We have been concerned about the situation of banks in Italy and the possibility of a broader banking crisis developing across the Eurozone. At his press conference on Thursday following a meeting of the European Central Bank (ECB), ECB president Mario Draghi sought to give assurances about the soundness and stability of the Eurozone banking system. A lesson learned from the last financial crisis, Draghi told his audience,
… is that we have made our financial system stronger. We made stronger our banking system. And we increased more generally the resilience of the financial services industry.
Contagion Prevention
We do not doubt that this is true. The list of reforms is long, including a single set of rules to ensure that banks are better capitalized and risks more controlled; single supervision directly by the ECB of the 129 largest banks, and for those remaining, national supervisors working together within an integrated system; a European deposit insurance scheme; and the Single Resolution Board, which will step in, when all else fails, to deal with a collapsing bank and prevent contagion. But also long is the list of nonperforming loans (NPLs) on the books of European banks and that list could lengthen significantly as the dramatic fall in oil prices hits firms in the energy industry and their suppliers. We are impressed by the reforms but continue to be concerned.
Draghi was asked about the NPL problem, with particular reference to the intense pressure on Italian banking-sector stocks this week due to concerns about exposure to bad loans, the new rules for failing banks under the Single Resolution Board cited above and fears that depositors will withdraw funds. Concerns were apparently strengthened last Sunday by an ECB statement that it has set up a task force to tackle nonperforming loans in Europe. The negative reaction came when the market learned several Italian banks had been asked to provide information. There were fears that banks would be required to take new actions. Draghi sought to correct what he termed a “misunderstanding” by the market. The gathering of information involved the whole of the Eurozone -- not just Italy -- and the objective is to obtain a view of what are “best practices” for addressing bad-loan problems. He stressed that “No new, unexpected provisioning or new, unexpected request for more capital will be made by the supervisor.”
200 Billion Big
Draghi’s words of assurance did not include any indication that progress has been made in the negotiations between Italy and the European Commission on how to tackle Italy’s massive NPL problem, which the Bank of Italy estimates to be 200 billion euros in size. In October the European Commission rejected an Italian proposal to create a “bad bank” that would take over all the NPLs of Italian banks and would then sell the loans on the market. Italy has now submitted a new plan under which banks could obtain public guarantees that would help them sell the bad loans. Both this plan and the earlier bad-bank proposal involve transferring the risk and financial burden to the public sector, which would be directly contrary to the European Commission’s objective of having bank bondholders, in addition to shareholders, as the first line of defense. Draghi did seek to disabuse those who think that a rapid, comprehensive solution is likely or desirable. Using Ireland as an example of the appropriate approach, he said the correction will have to extend over a number of years. In view of the size of Italy’s NPL problem, that time frame does appear necessary.
An earlier development in Italy’s banking crisis occurred in November with the failure of four small banks. What caught the market’s and the public’s attention was the bailout process, under which all stakeholders were put at risk. While this bailout was conducted by the national authorities, it signaled the kind of political issues likely to arise in relation to Europe’s new Single Resolution Board, which will handle all future bank failures, deciding when a bank has failed and should be put into “resolution.” It has strong powers to force senior creditors and even large depositors to take losses before public money can be used. In the case of the failure of the four small banks, the Italian government was forced by public pressure to promise financial help to those who were hardest hit.
The transition of the European banking system to a “banking union” should result in a stronger, more resilient system, as Draghi has asserted. It will mean the more loosely regulated and supervised national systems in Europe will have to operate under a more rigorous European regime. There will be political headwinds to this transition, especially over the extent to which public funds should be used to support financial institutions in difficulty or to compensate stakeholders suffering from losses. This issue relates to political differences about the size of public debt and responsible fiscal policy. In Italy's case, we note with concern that its debt-to-GDP ratio is 132%. Any government plan that will shift the 200 billion euros of NPLs now on the books of Italian banks to the Italian government will surely add to the nation’s debt.
Positive But Vigilant
We are not seeing indications that the problems in Italy’s banks are leading to contagion elsewhere in Europe, but we are carefully monitoring the situation. We maintain a positive view broadly for European equities as recovery in the Eurozone proceeds and further financial stimulus by the ECB now looks likely as early as next March. However, we do not include Italian equities in this positive view. We have not held an Italian equity market ETF in our International or Global portfolios for some time. While Italy’s economy picked up its pace of advance in both manufacturing and services in December and is projected to grow at a 1.4% rate this year, just slightly below the 1.6% average for the Eurozone, the downside risk from the banking crisis is quite worrying. Over the last six months through January 21, the iSharesMSCI Italy Capped ETF, (N:EWI), has done worse -- down 21.47% -- than the iShares MSCI EMU (Eurozone) ETF, (N:EZU), which is down 17.48%.
A Commentary by Bill Witherell.