Brexit Done, The Italian Job Awaits?

The WSJ highlights the bad debt problem in Italy as being potentially more dangerous than even Brexit in the immediate future. Brexit, with its attendant uncertainties about the trajectory of interest rates, appears to have exacerbated the problem,

In Italy, 17% of banks’ loans are sour. That is nearly 10 times the level in the U.S., where, even at the worst of the 2008-09 financial crisis, it was only 5%. Among publicly traded banks in the eurozone, Italian lenders account for nearly half of total bad loans.

This comes even as banks across Europe have been battered by post-Brexit fears that interest rates will remain lower for the foreseeable future,

Europe’s banks were already retrenching before the U.K. vote, and markets appear fearful many don’t have thick enough capital buffers. Even before the vote, shares were valued at levels that signaled distress. Since June 23, an index of European banks has dropped 17%, bringing total losses from the beginning of the year to 30%.

The problems of Italian banks have strong echoes with the situation in India, both in terms of the institutional environments and scale of the problem,

The profitability of Italian banks has long been among the worst in Europe, weighed down by bloated staffs and too many branches, leaving the banks with little extra capital to cover loans that go bad. Today’s low interest rates have hit Italian banks especially hard because of their heavy focus on plain-vanilla lending activities, with relatively little in fee-generating activities such as asset management and investment banking. When the financial crisis of late 2008 hit, Italian banks tended to roll over loans whose borrowers weren’t repaying on time, hoping an economic upswing would take care of the problem, say Italian bank executives... The result is that impaired loans at Italian banks now exceed €360 billion—quadruple the 2008 level—and they continue to rise. Banks’ attempts to unload some of the bad loans have largely flopped, with the banks and potential investors far apart on valuations. 

Banks have written down nonperforming loans to about 44% of their face value, but investors believe the true value is closer to 20% or 25%—implying an additional €40 billion in write-downs. One reason for the low valuations is the enormous difficulty in unwinding a bad loan in Italy. Italy’s sclerotic courts take eight years, on average, to clear insolvency procedures. A quarter of cases take 12 years. Moreover, in many cases, the loan collateral is the family home of the owner of the business, or it is tied up in the business itself. “There is a desperate need to make collateral liquid,” said Andrea Mignanelli, chief executive of Cerved Credit Management Group. “Right now, it gets stuck in auctions and judicial procedures that make cashing the loan very hard.”

While the Italians appear to have done more than India, it has hardly had an impact,

The Italian government has put forth a series of solutions since last fall, but with little success so far. The proposals include incentives to encourage the creation of a nonperforming-loan market, shorter bankruptcy procedures and new rules to push Italy’s 400-odd cooperative banks to merge.

Fortunately, India does not have the problem of complying with a harmonized cross-national banking regulations like the Italians have to, which compounds the problems and raises political hackles,

The Italian government has sought EU permission to inject €40 billion into its banks to stabilize the system. To do so would require bending an anti-bailout rule the bloc adopted in 2014 to force troubled banks’ stakeholders—shareholders, bondholders and some of their depositors as well—to pay a financial price before the country’s taxpayers must... Rome has criticized the EU’s new banking regime and doesn’t want to use “bail-in” rules that prescribe the order in which stakeholders must bear losses for winding down an ailing bank, in part because of the peculiarities of the Italian banking system. About €187 billion of bank bonds are in the hands of retail investors, whose holdings would be wiped out by a bank resolution under the new rules. Last year, more than 100,000 investors in four small Italian banks that were wound up saw their investments wiped out. Some lost their life savings. The controversy exploded in December after Italian news media reported that a retiree committed suicide after losing €110,000 in savings invested in one of the banks. Such problems carry little truck in Brussels.

The political implications of going ahead with the "bail-in" regulations may be catastrophic. The pain and suffering on depositors and retail investors would immediately resonate across the political spectrum, lending further credence and support for Beppe Grillo and the Five Star Movement's anti-EU rhetoric. A Quitaly coming on the steps of a Brexit can tip the balance towards gradual fragmentation of the Union. 

The more prudent way out would be to let the Italian government capitalize the banks, if need be by taking stakes, with strict conditions about structural reforms to the banking sector, including on diversification of their income sources. This would require relaxation of the extant EU regulations. 

This highlights the folly of globally harmonized regulations and the mindless intransigence with conformity to those regulations even when faced with extraordinary situations. Like Italy and the EU banking regulations, India has the problem of its Fiscal Responsibility and Budget Management Act. Just as EU should give a one-time relaxation to Italy to infuse capital, India should ease FRBM for two years and use the proceeds to finance only bank recapitalization.

Despite the moral hazard associated with them, given the exceptional circumstances, such one-time relaxations with strict conditions and timelines, may be a more prudent and efficient strategy to stave off a long period of suffering and political turmoil, and far bigger bailouts with greater incentive distortions. Among all the less than satisfactory solutions available, this may be the least bad one.

Update 1 (11.07.2016)
Nice article in the FT which examines the challenge faced by Italian banks. It points to a Goldman Sachs assessment of 38 billion euro gross capital gap. Unlike other European banks which restructured in the aftermath of the crisis and hived off their non-performing assets, Italy choose to kick the can down the road.