Is Italy Europe’s next (banking) crisis?

Since the outbreak of the global financial crisis in 2008, the European Union has made great strides in insulating its banking system. A banking union has been created and more than 40 legislative and non-legislative measures have been proposed, all to strengthen the banks, the euro and the financial architecture at large. Despite shortcomings and work ahead, progress has been made.

Now, Brexit has rocked this edifice. The ensuing market turmoil has put Europe’s banks in the spotlight. Barclays, RBS, Deutsche Bank, Société Générale, Unicredit, all saw their stock prices decline by 25% or more. Shortselling and extremely low interest rates that make lending less profitable, are putting pressure on the whole banking market.

But Italy in particular might be the catalyst for the next European banking crisis. Its banks are in the eye of the storm. They are sitting on roughly €360 billion (more than 20% of Italy’s GDP) of foul loans. Previous attempts by Prime Minister Renzi to solve this issue have failed. Experts estimate he needs €40 billion to cushion the banks against their losses. Renzi would like to inject public money but that would be illegal state aid under EU rules. The EU’s banking directive – as a consequence of the financial crisis – doesn’t allow a simple bail-out where taxpayers end up coughing up the cash for bank rescues. Instead, to protect taxpayers, it forces the banks’ investors to be bailed-in and take a hit.

This is a political nightmare for Renzi. Unlike in other countries, in Italy, these investors to be bailed-in aren’t just some kind of corporate giants who could stand a loss; they are ordinary Italian families. They own roughly 40% of bank debt. When the government applied these bail-in rules for a couple of small banks last November, widespread protests erupted. Already fear seems to be spreading in the market. A simple Google Trends analysis of the search term “Italian Banks” shows that, according to Google, there has been a breakout moment. July has seen a drastic increase of such searches.

This is the last thing Renzi needs. He’s already suffered a bloody nose in the local elections a month ago when he lost the mayoral contests in Rome and Turin to the 5 Star Movement, and now has to look towards his October national referendum on constitutional reform, on which he has staked his political future. Should this episode cost him the October referendum, Italy would be in a political crisis with no clear idea where it could lead. Undoubtedly, it would embolden the 5 Star Movement, particularly in its call for Italy to abandon the euro.

Italy’s banking issue is opening well-known wounds: it is again pitting the northern creditors against the southern debtors as well as banks against governments.

Chancellor Merkel has already said that the new rules for bank rescues have to be respected while Eurogroup President Dijsselbloem tried to downplay the issue this week saying that he sees no acute crisis with Italian banks. It’s understandable that Germany doesn’t want the EU’s banking union to fail its first test and have again more taxpayer money propping up banks; an issue that has led to widespread societal resentment against the financial sector and governments. Yet, to me Germany’s current dogmatism is a bit rich. Italy didn’t pursue any bailouts during the 2008 financial crisis while Germany whipped up a nearly €500 billion bank bailout programme. That’s of course a different context and the rules have changed since then, nonetheless it does leave a somewhat hypocritical aftertaste.

Germany’s Finance Minister Wolfgang Schäuble seems to have left the door open to some flexibility by not ruling anything out and is simultaneously temporizing. By arguing at this week’s Eurogroup meeting that one should wait for the results of a European bank stress-test, which will be published later this month, he’s buying more time. The question is, is he doing this to strengthen his bargaining position vis-a-vis Italy or because the results of the stress-test could give an objective assessment from which to legally take action? Or maybe both? Should the stress-test as expected come out negative for Italian banks, requiring them to raise more capital, it would clearly worsen the situation. It could lead to even higher losses, as was the case when the ECB sent a confidential warning to Monte dei Paschi di Siena a week ago. This would increase market pressure on Renzi and could put pressure on him to follow options prescribed by the Eurogroup/Schäuble with restructuring strings attached (and yes, restructuring of the Italian banking sector is necessary). But couldn’t such a strategy also backfire if there isn’t already an outline of an agreement fixed prior to the stress-test publication? Once the stress-test is published, couldn’t a market reaction be faster than political talks can come up with a solution if they haven’t by then come up with one? What if it prompts investors to stop lending and depositors to withdraw their money leading to a bank run? And wouldn’t a solution under such conditions possibly end up being more expensive than already coming up with a solution now under manageable circumstances?

Renzi has already started hitting back at German intransigence by pointing out the massive risk of Germany’s Deutsche Bank. At a joint press conference with Swedish Prime Minister Löfven he argued “if this non-performing loan problem is worth one, the question of derivatives at other banks, at big banks, is worth one hundred. This is the ratio: one to hundred”. Deutsche Bank, with its €54 trillion derivatives book that’s five-times the entire economic output of the eurozone, certainly is a problem. It has failed the stress-test in the US and its share price has taken a beating. As a possible indicator of worries, over the last month, google searches for its share price in Germany have increased by 800%. Worse yet, all these financial players are of course interconnected. Should Italy’s banking crisis worsen it could put pressure on Italian government debt to which again a whole range of other players are exposed. French and German banks hold around €330 billion of Italian government bonds with Deutsche Bank alone having more than €11 billion on its books.

Deutsche Bank knows how dire the situation is in Europe’s banking sector. That’s why its Chief Economist, David Folkerts-Landau, proposed on 9 July a €150 billion rescue fund to recapitalize European banks. This, however, is three times as much as the €40 billion needed by Italy’s banks and it seems Deutsche Bank is using the Italian banks as a pretext to launch a larger rescue fund that could buffer banks more generally and stabilize their bonds and shares by providing investors with more security. This plan has already been met with great opposition by various political parties.

So far it seems that only France’s Finance Minister, Michel Sapin, has shown flexibility towards Italy arguing that “it’s our duty to show solidarity…and apply the rules in an intelligent manner.” Indeed, there are exemptions in Europe’s state aid rules that could allow public money for Italian banks. For example, bail-ins could be avoided under exceptional circumstances, if they could have disproportionate results. And forcing losses on Italian household investors, could possibly fall under such a definition. This and other possibilities will undoubtedly be looked at, as the situation progresses.

Brexit isn’t solely responsible for Europe’s banking sector woes. But it triggered a shock that has exposed the significant underlying weakness that still remains in Europe’s banks, particularly for Italy. This is yet another European litmus test. If the EU and its Member States cannot come up with a sound solution, beyond the usual euro fudge of muddling through, markets could trigger a banking crisis with resulting political consequences that would further strengthen populists from Italy’s 5 Star Movement to France’s Le Pen.