With Italian banks in trouble, which route will Merkel take?

With Italian banks in trouble, which route will Merkel take?

With Italian banks carrying non-performing loans estimated at US$400 billion, we wonder whether Germany will offer them financial assistance to prevent the unravelling of the EU. Or could the troubled banking sector make Italy the next European domino to fall?

The US economy approximates US$18 trillion and its banking assets are slightly smaller than this.  The economy of the European Union (EU) comprising 27 countries is around the same size as the US, yet its banking system is nearly three times the size of the US at US$45 trillion.

Italy is the third largest economy in the EU with GDP of US$1.8 trillion and banking assets of US$4.5 trillion.  Carried on the Italian banks’ books are non-performing loans (NPL) estimated at US$400 billion, approaching 10 per cent of assets and 22 per cent of Italy’s GDP.  These are loans not being repaid by the borrowers but not fully written down by the banks.

In January 2016, the EU introduced a banking reform known as the Banking Recovery and Resolution Directive (BRRD), the objective being to shield EU taxpayers from bailing out troubled EU banks with taxpayer sourced funding.  The rules were modelled on the Cyprus banking crisis solution of 2013, known as “bail-in” – where bank bond holders and larger bank depositors were “at the front of the line” in terms of being used as a funding source to offset a write-down of the bad loans.  This was significant because bank depositors have now been added to the list of funding sources in offsetting the write-down of bad bank loans, while taxpayer based funding (a bailout) becomes a last resort.

Italian banks have issued US$200 billion in unsecured bonds to local investors.  This debt makes up a significant portion of the Italian banks’ capital structure and the sector appears to be in a major conundrum.  The Italian bank bondholders and larger bank depositors, often the same investors, have been put at the front of the queue to provide funding for any “bail-in” when and if the time comes.  That is, the BRRD reform will exacerbate any Italian banking crisis.

In the next couple of months, Italy is heading for its 64^th election in the 71 years since World War II, and Matteo Renzi, the current Prime Minister, has threatened to resign if he doesn’t get the changes to the Italian constitution he is seeking.  The changes, which are not associated with the banking sector, are focused on transforming the Senate of the Republic to a “Senate of Regions”.  Opposition parties have criticised the bill and a significant threat comes from a Eurosceptic party called the Five Star Movement, which was established by Beppe Grillo, a popular comedian and blogger, in 2009.  Part of the appeal of the Five Star Movement is to leave the EU, dump the Euro and return the Italian currency to the Lira.

Which leads us to ask questions about the survival of the European Union, and to ponder: Which ?  Will Germany, whose economy is around double the size of Italy, offer financial assistance supporting an Italian bank bailout prior to the election in October?

If the answer to this question is “Yes”, it will signal a willingness to stop the EU experiment from unravelling, and at the same time Germany would back away from insisting upon the implementation of the BRRD and the “bail-in” of the Italian bank bondholders and the larger bank depositors.

This potential move, adding to the concept of “helicopter money”, would definitely encapsulate the dictum from Mario Draghi, President of the European Central Bank, “whatever it takes” and the market would anticipate a win in the fight to reflate the European Union, with equity prices likely to enjoy a (continuing) bull run.

If the answer is “No”, it will signal a willingness to allow the Italian bank bondholders and large bank depositors to take a haircut, promote a run on every under-capitalised bank in the EU, see an eventual unravelling of the EU, and possibly provide a shock as big as allowing Lehman Brothers to fail nearly eight years ago.   The deflationists would become the clear winners.

A betting person would suggest Germany will back away from insisting on the implementation of the BRRD, and I recommend keeping a close eye on the Italian banks for any clues to the route Chancellor Merkel decides to take.  (In the past year, the share prices of the three largest Italian Banks, Uni Credit (-66%), Intesta Sanpaolo (-42%) and Banca Monte de Paschi (-87%), have recorded an average 65 per cent decline).

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Chief Executive Officer of Montgomery Investment Management, David Buckland has over 30 years of industry experience. David is a deeply knowledgeable and highly experienced financial services executive. Prior to joining Montgomery in 2012, David was CEO and Executive Director of Hunter Hall for 11 years, as well as a Director at JP Morgan in Sydney and London for eight years.

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