What’s going on with Italy’s banks?

On Sunday Italians go to the polls to vote on reforms to the country’s constitution. It has been speculated that the referendum, which has been championed by Prime Minister Matteo Renzi, could have far reaching consequences beyond Italy, threatening the stability of the European banking system and even the Eurozone itself.

The proposed reforms to Italy’s constitution are aimed at streamlining Italy’s political system, reducing the number of senators and limiting the senate’s power relative to the lower house of parliament. Prime Minister Renzi has staked his political career on the referendum, which he hopes will enable him to pass a major economic reform package, by promising that he will resign if the reforms are rejected by the Italian people.

Were this to unfold, reports suggest that up to eight of Italy’s troubled banks could fail, creating a wave of turmoil for European banks and global financial markets. Some have even suggested that the euro area itself could be at risk.

So what’s going on here?

Non-performing loans

The main problem lies with the €360 billion of non-performing loans which Italy’s banks have amassed over recent years. These are mostly loans which were made to small companies who have been unable to pay them back under the strain of a weak Italian economy, and are estimated to account for around 18% of all loans in Italy, and a third of all non-performing loans in the entire euro area.

Usually these loans would be marked down in value or written-off entirely, however if this were to happen then many Italian banks would become insolvent because they lack sufficient capital to absorb these losses. The Italian banking system therefore urgently needs an injection of capital, but sourcing these funds is proving difficult for the Italian government.

Bail-out or bail-in?

Under new EU rules introduced after the financial crisis, governments are prevented from recapitalising banks directly with a bail-out package. Instead, the new ​‘recovery and resolution’ rules (or ​‘bail-in’ rules) mean that losses have to be borne firstly by creditors, rather than the government. The rules stipulate that 8 per cent of a bank’s liabilities – such as bonds and corporate deposits – must be wiped out before any taxpayer support can be provided.

In order to keep the banks afloat, Prime Minister Renzi has therefore had to devise a market-based approach to recapitalising the banks, which includes a JPMorgan plan to recapitalise one of the larger banks and another private rescue fund called Atlante to recapitalise a number of smaller banks.

If Italians vote to reject the constitutional reforms on Sunday, it is widely feared that the resignation of Prime Minister Renzi and subsequent political turmoil may lead these investors to withdraw their support from the recapitalisation programme.

Under this scenario, a number of banks could be put into so-called ​‘resolution’ to avoid insolvency, whereby eligible liabilities would be ​‘bailed-in’ to keep the banks solvent. The problem is that many of these ​‘bail-in bonds’ are assets held by pension funds, insurance companies and, particularly in the case of Italy, individual bank customers, meaning that bank losses will still ultimately be borne by ordinary citizens. This in turn is likely to lead to even more political unrest.

An Italian banking crisis of this sort would likely have a strong contagion effect, leading to a spiking of Italian bond yields and sending a shockwave through other European banks, many of which are already in a fragile position.

Ultimately, the Italian state could decide to step in to avoid a doomsday scenario unfolding. But by breaching bail-in rules this would undermine the EU Banking Union, which is one of the few areas in Europe where progress has been made since the financial crisis, as well as the EU’s authority more generally.

Political contagion

While the short-term economic consequences could be severe, it is the long-term political consequences that are feared the most. If Prime Minister Renzi loses the referendum and resigns as he has promised, it is feared that the Five Star movement, who want Italy to leave the Eurozone, could come to power in an election next year.

Given Italy’s size and economic importance, an Italian exit from the eurozone could potentially land a fatal blow to the single currency. A fracture in the eurozone would likely lead to immense global economic, financial and political upheaval, the consequences of which are impossible to predict.

Is there a risk to the UK?

It is thought that UK banks are less vulnerable as they have already acted to reduce their exposure in Italy. But given that the UK has one of the largest, most concentrated, least diverse, most risky, most complex, and most interconnected banking systems in the developed world, any turbulence in global financial markets will hit the UK economy.

Moreover, if the eurozone economy is hit by another downturn bought on by a fresh banking crisis, it will damage prospects for the UK economy by reducing exports and hitting business investment. It could also unleash new waves of political volatility on the continent which would have consequences for the UK and beyond.