Just because a crisis is “slow moving” does not mean it can be successfully arrested.
The political and financial stakes in the ongoing Italian banking crisis rose today as the chairman of Societe General, Lorenzo Bini Smaghi, talked up the risk of a “pan European banking crisis” if the European officialdom didn’t relent and permit Italy to use government funds to shore up its bank most at risk of keeling over: number three Monte dei Paschi.
The spectacle of Bini Smaghi warning that an Italian banking implosion could kick off a broader European meltdown, while accurate, comes uncomfortably close to the famous scene in Blazing Saddles, where the sheriff threatens to shoot himself to ward off an angry mob.
So why is a major bank leader stoking fears about the health of Continental banks? And why did Italy’s prime minister Matteo Renzi throw mud back, saying that the troubles facing Italian banks were minuscule compared to those those of players with big derivatives books, meaning Deutsche and the big French banks? Mind you, Mr. Market took notice of the spat: European bank stocks fell, including SocGen’s. The fabulously undercapitalized Deustche Bank’s share price dropped to its lowest level since 1989.
By way of background, Italian banks have been in serious trouble for quite a while. Unlike the systemically important players in London, Paris, and Frankfurt, they weren’t exposed in a big way to the tightly coupled credit default swaps business, nor had they loaded up on US subprime exposures. As a result, their crisis-related bailouts were modest: a mere €22.0 billion, versus €114.6 each for the UK and Germany, €174.3 for Spain, €39.8 for the Netherlands, and €23.3 for Belgium.
Italian banks got sick the old-fashioned way: on lending to businesses in their markets. As a direct result of the damage of the crisis to the Italian economy, many loans went bad; more got in trouble as austerity pushed more enterprises into distress. Italian lenders are regularly accused of cronyism and there no doubt were plenty of cases where sick borrowers were given more credit to make them look solvent. But that’s a common practice. Japan’s banks did that en masse in their post bubble years (a move the authorities later said was a big mistake) and in the US, home equity lines of credit were put into negative amortization routinely (not only by not restricting access to the credit line when they were clearly having payment problems, but also encouraging borrowers to make token payments, like $5 a month, and declaring the account to be current).
The problem with the Italian banks thus isn’t the complexity of the problem; it’s the scale, and the fact that Italy sits in the Eurozone, which has a Rube Goldberg bank resolution scheme that the authorities are unwilling to admit won’t work in practice.
Italian banks have an estimated €360 billion of bad loans, which is roughly 20% of GDP. While the value of these loans is not zero, the losses that need to be taken to clean up the Italian banks are enough to focus the mind. Having Italy’s banks remain in a zombified state means they aren’t giving much in the way of credit to businesses that need it. Italy has a high proportion of small to medium-sized businesses. That makes it particularly dependent on bank lending, so the dodgy banks are a drag on the economy.
Normally, the approach for this sort of mess is the one used in the US savings and loan crisis and in Sweden in its early 1990s bank meltdown: spin out the bad loans into a “bad bank,” where they are worked out to recover as much value as possible. The shareholders of the original bank, now a “good bank” are wiped out as it is recapitalized by the government, and top management and the board are replaced. The good bank is eventually sold.
The impediment is the new banking rules that came into effect in January 2016. Thomas Fazi described at length in February why they are such a train wreck. His overview of the fundamental flaws of the bank resolution scheme:
….a very strict and inflexible burden-sharing hierarchy aimed at ensuring that (i) the use of public funds in bank resolution would be avoided under all but the most pressing circumstances, and even then kept to a minimum, through a strict bail-in approach; and that (ii) the primary fiscal responsibility for resolution would remain at the national level, with the mutualised fiscal backstop serving as an absolutely last resort.
The danger of a bail-in is it is a one-size-fits-all approach guaranteed to cause bank runs. A “bail-in” means that rather than using new money to restore bank equity, shareholders are wiped out then junior creditors if needed, and enough of the remaining creditor funds are forcibly turned into shareholders for the bank to have a decent level of equity. As Fazi points out, it’s a potentially useful tool but a terrible idea as a forced solution. For instance, the first time bail-ins were used was in Cyprus. Those banks had little in the way of borrowed money, so it was depositors who took haircuts. In the case of Spanish banks, many depositors had been persuaded to invest in equity-like instruments that they were falsely told were the same as deposits. That puts them near the head of the line for taking losses in the event of recapitalization. In Italy, some banks have apparently resorted to similar chicanery, but not on the scale that took place in Spain. However, many consumers are investors in bank bonds, so they would be hit in the event of a bail-in. And given the Cyprus precedent, a bail-in of any size should scare depositors, and will lead them to move deposits from weak banks to stronger ones, creating liquidity stress and even bank runs.
It’s not as if Italian officials are ignoring this risk; they’ve proposed implementing a good bank/bad bank structure, and sought emergency relief so they can exceed Maastrict deficit limits to assist their banks. They were told in effect that their problem was not an emergency and they need to follow the unworkable bail-in regime. Renzi was rebuffed by Merkel when Italy tried again in the wake of the Brexit vote, arguing that the situation had become more dire. Merkel insisted that Italy needed to follow the new rules.
It’s not just that the Bini Smagi’s-Renzi spat had put more pressure on European banks, leading Bloomberg to point out in an editorial that failing to give Italy slack from “half-baked” rules will prevent it from handling an otherwise manageable banking crisis. It is also that the Italian banking crisis has the potential to break up the Eurozone.
It’s bizarre to see European officials taking a hard line with the UK, motivated by the perceived need to beat back threats like Marine Le Pen and Belgian and Spanish separatists, yet ignore the fact that Italy is as big a risk to the EU. That should imply they need to weigh political considerations along with the economic ones. But that isn’t happening.
While Marine Le Pen has long said she would have France leave the Eurozone if she were to become Prime Minister, the odds of her winning are low. As I understand it, the final round of French elections are a two-party matchup. So even if her Front National made it to the last stage, the mainstream parties that were on the sidelines would almost certainly urge their voters to support her opponent.
By contrast, as Ambrose Evans-Pritchard has long pointed out, from an economic standpoint, Italy is the country that would both benefit most from departing the Eurozone and has the heft to best go it alone. And the internal politics also make the odds of a fracture look higher than in France. From the Financial Times:
The populist Five Star Movement has emerged as Italy’s leading political party, overtaking Matteo Renzi’s ruling Democratic party (PD) in four separate opinion polls that have exposed the growing vulnerability of the country’s centre-left prime minister.
The primacy of the Five Star Movement, which is led by the sardonic comedian Beppe Grillo and has called for a referendum on ditching the euro, reflects a shift in public opinion against Mr Renzi that will heighten fears of a return to political instability and uncertainty in the single currency’s third largest economy….
It will also raise alarm bells about the fate of an autumn referendum on constitutional reform on which Mr Renzi has staked his political career. He has threatened to resign should it be defeated…
According to polls released on Wednesday by Ipsos, the Five Star Movement is supported by 30.6 per cent of Italians, compared with 29.8 per cent for the PD…
The polls look even darker for Mr Renzi if the likelihood of a run-off between the two largest parties — which is called for under Italy’s new electoral law if no party exceeds 40 per cent — is taken into account. In those scenarios, the Five Star Movement would defeat the PD by as much as ten percentage points, as right-wing voters would coalesce around the protest party.
Renzi has already taken a hit thanks to his interior minister having been caught out having a brother recently hired by the postal system. But this pales compared to the damage he would take if bank bail-ins were to start.
Merkel has played king-maker in Italy before. The Economist credits her with helping dispatch Berlusconi. But the famed Teutonic insistence on following the rules, which Merkel’s peers believe are the best chance to preserve the EU, is self-destructive when those “rules” are guaranteed to precipitate a financial crisis. Everyone knows Germany would have to relent in the case of Deustche Bank, which as Renzi points out, is likely to list if bank bail-ins commence. But that is tantamount to a full bore financial crisis. The Eurocrats need to stop obsessing about perfidious Albion and recognize that just as imminent a crisis is sitting on their doorstep.