economy’s strength as gauged by the recent jobs report (showing unemployment at its lowest level since 2007). 
James Spellman is an independent economic consultant with Strategic Communications LLC
  “Italian banks' shares fall after vote.”  BBC, December 5, 2016.
   IMF, IMF, Italy:  Selected Issues.  July 11, 2016. 
“The Italian economy is recovering gradually from a deep and protracted recession. Buoyed by exceptionally accommodative monetary policy, favorable commodity prices, supportive fiscal policy, and improved confidence on the back of the authorities’ wide-ranging reform efforts, the economy grew by 0.8 percent in 2015 and continued to expand in the first quarter of 2016. Labor market conditions have been improving gradually, and nonperforming loans (NPLs) appear to be stabilizing at around 18 percent of total loans. Nonetheless, the structural challenges remain significant. Productivity and investment growth are low; the unemployment rate remains above 11 percent, with considerably higher levels in some regions and among the youth; bank balance sheets are strained by very high NPLs and lengthy judicial processes; and public debt has edged up to close to 133 percent of GDP, a level that limits the fiscal space to respond to shocks.

“Against this backdrop, the recovery is likely to be prolonged and subject to risks. Growth is projected to remain just under 1 percent this year and about 1 percent in 2017. Risks are tilted to the downside, including from financial market volatility, the refugee surge, and headwinds from the slowdown in global trade. This growth path would imply a return to pre-crisis (2007) output levels only by the mid-2020s and a widening of Italy’s income gap with the faster growing euro area average. It also implies a protracted period of balance sheet repair, and thus of vulnerability.” 

  According to press reports, Renzi and Mattarella agreed to delay Renzi’s 

  James Masters, “Italy: Renzi's resignation delayed after meeting with President.” CNN, December 5, 2016.
  Jill Treanor, “Monte dei Paschi shares fall after Italian referendum result.  The Guardian (U.K.), December 5, 2016. .  Also:  Giovanni Legorano and Deborah Ball, “Italy Vote Increases Pressure on Banks.”  Wall Street Journal, December 5, 2016.  

   Ben Marlow and Szu Ping Chan, “Italy in race to seal €5bn bank bail-out.” Daily Telegraph, December 3, 2016.
  Rachel Sanderson and Martin Arnold, ‘Monte dei Paschi readied for state bailout after Renzi defeat.” Financial Times, December 5, 2016.   

  Jack Ewing, “Markets Weather Italy Referendum Result, but Banks Are Vulnerable.”  New York Times, December 5, 2016.

  European Banking Authority.  2016 EU-wide stress test results.  July 29, 2016. . 
 Italian Banks9
  IMF, Italy:  Selected Issues.  July 11, 2016.  Also:  Andreas Jobst and Anke Weber, “Profitability and Balance Sheet Repair of Italian Banks.”  IMF, August 19, 2016. .   “A bottom-up analysis of the 15 largest Italian banks suggests that the system is on the whole profitable, but that there is significant heterogeneity across banks. Many banks should become more profitable as the economy recovers, but their capacity to lend depends on the size of their capital buffers. However, a number of smaller banks face profitability pressures, even under favorable assumptions. There is thus a need to push ahead decisively on cleaning up balance sheets, including through cost cutting and efficiency gains.”