5 December 2016

Don’t worry, Italy won’t bring down the banking system


Last weekend’s referendum defeat for the Italian Prime Minister, Matteo Renzi, has been depicted as another pro-populist blow against the European Union and its minions, and an advance tremor ahead of the coming collapse of the Italian financial system.

It is neither. If there were anything “populist” and anti-status quo in this drama, it was in Renzi’s reform proposals, not the opposition to them. As for the earthquake due to bring the Italian banking system tumbling down, don’t hold your breath. Italy’s banks have problems, but they are solvable problems.

This is why the rejection of Mr Renzi’s referendum was greeted by an almighty shrug in the markets. The overall index of Italian banking shares went down – a bit – and then went back up.

The markets are reflecting what they already know, the fact that the reform of Italian banking is an on-going story, and so far it is not a story of failure but of success.

Italy is a strong, well-diversified advanced economy with a healthy current account surplus: in that context the real problems of Italian banking are fixable, and that is exactly what the Italians have been busy doing.

To understand what is going on in Italy’s finance sector, it helps to stand back for a moment and survey the sad story of banking since the financial crash.

Just about everywhere in the G20 economies, private banks emerged from the crisis in terrible shape, having had to be bailed out by taxpayers or by taking emergency transfusions of capital from rescuers such as sovereign wealth funds – rescuers who charged steeply for their services.

But the bailout phase was just a rescue – a bid to keep the banks alive long enough to get to intensive care and start investigating what was really wrong. What was wrong turned out to be the fact that banks had spent years issuing loans that were never going to be paid back. Italian banks were as bad as most.

Thanks to the generous European taxpayer, the region’s banks fairly quickly got rid of the crazier items on their books – things like collateralised debt obligations, which were accounting fictions usually based on near-worthless residential property loans.

But it then transpired that the crazy stuff was only one small part of the problem. In an EU economy set to grow below trend for years, banks also had huge holdings of loans that were merely poor quality.

These may have looked fine in the boom years when there was always another refinancing offer around the corner. Post-crisis, with regulators turning their credit-rating noose ever tighter, they no longer looked fine.

These are the so-called non-performing loans or NPLs that Italy’s banks are struggling to purge – and Italian banks have a lot of them. The NPL maths is always partly guesswork, but the total for Italy probably amounts to somewhere between €300 billion and €400 billion.

The NPL name is somewhat misleading, because in most cases the loans are “performing”, but just not very well. As in other European economies, only a small proportion of the loans are residential property-related.

They may be business loans, secured on business assets, or even on turnover. They may be packages of leases of anything from buildings to machinery to intellectual property. They may be credit card debt, or unsecured personal loans.

Whatever, the banks want them off their books in order to clean up their balance sheets and capital adequacy ratios and keep the regulators happy.

The story of the banking sector for the last five years or so has been the story of the NPL market. Banks package up their loans, usually with a mixture of good, not-so-good and very bad loans in the mix.

They then sell them to specialist investors – often to private equity funds that currently have a lot of cash to invest but are finding it difficult to find good companies to buy – who will administer them, running the good loans like a bank might and recovering assets from bad loans where possible.

This is something that has been happening across Europe. In the UK the process is almost complete. In Greece it has barely begun. And in Italy there has been a lot of progress, with Italian banks putting more NPLs into the market this year than in any other EU economy.

Successful purging of NPLs depends on governments. The sale of an NPL package requires that a lot of conditions be fulfilled: there has to be a creditor-friendly court system that allows recovery of assets. There has to be a legal framework that allows “securitisation” of debts – essentially the packaging up of loans in a form acceptable to financial investors.

And banks have to have realistic expectations of the prices they can expect from their NPL sales, something that often takes a bit of what analysts quaintly call “moral suasion” from the relevant minister. That is, governments have to tell banks to pull their fingers out and get selling, or else.

Italy’s record is good. Although investors still complain that it can take five years to recover assets through the courts, they can be recovered. Securitisation has been updated, with a new securitisation law passed in 2014 that put NPL packaging on to a much more secure footing.

Investors are keen to buy Italian private debt, which is why the total value of completed plus on-going NPL transactions this year will probably be equal to about a quarter of the estimated total of outstanding loans.

That is a serious step to cleaning up the sector’s problems. No other European banking sector has come anywhere close to that level of NPL clearance this year – the closest is Ireland, another economy where banking stabilisation is well advanced.

The hapless Mr Renzi’s referendum failure has not made banking reform easier. Some smaller banks may need government money. But the reverberations are not sounding very loudly in Italy itself – and it is Italian sentiment that counts, since Italy’s banking clean-up is largely a matter of Italian buyers investing in Italian debt.

If you want to find a rotten European banking sector, you have to look elsewhere to economies that have not even begun to grapple with their bad loans and systemic vulnerabilities. Try Portugal. Try Greece. Italy, no. Not so much to see here.

Richard Walker is a journalist and communications adviser to financial companies.