By Jacob L. Shapiro

Summary Italy’s non-performing loan issue is now becoming common knowledge. The next step in the crisis is deciding who will be forced to deal with the repercussions of settling Italy’s impaired debt. That is a political question, and the answer depends in large measure on who holds Italian bank debt.

When we last addressed the emerging Italian banking crisis, the European Commission and Italy had at long last come to an agreement on how Italy could offload bad debt from its banks’ balance sheets while still meeting European Union regulations. Since then, there have been some newsworthy developments, including a large merger between Banco Popolare and Banca Popolare di Milano and a favorable European Central Bank (ECB) opinion on the Italian decree to reform Italian cooperative banks and offer state guarantees for the sale of non-performing loans. None of these developments, however, fix the non-performing loan (NPL) problem that led us to forecast an Italian banking crisis this year. What was mainly an economic issue has turned into a political question: who is going to be forced to absorb the losses?

Quantifying the NPL Problem

The Italian banking crisis has now become headline news, and depending on the article and publication, different statistics and numbers are used to define the severity of Italy’s NPL problem. Therefore, though we have been consistent internally with our own figures, it is important to explain the numbers we’ve used. For the value of Italian NPLs, we relied on a report released by the European Banking Authority (EBA) in November 2015 that determined NPLs represent 17.1 percent of Italy’s $2.141 trillion GDP. That means Italy’s non-performing loans are worth roughly $366 billion.

Two additional points must be made. First, there is a problem of definition. Since the ECB assumed responsibility for oversight of EU banks, a question has arisen over whether loans that are 90 days past due should be classified as non-performing or deserve their own category. The Bank of Italy used to categorize them separately, but the EBA classifies them as non-performing. A report by the Associazione Bancaria Italiana estimated that at the beginning of 2013, 53 percent of impaired Italian loans were non-performing, but that did not include loans 90 days past due. Since 2013, the total value of NPLs in Italy has increased by almost 27 percent. A conservative estimate then is that $173 billion of Italian NPLs are dead weight.

Second, the source of Italian NPLs is overwhelmingly corporate. According to a February 2015 International Monetary Fund paper, 80 percent of Italian NPLs were in the corporate sector. Moreover, the regional average for corporate NPLs is above 30 percent, and in some southern regions in Italy exceeds 50 percent. This is not a problem confined to a few individual borrowers. This is a larger issue affecting small and medium-sized enterprises that provide jobs for the Italian economy. It is a systemic issue, and though it is far worse in southern Italy, it is not confined there.


Searching for Solutions

It is impossible to make positive or negative pronouncements on the broader NPL problem by looking at individual deals between banks. And there have been a flurry of recent such deals. One of the most widely reported is Banco Popolare agreeing to take a controlling share in Banca Popolare di Milano, which will create Italy’s third largest lender. The merger, even if it does portend greater consolidation in the famously fragmented Italian banking sector, will not make either bank’s stack of NPLs disappear, nor will it raise interest rates or loosen capital restrictions to make lending easier for the new super-bank.

But this merger is interesting because it is a harbinger of how an economic issue turned into a political one. When the chief executives of the banks began negotiating back in February, there was to be no provision for raising new equity. This despite the fact that Banco Popolare has almost $14 billion in bad debt, which exceeds the EU’s limits on NPLs compared to capital on hand. Moreover, it was agreed that 19 directors were needed on the board of the new bank. The European Central Bank vetoed both of these arrangements, and the Italian government was forced to fall in line and back the ECB’s position. Now, before the merger begins, Banco Popolare must raise 1 billion euros ($1.13 billion) and the board must have only 15 directors within three years. Therefore, the ECB is imposing its will on Italy. It doesn’t want to bail out the banks – it wants investors, shareholders and the Italian government to raise capital and take losses in order to eliminate NPLs.

Unlike other countries, Italy cannot simply print money to raise the capital necessary for getting itself out of this predicament. Its membership in the eurozone precludes such a move, and the ECB is not going to print more euros for Rome. And though Italy is the third wealthiest country on the European continent, it doesn’t have the resources on hand necessary to bail out these banks by itself. Italy’s debt-to-GDP ratio is more than 132 percent, second only to Greece in the eurozone, and based on the approved 2016 budget the Italian government is going to run a deficit equivalent to 2.4 percent of GDP.

To rescue four smaller banks in November, the Italian government had to raise 3.6 billion euros from the private sector – and it did that by getting three-year advances of 600 million euro loan installments from healthier Italian banks. The government may be able to save a few banks, such as Monte dei Paschi di Siena, which is struggling to find a buyer, but Italy doesn’t have the ability to bail out the entire banking sector. Taking out loans is theoretically possible, but the premium Italy will have to pay for borrowing money is only going to increase.

Implications for Europe

However, the ECB also cannot afford a collapse of the Italian economy. The ECB is striking a hard bargain with Italy on certain issues, but on others it has been amenable to compromise. Last month, officials from the Italian Treasury told Reuters that they were in talks with the ECB to purchase some of Italy’s bad debt. Of course, the ECB would not simply take the NPLs off an Italian bank’s hands – the Italian banks will bundle these loans into asset-backed securities (ABS), and the ECB will buy the “senior tranches” or bundles of the least toxic NPLs. This amounts to the ECB breaking its own policies. On the ECB website, in reference to purchasing ABS, it notes that any loan included in an asset-back security “should not be in dispute, default, or unlikely to pay.” This is essentially the definition of a non-performing loan. This is part of the reason the ECB is actually dependent on the Italian law that enables state guarantees of these ABS – it may allow the ECB to justify the investment.

This brings us to a deeper question for which it is impossible to get precise data: who is exposed to Italy’s non-performing loans besides the Italian banks? One potential place to look is Deutsche Bank, which has been experiencing troubles of its own lately with Moody’s downgrading its long-term debt position in January and Standard & Poor’s downgrading its creditworthiness last summer. According to its 2014 Annual Financial Report, Deutsche Bank’s net credit risk exposure to Italy was over 14 billion euros, larger by far than any other eurozone country. Of that, roughly 3.4 billion euros are exposed to Italian financial institutions, which the report defines as “larger banks in Italy typically collateralized.” The report does not reveal how much Italian bank debt Deutsche Bank might own, though it does at multiple points note that its bottom line was improved by disposing of Italian non-performing loans.

Meanwhile, last September, the Wall Street Journal reported that General Electric, Royal Bank of Scotland, Prelios and Crédit Agricole were looking to sell NPLs worth approximately 4.2 billion euros. Deutsche Bank reportedly was interested in submitting a bid to purchase one of the portfolios in question. The Wall Street Journal also cited anonymous sources saying the value of the NPL packages would be between 150 million euros and 200 million euros – not exactly an excellent return on investment. Despite its efforts, Italy was only able to sell 10 billion euros worth of NPLs in 2015 precisely because holders of Italian bank debt did not want to accept such low prices. Some are willing to cut their losses, and others see a financial opportunity. Both of these, however, are indicators of what may be a deeper problem and why the ECB has to find common ground with Italy – exposure to non-performing loans is not only an Italian problem.

No amount of paper shuffling by Italy or the ECB can eliminate Italy’s non-performing loans. The issue now revolves around the political question of who is going to be forced to face the repercussions. No matter who does, our forecast for Italy seems well on track.