It’s Italy’s turn. Europe’s fourth-biggest economy is the latest affluent democracy to experience a political upheaval, after voters on Dec. 4 defeated a constitutional referendum on government reforms backed by Prime Minister Matteo Renzi. He’s tendered his resignation, and while power is likely to pass to an interim government, populist parties on the left and right are calling for snap elections.
In the eyes of the markets, the main risk isn’t the drama unfolding in the halls of power in Rome. This is a country that’s flipped through more than 60 governments since World War II, so what’s one more? Italy’s shaky banks are the real worry.
Saddled with €360 billion ($387 billion) in soured loans, which equals a fifth of Italy’s economic output, the country’s top 12 banks have lost more than half their stock value so far this year. The industry is in dire need of stability, and the political turmoil has added a new uncertainty. “From today on, this becomes a banking story,” Megan Greene, chief economist at Manulife Asset Management, told Bloomberg Television after the vote.
Still, short-term market moves can confound expectations. Shares of UniCredit, Italy’s largest lender, with €874 billion in assets, jumped 18 percent in the three trading days after the polls closed. Investors had already assumed a “no” result and priced that into their valuations for bank stocks, says Federico Santi, an analyst with Eurasia Group. But they may be underestimating the political risks that could arise over the next few months, including the possibility of an election before the one scheduled in 2018. “All of the factors that contributed to Renzi’s defeat will still be present in 2017,” Santi says.
All eyes are on Banca Monte dei Paschi di Siena, a 544-year-old institution that epitomizes the shoddy underwriting that’s plagued so much of Italy’s financial system. The bank has €27.7 billion in bad loans it’s trying to sell. Monte Paschi has already burned through €12 billion in cash it received from bailouts and share sales over the last few years, and the European Central Bank says it still needs to improve its capital position. Now Monte Paschi is going back to the well again, by preparing to raise €5 billion worth of capital from investors.
Even before the referendum, this was going to be challenging. Now? It may be quixotic. On Dec. 6, Chief Executive Officer Marco Morelli persuaded the bank’s bondholders to swap about €1 billion of subordinated notes for stock, a significant step forward in selling the plan. Stockholders, unlike bondholders, don’t have to be paid back, so trading debt for equity relieves pressure on a balance sheet.
Morelli still needs to win over heavy hitters such as sovereign wealth funds to seal the deal. If that doesn’t work, he may turn to the Italian state for help. Government officials have been preparing such a plan, according to people familiar with the situation. On Dec. 7 the bank said it wanted until Jan. 20 to raise capital by private means.
It’s no longer easy to extend taxpayer-funded lifelines to banks in Europe. Under new European Union rules, bond and stock investors have to absorb losses first. In Italy, many investors in troubled banks aren’t hedge funds or institutions—they’re households, small businesses, and individual depositors. If the state hits them with heavy losses, there will be a political price to pay. However, it’s possible the ECB will approve a way to protect individuals from losses by reimbursing them.
A prime beneficiary of any national outrage against banks and their government protectors will be the Five Star Movement and other populist parties. If a snap election is called, polls show the Five Star Movement would probably win. The party wants to hold a referendum on quitting the euro zone. No member of the 19-country monetary union has ever left—such a departure could destabilize the euro.
Even if Monte Paschi completes its recapitalization, it won’t be enough to break the cycle of crisis that’s trapped Italy for years, says Sony Kapoor, the managing director of Re-Define, a London-based research group. The situation may be traced to a decision Italy made in 2012, when the debt crisis was threatening the solvency of overleveraged Mediterranean countries. Spain used a €59 billion bailout to reboot its troubled banking sector, and now its economy is growing at a 3 percent clip. Italy, which hadn’t indulged in the real estate speculation that crippled Spanish lenders, chose not to seek a bailout. But recessions have swept the economy, and banks have grown weaker as distressed borrowers default on loans. Italy’s gross domestic product per capita today is lower than it was in 1999.
With the banks being stingier with loans as they manage their losses, Renzi and his predecessors labored to get the economy going with one arm tied behind their backs. “The Italian banking problem is a huge drag on growth, but it won’t solve itself spontaneously,” says Nicolas Veron, a senior fellow with Bruegel, a Brussels-based think tank. He says political and finance leaders need to agree on a plan to clean up the lenders once and for all.
One way to start would be jolting the economy with a stimulus program, such as an infrastructure package, Kapoor says. A burst of short-term growth would help banks “reduce outstanding bad loans, which would help alleviate political backlash against the establishment,” Kapoor says. “But will the next government be able to do that in the next 18 months? Italy’s problems look so intractable.”
The bottom line: Italy’s banks are carrying a huge load of bad debt, and political turmoil isn’t making that any easier to solve.