Japan's Lesson Tells Italy Capital Alone Won't Fix Its Banks

  • Bruegel report says bad banks needed to work down bad loans
  • Authorities lacking incentives to use tools in unison

Fixing a rotten banking sector requires policy makers to deploy three tools in unison -- and Italy, like Japan two decades ago, is in danger of coming up short.

In addition to prompt recapitalization and robust, independent supervision, reviving lenders saddled with soured loans means governments must step in with “bad banks” that lift troubled assets off balance sheets, according to a new study by the Brussels-based Bruegel Institute.

The report’s authors, Mark Hallerberg and Christopher Gandrud, look back at rescues of credit cooperatives Tokyo Kyowa and Anzen in the 1990s. They conclude that even when banks have been recapitalized, lack of action to relieve them of non-performing loans means they can still founder, locking the economy into a cycle of weak lending and weak growth. Now, with proposals to create a pan-European bad bank going nowhere, policy makers risk making the same mistake in Italy.

“The problem is not that this combination of policy tools is unknown, but that banks and governments lack incentives to use them in combination,” the authors write. “Italy’s December 2016 package providing 20 billion euros ($21 billion) for recapitalization of banks is a step in the right direction. Similarly, pressure from the European Central Bank on Italian authorities and on banks to address NPLs is welcome. However, policy tools to manage and dispose of NPLs and, just as importantly, incentives to use them, are lacking.”

Although Japan in the 1990s and Italy now aren’t directly comparable, there are similarities. In Japan, a real-estate bust and a slowing economy meant companies and households increasingly couldn’t pay back loans, and banks were unwilling or unable to take the hit to capital that complete write-offs would have entailed. 

Hallerberg and Gandrud write that a spate of public and private-sector recapitalizations and loans -- termed hogacho after a traditional way of raising money -- failed to break the cycle, even with the presence of a new, independent regulator that encouraged tough revaluations of assets. It wasn’t until the Industrial Revitalization Corporation of Japan began buying up and disposing of distressed loans after 2002 that the healing could begin.

In Italy, the stagnation of productivity and lack of any real economic growth in the past two decades has slowly eroded the capacity of the banks to rehabilitate themselves. The agonies over the state’s rescue attempts for Banca Monte dei Paschi di Siena SpA and other lenders have provided a persistent worry for investors in Europe, without a clear prospect of a solution.

This week, JPMorgan Chase & Co. wrote that investors should sell the senior bonds of Banca Popolare di Vicenza SpA and Veneto Banca SpA because Italy may not win European Union permission to provide aid to the lenders that prevents those bondholders from losses. And even though the Italian state has set aside funds, a pan-European bad bank to finally clean up their balance sheets in a way that doesn’t sink the nation’s creditworthiness seems remote.

Andrea Enria, chairman of the European Banking Authority, has proposed setting up a bloc-wide asset-management company to take over and manage the sell-off of the loans. The regulator’s executive director, Adam Farkas, said last month that a “realistic aim could be to move about a quarter” of all bad loans off banks’ balance sheets.

The ECB, in its role as bank supervisor, has made a concerted effort to get lenders to work through their NPLs and restructure them. But the ECB -- unlike the Bank of Japan in the 1990s -- can’t use its own funds to assist commercial banks.

Without a breakthrough in NPL management, the authors write, Italy may be heading for a replication of the Japanese experience in which crippled banks contributed to a lost decade of sub-par growth. Italy’s economy has already barely grown since joining the euro in 1999.

For Monte Paschi, the matter is urgent. Executives at the bank are said to want an accelerated sale of bad assets if and when the European Union approves its new business plan, according to people familiar with the matter. That would combine fresh capital with a scrubbed balance sheet if the plan goes through.

“Recapitalizations are necessary so that banks can continue during balance-sheet restructuring, but recapitalization alone is not sufficient to guarantee that the problem will be addressed,” the authors write. “Italy might have repeated many of the mistakes Japan made in the 1990s, but with the combination of significant recapitalization, tough independent supervision and tools with enough heft to dispose of NPLs, it can recover.”

— With assistance by Giovanni Salzano, Sonia Sirletti, and Luca Casiraghi

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