Italy `Bad Bank' Promises No Gain Without Pain for Lenders

  • Offloading bad assets may force lenders to recognize losses
  • Meeting EU rules could mean capital increases, analysts warn

Italy’s banks may have to swallow a bitter pill if they’re to offload billions of euros of non-performing loans to a state-backed bad bank.

The government is set to agree with the European Commission on a mechanism to help banks sell soured loans, said two people familiar with the matter who asked not to be identified because the talks are private. State guarantees for the program, which could be used by individual lenders or several banks jointly, would be less than 40 billion euros ($44 billion), they said.

While removing bad assets will help lenders cleanup their balance sheets and spur lending, it may first force them to recognize billions of euros of losses if disposals achieve lower prices than the value recorded in banks’ accounts. Italian banks have put aside money to cover less than half of the nominal value of their bad loans, so asset disposals at even lower levels imply losses.

“A bad bank is seen as good news but if one were set up now, it would need to buy loans at market prices to avoid regulatory objections,” said Francesco Castelli, a London-based portfolio manager at Banor Capital. “But market prices are lower than the book values so banks may be unable to offload loans without booking losses.”

Italian banking shares are extending a two-day rebound as officials signaled they’re moving closer to reaching an agreement on setting up a bad bank for soured loans. Italy’s Finance Minister Pier Carlo Padoan said on Friday at the World Economic Forum in Davos, Switzerland, that negotiations with the European Commission “are down to details,” and focusing on the pricing of guarantees.

Draghi Reassures

“It should have been done by the government and in place,” Padoan said. “We’re working as quickly as we can and we’ve been working for months to reach an agreement with the commission on these issues.”

Banca Monte dei Paschi di Siena SpA , which has 24.4 billion euros of net non-performing loans, has been hardest hit by investor concerns tied partly to European Central Bank requesting more data on non-performing loans. The questionnaire was sent to “several banks” in the euro area and is “not an initiative that would push the banks to deal with NPLs urgently,” ECB President Mario Draghi said on Thursday, in reassuring investors.

“It’s not about the amount of NPLs -- that we know -- it’s about the processes the banks have put in place to address the NPLs,” ECB Executive Board member Benoit Coeure said at a WEF panel on Friday. “It’s about whether the banks are forceful enough in addressing” their soured loans, he said.

Large Gap

The Italian banking industry has an average coverage ratio of 43 percent, according to data compiled by Bloomberg. For banks including Banca Monte dei Paschi and Banco Popolare SC, the doubtful loans they haven’t provisioned for will exceed their tangible common equity by more than two times, Milan-based brokerage Fidentiis Equities wrote in a Jan. 21 client note.

Italy may set up several bad banks for individual lenders rather than a single institution, Il Sole 24 Ore reported on Jan. 14.

The gap -- between how banks value the loans and what they would receive from the bad bank -- may be large, according to John Raymond, a London-based analyst at CreditSights Ltd. That’s because Italy’s portfolio of bad loans is messier than in other European countries such as Spain, which set up a bad bank, Sareb, three years ago.

“In Italy the bad loans to small businesses are varied, whereas in Spain they were mostly bad mortgages,” Raymond said. “It takes longer to value thousands of chunks of loans and it’s harder to get the right value -- that could mean the banks getting rid of the loans for big discounts,” he said.

‘Not Concerned’

To be sure, the country may choose to set up the bad bank in a way that spreads out the losses over time or limits them, Raymond said.

Italian banks, which showed the largest combined capital shortfall in the ECB’s review of the region’s lenders completed in October 2014, reinforced their capital from private sources by about 11 billion euros that year. Monte Paschi, after having raised 5 billion euros in 2014, tapped investors again less than a year later for an additional 3 billion euros. The lender may be forced into another capital increase, Castelli said.

“The question is how much cleaning up have they done?" said Marco Elser, an investor in distressed financial assets at Lonsin Capital in Rome. “If they’ve done all the cleaning up that they told Italian banking authorities they’d done, I’m not concerned. If they still have cadavers in the closet, then that’s another matter.”

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