Brexit and Italy’s Pandora’s box of banking malaise

The Brexit referendum did not impact only British politics but also outside the British Isles.

Apart from spinoffs such as encouraging eurosceptics like Marine Le Pen in France, xenophobics in Hungary and other countries, it is now having a direct impact on an unlikely country, Italy.

Brexit has caused a chain reaction that has exposed the problems in the Italian banking system. The UK’s decision to leave the EU made investors fearful that the union would face a new crisis or even break up. This, together with internal Italian reasons, led to a swift withdrawal of these funds from the most fragile sections of Europe’s financial markets.

Italian banks are one of these most fragile areas. The main problem with Italy’s banks is that they are swamped with non-performing loans. These are loans on which the debtors have not made scheduled payments for at least 90 days. In other words, Italian banks are not getting back some of the money they have lent out.

According to data from the Bank of Italy, NPLs of Italian banks amounted to €360 billion in 2015, or 18.1% of all loans they made. Of these loans, €210 billion are really bad and no longer collectable. The remaining €150 billion are of slightly higher quality.

Italian banks are thus incredibly exposed to NPLs. These equal almost a quarter of Italy’s GDP and a third of the total NPL exposure of EU members. Practically speaking, NPLs are a big drag on the ability of Italian banks to finance investments and growth in the real economy. Accordingly, it is a major threat to the stability of the entire EU.

This NPL problem has its origins in the seven year recession that followed the 2008 global financial crisis and the ensuing European sovereign debt crisis. The reason is simple: if the economy does not go well, companies and households struggle to repay their debts to the banks.

Another cause of the NPL problem is the fact that Italian bank managers also made bad investment decisions, often allocating loans on the basis of favouritism. It would not be an exaggeration to say that an independent inquiry on the issue should be established, a sort of NPL audit which should be open to independent experts and civil society.

Another cause of the NPL crisis is the Italian government’s inability to solve the issue, as other European countries have. Germany and France for example intervened directly with state funds to provide new capital to their banks, thanks also to relatively more solid public finances.

Ireland and Spain have instead used bad banks cofunded by both states and private investors. These so-called bad banks use these funds to buy other financial institutions’ bad loans. They focus on managing the non-performing assets, for instance by trying to recover the money from borrowers. The other institutions, relieved of their bad debts, can instead healthily resume their normal activities of lending and borrowing. Direct state bail-out and bad banks are not mutually exclusive solutions. In fact, they are often used together.

In the case of Italy, the government could not intervene directly with public money. Italy’s huge public debt does not give fiscal space for substantial public funds going to struggling banks. Some exceptions were made for several banks including Banca Monte dei Paschi di Siena in the period 2008-12.

More importantly, by the time the Italian government decided it would do something about the small troubled banks in 2015, new EU rules, including a bail-in, were already on their way to being fully implemented. These dictate that when a bank is in crisis, its creditors – bondholders and depositors together with shareholders – would bear the burden by having part of the debt they are owed written off. This was so that governments could avoid rescuing banks using taxpayer money.

In other words, Italy’s banks are in a dire enough situation to require direct state intervention, but this cannot be done under current EU banking regulation. As a result, the Italian government is clashing with the European Commission to develop alternative and more complex solutions which avoid relying on taxpayer money.

Unfortunately, these would merely keep the banks alive, but do not thoroughly restructure their governance and business strategies so that they could start lending again.