QuickTake Q&A: Why Italy’s Bank Problem Challenges the Rulebook

Italy’s banks are a basket case. Helping them has divided policymakers and called into question Europe’s attempts to end taxpayer bailouts. The stakes are high: After Britain’s shock vote to leave the European Union last month, the shares and riskiest securities of European banks have plunged. If Italy’s banking crisis isn’t solved soon, there are worries it could spread to the rest of Europe.

1. What’s wrong with Italy’s banks?

They’re saddled with about $400 billion of bad loans and lack the financial reserves to sell them off. The combined stock market value of UniCredit SpA and Banca Monte dei Paschi di Siena SpA, Italy’s biggest and third-biggest banks respectively, has tumbled by more than half this year to just $13 billion. By comparison, Snapchat Inc., the photo-sharing app, was recently valued at $18 billion by venture capitalists.

2. How did we get here?

During the 2008 global financial crisis, banks in the U.S., U.K., Spain, Ireland and elsewhere were bailed out with taxpayer funds. Italy, not facing an immediate need to recapitalize its lenders, waited for an economic recovery that never came. The government this year sponsored attempts to recapitalize troubled banks and buy bad loans. Investors were underwhelmed. Skittishness about banks intensified and stocks slid after Europe woke up to the reality of Brexit. Prime Minister Matteo Renzi is now seeking to inject public funds.

3. What’s the issue?

It all comes down to who pays for the mess. State-aid and banking rules normally require shareholders and junior creditors to share losses before public money can flow. That was meant to end the "too big to fail" problem by making private investors foot the bill for bank failure before taxpayers.

The problem is there are a lot of private investors -- often middle-class individuals who have put their savings in bank bonds. Bondholder losses at four small banks in November sparked protests by savers, a nationwide selloff of bank debt and one suicide.

Renzi’s government is considering injecting as much as 40 billion euros ($44 billion) into banks, a person with knowledge of the plans said last week.

4. What’s next?

Renzi needs a solution that avoids a bail-in, which would force bondholders and other creditors to take losses. A bail-in could spark an economic crisis before a crucial October referendum on constitutional reform that Renzi needs to win to stay in power. He has some support outside Italy, but German Chancellor Angela Merkel has so far slapped down attempts to bend EU rules. Renzi said Italy doesn’t need "a lesson by the schoolteacher."

The issue of creditor losses has become the sticking point in negotiations over Monte Paschi between Italy and the European Commission, people familiar with the discussions said Wednesday.

5. What are financial markets saying?

Monte Paschi, the world’s oldest bank, has survived more than five centuries. But it’s lost 99 percent of its value since the collapse of Lehman Brothers Holdings Inc. in 2008, and credit markets signal an approximate 60 percent probability of default on its junior bonds within five years. Investors in under-capitalized banks like Banca Carige SpA and UniCredit are also getting nervous.

6. What’s the potential for a surprise?

Most investors expect some sort of fudge, in which the EU approves further aid that’s well short of what Italy is seeking. But European officials have sweated away for thousands of hours devising complex rules for how to deal with failing lenders, and they may not be prepared to throw out the rule book just yet.

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