Mark Gilbert is a Bloomberg Gadfly columnist covering asset management. He previously was a Bloomberg View columnist, and prior to that the London bureau chief for Bloomberg News. He is the author of “Complicit: How Greed and Collusion Made the Credit Crisis Unstoppable.”

When Italy's largest lender offloaded a bundle of bad loans this month, it dubbed the transaction FINO -- Failure Is Not An Option. That's an apt description for how important cleansing the balance sheets of the region's banks is to the wider economy.

Euro area lenders were saddled with 927 billion euros ($1.1 trillion) of non-performing debt at the end of last year, according to the European Central Bank. Italy's banking industry accounts for almost a third of the total.

The Dead Hand of Bad Loans
Non-performing loans as a percentage of total
Source: ECB via Bloomberg

But after years of allowing its bad debt problem to fester, the country is starting to get its act together. As part of the taxpayer-funded recapitalization of Banca Monte dei Paschi di Siena SpA, for example, the bank will transfer about 26 billion euros of bad loans to a privately funded special vehicle.

Earlier this month, Unicredit completed the sale of half of the 18 billion-euro portfolio of bad debt -- dubbed FINO -- to Pimco and Fortress Investment Group LLC. The lender expects to offload the rest in the coming months.

In total, the actions taken so far this year by Italian lenders have probably reduced the total burden to a five-year low of 13 percent of total loans, according to estimates from Bloomberg Intelligence analyst Marta Bastoni.

Heading in the Right Direction
Non-performing loans and bad debts at Italian banks as a percentage of total
Source: Bloomberg Intelligence

Investors are buying the improvement. Italian financial stocks, as measured by the MSCI Italy/Financials Index, have handily outpaced both the benchmark domestic equity index and the broader European index this year. They also a trade at narrower discount to book value, indicating shareholder concern about the state of the companies' balance sheets is waning.

Narrowing Discount
Italy's largest banks are trading at a slimmer discount to book value
Source: Bloomberg
Estimated price to book ratio on blended 12-month forward basis

The Italian Banking Association said last month that it expects the NPL ratio to decline to 9.3 percent in 2020; Morgan Stanley said earlier this month it could take a decade for Italy to reach the euro zone average.

In its April financial stability report, the Italian central bank noted that the average price Unicredit was willing to accept to get rid of its bad debts was 13 percent of face value. That's "much lower" than the average recovery rate between 2006 and 2015 of 23 percent, the central bank said, reflecting the poor quality of the loans and the length of time they've gone unpaid.

If the only way to find buyers for impaired debt is to sell at a deep discount -- almost certainly at prices below what the loans are booked on the balance sheet at -- so be it. Cleaning up the balance sheets of Europe's banks is essential if the nascent economic recovery is to be cemented.


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