Italy: Unresolved bankingsector issues remain a burden for bonds
While the new bank rescue fund will diminish the chances of near-term recapitalizations failing, the outlook for the Italian banking sector remains grim. Especially, the banks are burdened by considerable contributions to different funds. In addition, the size of the fund is small and the problem of nonperforming loans will be solved slowly at best. The prospects of Italian banks supporting economic growth any time soon look slim. We find more value in Spanish than Italian government bonds.
New bank recapitalization fund adding pressure on the banking sector as a whole: Italy announced that it will establish a new fund ‘Atlante’ to operate as a backup in the capitalization cases in the Italian financial sector on Monday.
The size of the fund will be EUR 5bn. According to the available information, the major part of the fund will be collected from the commercial banks. This will add up to the burden of contributions that the Italian banks are obliged to pay to the deposit guarantee fund and the resolution funds. We estimate that annually these contributions (without the new fund) will amount to EUR 2.5 – 3.0bn in the coming years (see Table 1). The fund is backed by the government. The technical details of that organization are to be revealed.
A large share of contributions is due to the resolution activities that were undertaken by the Italian authorities in November 2015 in order to save four small banks. The Italian resolution fund at that point provided EUR 3.6bn, which means that the Italian banks are due to pay significant expost contributions until the hole in the fund is fully covered.
The huge contributions to the different support mechanisms and safety nets will put a huge burden on the already weak profitability of the Italian banking sector.
The capacity of the new fund limited
Taking the November actions as an indication how the new fund could be used in a worst case, one inevitably ends up into a conclusion that EUR 5bn will not be enough to save the Italian banking sector. If it cost EUR 3.6bn to recapitalize four small banks, EUR 5bn does not seem that large, assuming of course that a number of larger banks need capital.
The size of the fund is almost comparable to the estimated amount of contributions by the Italian banks to the bankingunion-wide Single Resolution Fund (SRF). Based on the size of the banking sector (excl. capital and covered deposits), those contributions are estimated to amount to around EUR 6bn out of the EUR 55bn fund in total. However, the SRF is sized under the assumption that it will be used only after an 8% (of the balance sheet) bail-in, which is likely to be enough to cover losses in all but the most extreme cases.
So far, the Italian authorities have been very reluctant to use the bail-in tool to solve the problems in the banking sector, and the new fund is a strong signal that reluctance to continue. However, without a bail-in, the capacity of the new fund will not amount to much more than supporting the recapitalizations of a couple of medium-sized Italian banks.
Changes to insolvency legislation will help, but…
The Italian insolvency legislation is a big obstacle to resolving the huge problem of non-performing loans (NPL), which have been estimated to amount to as much as EUR 350bn. Because of the inefficient system, it can take many years to seize and sell the collateral backing a loan.
The government now intends to reform the insolvency system to make it more efficient, which is welcome. However, it will take a long time for the new legislation to help resolve the NPL issue, which means that no quick solutions are in sight.
The most distressed
In terms of value, non-performing loans held by Italian banks totalled around €350bn in the last quarter of 2014, nearly four times higher than the amount accumulated in 2007.
As the chart below shows, more than half of these loans were made up of “bad debts”, a classification signalling that they are the most distressed of the pile. While the value of “loans overdue” — the least worrying subgroup — fell in 2014, the amount of bad debts and substandard loans grew 13 per cent.
Banking sector not in a position to support economic growth any time soon
While some steps are being taken to repair the Italian banking sector, the process will be very slow at best. The current strategy assumed by the Italian authorities seeks to spread the cost of the problem across the entire banking sector, which will hurt profitability and with that the outlook for loan growth. While the ECB’s targeted longer-term refinancing operations (TLTROs) will guarantee cheap funding, it is unlikely to be enough to overcome all the other headwinds. The state of the Italian banking sector will continue to limit the potential of the Italian economy for now.
Italy’s five largest banks hold the bulk of the country’s non-performing loans at around two-thirds of the total value. This is not only because of their larger absolute size but also because they have a higher average exposure to bad loans than small banks, at 18.5 per cent versus 17.8 per cent according to a Bank of Italy study.
However, where smaller banks are concerned, this lower average hides numerous single cases of large exposure, as the recent rescue of four small Italian banks demonstrates.
The worst-hit banks have been UniCredit and Intesa Sanpaolo, which together accounted for about €150bn of impaired loans in 2014. Both also have an above national average exposure to non-performing loans at around 20 per cent according to S&P Capital IQ.
Spanish bonds with more value than Italian ones
Spanish bonds are the closest comparables to Italian government bonds. We see more value in Spanish bonds at the moment, especially in the 10-year sector, where Spanish bonds offer more pick-up over Italy than in the 5-year sector. While the bonds of both countries will benefit from the ECB’s bond purchases and upcoming TLTROs, we see more risks in Italy due to the banking sector issues than in Spanish politics. Further, the Spanish growth outlook is much better compared to Italy, while government debt is lower.
Spain faces its own uncertainty, since the government formation negotiations have been continuing for months without concrete results. In fact, new elections will likely take place in June, but according to the recent polls, the results will not be that different compared to last December. As a result then, government formation will probably be hard also after the elections.
The real risk to the Spanish outlook would be an anti-reform government, which could be formed by the Socialists (PSOE) and Podemos. However, at least in light of the recent polls, these two parties will not be able to form a government, at least not without help from other parties. As a result then, while the political situation is unlikely to support a continued reform path, a reversal of the previous reforms does not look likely either.
Sources: Nordea Bank, FT, Bloomberg, ECB