Finance

Lionel Laurent is a Bloomberg Gadfly columnist covering finance and markets. He previously worked at Reuters and Forbes.

Italian banks have good reason to fear the mailman -- especially if the letter has a Frankfurt postmark.

Roman Ruin
Italian bank shares are underperforming European peers
Source: Bloomberg data

Regulators at the European Central Bank are firing off missives to the country's lenders to get them to raise capital, merge or bolster deposits to ensure their survival.

The ECB is right to complain that Italy still needs to fix its banks after years of stasis. But it needs to tread carefully. If the ECB fails, it risks triggering a vicious cycle: declining investor confidence leads to a funding drought that leads to bail-ins.

Banca Carige was the latest Italian bank to get a letter from the ECB last week. The regulator demanded the 500-year-old lender quickly come up with a new funding plan amid a fall in deposits and deepening losses.

Funding Sources
Banca Carige's consumer and institutional deposits fell last year
Source: Company reports

Although there was no indication that more capital was needed or that more provisions would need to be taken, the reaction from the market was stark: Carige's shares slumped 10 percent.

That's not to say that the warning was unwarranted: Carige revealed it would have to double its previously stated net loss for 2015 after additional write-downs of goodwill. The bank has also disclosed it suffered deposit outflows in 2015.

The regulator's previous efforts to overhaul banks in Italy haven't been entirely successful -- in part because they've been frustrated by the actions of the local banks.

The ECB ordered Popolare di Vicenza to raise 1.8 billion euros ($2 billion) in a letter published last week. Over the weekend, the lender's owners approved plans for a initial public offering to raise the funds. This wasn't the first time the lender had been ordered to bolster capital. But the ECB discovered the lender had met its two previous cash calls by lending money to customers to help them buy the shares.

Another case in point is Monte dei Paschi -- the only Italian bank with a higher ratio of non-performing loans than Carige, according to Bloomberg data. As my Gadfly colleague Duncan Mavin has written, regulatory probes and losses inflicted on bondholders have undone all the work the ECB and Paschi did to try and bolster the bank. Since raising $8.7 billion in two stock offerings since June 2014, Monte Paschi's market value today is less than 30 percent of all the equity it raised.

Italian banks are already grappling with souring loans -- the country's top five banks have about 120 billion euros of non-performing loans.

If the ECB's intervention at Carige adds access to funding to the list of concerns about Italian banks, that is all the more reason for regulators to tread carefully.

Zero Bound
A high proportion of Italian bank deposits don't pay interest
Source: Credit Suisse

The situation may become even more fragile this week, when the ECB is expected to cut its deposit rate deeper into negative territory. If that prompts depositors to move their money elsewhere, it risks forcing lenders to increase their reliance on wholesale funding. If Italian banks can't get that funding at a reasonable cost, they will turn to the ECB.

Granted, Italian banks are making some progress. Loan quality started to improve in the fourth quarter and the latest lending data points to further improvement, analysts say. Italy and the European Commission have agreed on a plan to help banks offload bad debts, even if it does not go as far as hoped. Private equity funds are still in the market to buy those loans. But additional concerns about the viability of Italian banks could snuff out these gains.

The ECB simply can't afford to get Italy's banks fiasco wrong -- but it's going to be perilously difficult to clean up the mess.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Lionel Laurent in London at llaurent2@bloomberg.net

To contact the editor responsible for this story:
Edward Evans at eevans3@bloomberg.net