Will Italy's Banking Crisis Go From Bad to Even Worse?

A logo of Monte dei Paschi di Siena bank
A logo of Monte dei Paschi di Siena bank is seen on the ground in Siena, Italy, November 5, 2014. The European Central Bank refused to give the Italian bank an extension to raise more money during the Italian banking crisis. Giampiero Sposito/REUTERS

This article was originally published on The Conversation. Read the original article.

In the wake of the Italian constitutional referendum, the country's banking crisis is going from bad to worse. The European Central Bank (ECB)'s decision to refuse an extension to Banca Monte dei Paschi di Siena to raise 5 billion euros has left the country's third-largest bank facing a government bailout that looks likely to inflict severe pain on many ordinary Italian savers.

As if that were not enough, Italy's biggest bank, UniCredit, announced a restructuring plan that requires a capital raising of 13 billion euros in the first three months of next year. Given the torrid time Monte dei Paschi has had trying to find sufficient private backing, will UniCredit need help from the Italian taxpayer, too?

The problems at Monte dei Pashci and UniCredit reflect the parlous state of the country's banking system. The economy has been struggling for a number of years and borrowers have been defaulting, creating a mountain of bad loans. Around 20 percent of bank loans are bad, amounting to a staggering 360 billion euros (about one-third of all bad loans in the eurozone).

More than 70 percent of these loans are to small and medium-sized businesses. Small firms in Italy tend to have numerous bank relationships, commonly with accounts at four or five banks. Hence their defaults have polluted bank balance sheets across the sector.

I hear critics saying the Bank of Italy, the regulator, was slow to deal with the problem, only intervening within the past 18 months. Individual banks also stand accused of being complicit in rolling over non-performing loans—disguising the true picture. The situation is worse for banks in the south, where economies have been faring even worse. And Matteo Renzi's defeat in the referendum exacerbates the whole problem by denying the sector reforms to help banks recover bad loans by speeding up insolvency processes, among other things.

The bail-in problem

The Bank of Italy restructured four small banks last year, but its ability to rapidly resolve problems at bigger banks is hindered by EU bank bailout and state aid rules. These say direct state aid cannot be provided until a bank has looked for private injections of capital, including making investors in a class of bank debts known as bail-in bonds take some pain by converting their bonds into shares.

The logic is that these unsecured bondholders should bear the same risks as shareholders, thus reducing the burden on the taxpayer in the event of a rescue. Investors have nonetheless been lured into these bail-in bonds, including those of Monte dei Paschi and UniCredit, by higher returns than other bank bonds, betting they would not end up being converted.

In most countries institutional investors including pension funds and insurance companies are the main investors in unsecured bank bonds. But in Italy there's an additional problem: households own about a third of the total—40,000 retail investors own Monte dei Paschi bonds, for instance.

When the four small Italian banks were restructured, the value of their bonds was wiped out. In addition to political condemnation, there were widespread protests and at least one suicide. Particularly when the country is going through such a politically volatile period, the government will be very wary of another bail-in as part of any Monte dei Paschi rescue. Depositors above around €90,000 are also supposed to lose out, though it is hard to see this being politically possible regardless of the rules.

What comes next

The ECB decided the request from Monte dei Paschi for a deadline extension for its recapitalization from year-end to January 20 was a delaying tactic. It said the bank had to sort things out faster—together with the new Italian government, headed by Renzi loyalist Paolo Gentiloni. This means the world's oldest bank, established in 1472, now has barely two weeks to find a private solution and avoid inflicting a bail-in on the country.

The recapitalization plan has three components. The first is a voluntary bond swap—similar to bail-in bonds, except bondholders choose whether to convert their bonds to shares or not. This has raised around 1 billion euros from institutional investors, but there has been no take-up from retail investors. They have viewed the exchange as too risky and have been concerned about whether the regulator has fully approved the retail swap transactions.

Second, Monte dei Paschi hopes to get €1 billion from Qatar's sovereign wealth fund. Finally, a consortium of banks has said it will try to sell the bank's shares in the open market. They will not be underwritten, however, so there is no guarantee of raising significant funds.

So even if the capital-raising is successful there is likely to be a shortfall of several billion euros. The question then is what happens next. The government will certainly not let this historic institution fail, despite a national debt in excess of 130 percent of GDPamong the highest in the world.

Failure to resolve the problems would compound financial market jitters surrounding Italian banks. That could lead to widespread failure and the export of similar problems, due to a collapse of confidence, to other fragile eurozone countries.

To unlock an injection of state funds the Bank of Italy would therefore need to decide whether to follow the EU rules and risk the wrath of the retail bondholders with a bail-in—and/or provide guarantees to cover their losses. Ironically, the ECB would then potentially have to provide guarantees, liquidity injections and capital support to maintain confidence in the Italian system.

Meanwhile, all eyes will be on the UniCredit capital-raising to see if it fares any better. It should do: UniCredit's proposed rights issue requires market credibility that Monte dei Paschi does not have at present. Were it to hit difficulties, however, this crisis will move from major to monumental. Either way, it looks likely to be some time before the problems in Italian banking even begin to look like being resolved.

Philip Molyneux, Professor of Banking and Finance, Bangor University