Italy is nearing its Lehman moment
Officials are urgently seeking a bailout solution as stress in the Italian banking system worsens by the day
The resilience of financial markets knows no bounds.
Barely three weeks after British voters decided to sever their country’s 43-year membership of the European Union (EU), sending shockwaves through global markets and prompting renewed fears about the fragmentation of Europe’s single currency area, investors are already regaining their appetite for risk.
On Wednesday, the pound, which has borne the brunt of fears about the consequences of a British exit from the EU, continued its recent rally after Theresa May replaced David Cameron as the UK’s premier earlier than expected, allaying some of the concerns about Britain’s political crisis.
US equity markets have bounced back, with the benchmark S&P 500 index now standing at a record high, buoyed by signs of positive earnings from US companies and more economic stimulus measures, notably in Japan following premier Shinzo Abe’s convincing victory in Sunday’s upper house elections.
Yet beneath the surface of improving sentiment, another, potentially more damaging, crisis is brewing in Italy.
Since the day of the UK referendum on June 23, the shares of Italian banks have fallen dramatically. The stock of Banca Monte dei Paschi di Siena (MPS), the world’s oldest bank and Italy’s most vulnerable lender, has dropped by a staggering 43 per cent, bringing its decline over the past year to more than 80 per cent. Even UniCredit, Italy’s largest bank by assets and the only one of systemic importance, has seen its share price fall more than 20 per cent since the Brexit vote.
Investor sentiment towards Italy’s banking sector has deteriorated to levels last seen at the height of the eurozone crisis at the end of 2011. A gauge of systemic stress published by the European Central Bank (ECB), known as the Composite Indicator of Systemic Stress, has shot up over the past two months and is currently at its highest level since Greece’s debt crisis in the spring of 2012.
The Brexit vote is exacerbating vulnerabilities in Italy’s banking sector which is burdened by a dangerously high share of non-performing loans (NPLs) amounting to some €360 billion - nearly one fifth of Italy’s GDP.
Italy is caught in a vicious circle in which a conspicuous lack of growth (the economy has barely grown since Italy joined the euro in 1999 and has only just emerged from a protracted recession), a woefully undercapitalised banking sector suffering from very poor asset quality and low profitability, one of the highest public debt burdens in the world and an increasingly unstable political scene are all feeding on each other.
Make no mistake, Italy’s weaknesses have the makings of the next crisis in Europe - and one which, if not properly contained, could make the Brexit vote look like a sideshow.
Not only is Italy the third largest economy in the eurozone, its government bond market is the world’s fourth largest amounting to some US$2.1 trillion, according to Bloomberg.
On Monday, the International Monetary Fund (IMF) warned of the dangers posed by Italy’s creaking banking sector, which holds a large amount of the country’s public debt. “If downside risks were to materialise, regional and global spillovers could be significant given Italy’s systemic weight.”
The problem is that Italian and European policymakers differ as to how to shore up Italy’s banks.
New EU rules on rescuing troubled banks, adopted at the behest of Germany which strongly objects to taxpayer-funded bailouts, severely limit the ability of governments to use public money to recapitalise lenders without firstly ensuring that private investors foot some of the bill, or are “bailed in”. Yet in Italy some of these investors are mom-and-pop retail investors who own a large chunk of Italian bank bonds. Two retail investors who lost their savings in a bank rescue last year committed suicide in a sign of how politically fraught Italy’s banking problems have become.
A solution needs to be found urgently. On July 29, the results of stress tests on European banks will be published. Italy is expected to perform poorly, increasing the scope for an even sharper sell-off in bank shares.
The IMF believes a compromise agreement can be reached in which Italian banks are recapitalised without breaching EU bail-in rules.
The big question, however, is whether any deal will allay market concerns about Italy’s banks and, crucially, act as a catalyst for reducing the stock of NPLs and boosting much-needed lending.
Fears about Brexit may have ebbed for the time being but concerns about Italy are intensifying by the day.
Nicholas Spiro is a partner with Lauressa Advisory