ECB Finally Addressing Italian Bank Woes

December 15, 2016

Italy’s banking problem has been left unaddressed for too long. Similar to Japan in the 1990s, it is best understood as a combination of structural and cyclical factors.

Most of Italy’s banks, many of which are small and local, have politicized governance features that blur commercial incentives. As a consequence, they were unable to rein in their lending during the downturn of the late 2000s.

Many of these loans turned sour in subsequent years and local connections prevented the banks from working them out, so they kept supporting borrowers in a pattern of “pretend and extend.”

The system’s nonperforming exposures now total hundreds of billions of euros. Many of these loans are collateralized, but repossession is not really an option given the country’s antiquated judicial system.

It gets worse—many banks sold their own shares and debt to their retail clients, often without proper disclosure of the risks and at inflated prices. Such self-dealing is prohibited in many jurisdictions, but wasn’t prevented in Italy and even received favorable tax treatment until 2011.

Bank equity and debt became even riskier once the European Union introduced legislation on the resolution (or orderly liquidation) of failing banks, a shift that was signaled as early as 2009–10 and became official in mid-2012.

By then, Italian authorities should have forced the banks to buy back their risky securities from nonprofessional clients. That they failed to do so was a massive failure of public policy.

This context largely explains the country’s subpar growth rate—banking system fragility results in credit misallocation and a severe drag on economic activity.

Particularly in the last half decade, weak Italian banks have been culprits, not just victims, of economic sluggishness. In a telling contrast, Spain started cleaning up its banks in 2012 and has enjoyed comparatively dynamic growth since.

The problem was diagnosed more than two years ago by the European Central Bank (ECB) during its comprehensive assessment of the euro area’s 130 largest banking groups (of which 15 are Italian), which paved the way for its assumption of supervisory authority as part of a broader reform known as banking union.

Nine Italian banks were among the 25 that failed the exam, and four of them were still undercapitalized when the results were announced in October 2014.

Remarkably, they were the same that are widely believed to be in need of fresh capital now—Monte dei Paschi di Siena (MPS), Banca Popolare di Vicenza, Veneto Banca, and Carige.

The ECB did not immediately assert itself and, earlier this year, the constitutional referendum campaign deterred any forceful action. But the ECB appears to be moving into action now.

It is forcing MPS to find fresh capital before year-end. If this fails, the “world’s oldest bank” will face nationalization and drastic restructuring (with a specific protection scheme for victims of past misselling).

Similar initiatives are expected with the other three significant problem banks, and probably follow-up moves in the first half of 2017 to identify and handle weaknesses among the country’s hundreds of smaller banks which remain supervised by the Bank of Italy.

Mercifully, favorable market reactions to recent announcements by UniCredit, another large Italian institution, show that those banks that are not critically weak can still mobilize private capital.

Assuming reasonably competent handling, the entire system might reach broadly adequate capitalization to start seriously working out its bad loans by the summer of 2017.

This would have beneficial impact on three separate levels. First, putting an end to Italy’s banking fragility will revive the country’s growth, and also mark the near-completion of a protracted process of bringing the euro area’s banking sector back to soundness, in which Italy has lagged behind most other countries.

Second, it would herald the successful inception of banking union, with the ECB being a demonstrably more forceful supervisor than the national authorities it replaced in 2014.

Third, it could unlock a new phase of reform grounded on that success, including the long-debated creation of a European deposit insurance scheme and related policy measures to deepen Europe’s still unfinished banking union.

As usual in Europe, the path of progress is belated and tortuous. But it may well be that an important corner is just being turned.