Just as we were concluding our write up on the return of Europe's solvency crisis, facilitated by Donald Trump's NATO funding demands and the end of the ECB's unprecedented can kicking exercise, the FT reported that as many as eight of Italy’s troubled banks "risk failing" if prime minister Renzi loses next weekend's constitutional referendum and ensuing market turbulence deters investors from recapitalizing them, citing senior bankers.
This particular rather adverse outcome is captured by the lower-right, glowing red box in the Danske Research flowchart shown below
Renzi, who has previous said he will quit if he loses the referendum although has since changed his tune, has championed a market solution to solve the problems of Italy’s €4tn banking system and avoid a vote-losing “resolution” of Italian banks under new EU rules. A resolution restructures and, if necessary, winds up a bank by imposing losses on both equity and debt investors, particularly controversial in Italy, where millions of individual investors have bought bank bonds.
The following chart from the ECB demonstrates why a bail-in of Italian banks would be the equivalent of political suicide: the vast majority of bail-inable Italian debt is held domestically, read savers and pensioners. Should they be impaired, it would lead to an overnight social crisis.
However, if Renzi is already on his way out post a "No" vote, which most polls have assured is the most likely outcome, he will have far less motivation to seek a private bail-out, making a bail-in far more likely, boosting the chances of an adverse social reaction. As the FT adds, in the event of a “No” vote and Mr Renzi’s exit, bankers fear protracted uncertainty during the creation of a technocratic government. Lack of clarity over a new finance minister may lethally prolong market jitters about Italy’s banks. Italian lenders have more than halved in value this year on concerns about their non-performing loans.
For those who have followed the neverending saga of Italy's insolvent banks, the details are familiar: the "boot" has eight banks known to be in various stages of distress: its third largest by assets, Monte dei Paschi di Siena, mid-sized banks Popolare di Vicenza, Veneto Banca and Carige, and four small banks rescued last year: Banca Etruria, CariChieti, Banca delle Marche, and CariFerrara.
As warned here since 2011, the biggest problem facing Italy's (and Europe's banks) is the inordinate share of NPLs: Italy’s banks have €360bn of problem loans versus €225bn of equity on their books after successive regulators and governments failed to tackle a bloated financial system where profitability was weakened by a stagnant economy and exacerbated by fraudulent lending at several institutions.
The problem is that a market rescue of the insolvent banks has proven nearly impossible due to fears over the full magnitude of the bad debt problem:
But the market solutions, including a JPMorgan plan to recapitalise Monte Paschi and the efforts of a government-sponsored private vehicle Atlante to backstop problems at smaller banks, are looking shaky in the face of expected market turbulence if a “No” vote wins, said officials and bankers.
Lorenzo Codogno, a former chief economist at the Italian Treasury and founder of LC Macro Advisors, argued that the “biggest concern” in the aftermath of the referendum is its impact on “the banking sector and implications for financial stability”.
“The capital increases of Italian banks due to be announced right after the referendum may become even trickier than currently perceived in the case of a “No” vote”,” Mr Codogno said.
What is the worst case scenario (for now)? The answer: the third consecutive failure of Monte Paschi (which would likely have significant downstream consequences on all other Italian banks). Senior bankers and officials said that the worst-case scenario was where a failure of Monte Paschi’s complex €5bn recapitalisation and bad-debt restructuring demanded by regulators would translate into a wider failure of confidence in Italy and imperil a market solution for its ailing banks.
Under this scenario, officials and senior bankers believe that all eight banks could be put into resolution. They fear that contagion from the small banks could threaten a €13bn capital increase at UniCredit, Italy’s largest bank by assets and its only globally significant financial institution, planned for early 2017.
Should the Monte Paschi bailout deal fail, “all theories are possible” including “a resolution of the eight banks”, especially if a “No” vote led to Mr Renzi quitting office and a period of protracted political uncertainty, according to the FT. Indeed, the prospectus for the recapitalisation of Monte Paschi, which includes a debt for equity swap that begins on Monday, warns that the vote weighs on its chances of success. The Bank of Italy has warned of market volatility around the vote. Critics of Mr Renzi have accused the central bank of fear-mongering ahead of the vote.
No matter what, a renewed focus on BMPS would likely be the catalyst for the next Italian, and shortly after, Europen banking crisis. At that point the Italian dominos would - once again - be in free fall.
To be sure, the market has already sniffed out much of the risks with spreads on Italian government bonds versus German Bunds rising above 190 points on Friday, a level not seen since October 2014, as markets priced in expectations of turbulence.
One possibility is bailing out any domestic investors who get bailed in as a last ditch workaround to prevent a full-blown banking panic:
Bankers and officials can envisage a technocratic government agreeing with Brussels and Frankfurt a systemic “bail-in” of vulnerable Italian banks which emerged among Europe’s weakest in stress tests two years ago and again this summer. Under a bail-in, which forces losses on bond holders, Brussels could allow for some compensation for vulnerable retail investors, officials said.
Germany, however, would be less than enthused by such an outcome. Unfortunately, no matter the political framworks, Italy's banks are only going to deteriorate following next Sunday's vote:
Nicolas Véron, senior fellow at think tank Bruegel, argued that “if anything the ECB has been very lenient in addressing the system-wide banking situation [in Italy] that has been very visible since the comprehensive assessment two years ago”. “It is a very difficult moment but it is not sustainable. The problem of banking fragility is not going away. It is not something that resolves itself with time,” Mr Veron said.
All hope is not lost, however. The Economist, the once reputable economic and financial publication half-owned by the Rothschilds, has had a terrible track record of advising its declining readers on how to vote in critical political events: from urging a "Bremain" vote this past June, to begging for a vote for Hillary on November 8, the Economist has gotten virtually every major political event wrong. Which is why the fact that over the weekend the publication came out with an article "Why Italy should vote no in its referendum" may be the best hope Renzi has to remain in power.