Earthquake in Italy: European banks tremble

Another vote, another shock

Yesterday, Italy became the most recent domino to fall in the global populist revolution about which I wrote in this month’s MI magazine. If Mr Cameron (score: 48 percent) resigned at half past eight in the morning, Signor Renzi, the Italian Prime Minister (score: 40 percent) resigned at midnight. He had offered the Italian people some quite reasonable constitutional reforms (reduction in the powers of the Senate and a curtailment of regional governments) but they used the vote to register their general dismay with the status quo. Another metropolitan sophisticate Prime Minister has been humbled.

With a NO vote seeming inevitable in the Italian referendum, the Euro fell below $1.06 in late trading late on Sunday, down 0.8 percent from Friday’s close. The common currency had already registered sharp losses since the beginning of November, when it was trading close to $1.13. This morning European bourses have thus far shrugged off the vote (the FTSE-100 opened higher), though bank stocks are down. Italian government bond yields have risen sharply.

A possible systemic crisis across the European banking system would have huge repercussions for Europe’s economy.

As I have been arguing for some time, we are facing the prospect of a European Spring in 2017 which will make the Arab Spring of 2011 look like a Sunday afternoon promenade. These seismic political shocks come at a time when the European banking and financial system is extremely fragile. Italy, with a banking sector burdened with unparalleled volumes of non-performing loans (NPLs) and a state sector sinking under unsustainable levels of debt, is under extreme financial stress. Yet, being the third largest economy in the Eurozone, it is too big to fail. But how could it be saved?

French and German banks are highly exposed to the Italian banking sector. A possible systemic crisis across the European banking system would have huge repercussions for Europe’s economy. How bad is it? What are the policy options available to the ECB and European governments? And how can savers and investors in the UK – where we are mired in the imponderables of Brexit – best protect themselves?

The Italian Question

Italy can boast the dubious distinction of having the third largest government bond market in the world with well over €2 trillion of outstanding government debt in circulation. Much of that debt is held by Italian banks who regard government bonds as a source of zero risk return. In the old days, of course, when the base rate on the Lira was around 14-17 percent, Italian bankers could go out for long, excellent lunches and still make money. In a world of zero-interest rates, that’s not so easy. But government papers still account for a large slug of the assets side of their balance sheets. The Italian state and its banking sector are intimately co-dependant. If one goes, it takes the other with them.

Banca Monte dei Paschi di Siena is the oldest bank in the world, founded in 1472. Its fate is highly uncertain. It has had two bailouts already and a third is now proscribed by EU rules. Currently, it is the subject of a complex €5 billion recapitalisation. And the entire Italian banking system is in trouble. Italian banks hold over €4 trillion of loan assets of which nearly 20 percent are distressed (depending on which figures you believe – it could be more).


One of the problems of the Italian banking system is that the insolvency regime in Italy is very slow to classify a bankrupt company as insolvent. Therefore, a lot of zombie companies peg on for years when they are in reality broke. This means that, if anything, the official statistics for NPLs are an under-estimate. Just to compare with Italy’s peers, only 5 percent of all outstanding bank loans in France are non-performing. In the US it is 2 percent and here in the UK it is just 1.5 percent.

Behind the statistics for the volume of NPLs a dark picture of economic failure is emerging. An astonishing 97 percent of Italians have lower disposable incomes today than they had in 2005. Of course, here in the UK the Institute for Fiscal Studies (IFS) told us last week that median wages had not improved for – get this – ten years. But the fact is that while the UK has grown since the financial crisis, Italy’s GDP is some 7-8 percent below its 2008 level. The sclerotic growth record has much to do with the way that the single currency has dis-favoured nations which tend to run current account deficits.

Under the EU Stability and Growth Pact (1998) Eurozone member states must keep their budget deficits below three percent of GDP, and should sustain a national debt of less than 60 percent of GDP. Italy’s target budget deficit this year will be 2.4 percent and 2.3 percent in 2017[i] – better than previously thanks to draconian anti-tax dodging measures. (The Italian tax authorities have the right to withdraw money from citizens’ bank accounts automatically). But Italy’s debt-to-GDP ratio has soared to a current level of over 142 percent of GDP, attracting the unwelcome attention of the European Commission.

I doubt that even a government headed by Beppe Grillo’s Five Star Movement would actually initiate Quitaly (an Italian exit from the EU). They know, as the Greeks do, that to exit the Euro would trigger national default and would plunge the banking system into crisis anyway.

Meanwhile in Brussels… the Greek Question…

Eurozone finance ministers will meet today in Brussels to discuss short-term debt relief for Greece. Germany’s Finance Minister, Wolfgang Schäuble, has stuck to the line that Greece must implement further “reforms” and should not nurse hopes of any debt being “forgiven” (as bankers say).

But the Greeks believe that this juncture may be a moment for them to escape their bondage. “Everyone realizes that Europe cannot stand a rekindling of the Greek crisis, when there are issues with Italy,” said the Greek Government spokesperson, Dimitris Tzanakopoulos last night. “The general uncertainty which prevails in Europe – which is both political and financial – creates a momentum for a comprehensive and permanent solution for the Greek issue.” In other words the Greeks want debt relief as a price for political solidarity in a moment of crisis. Who can blame them?

Bank of Greece Governor Yannis Stournaras said new measures were needed to lighten Greece’s debt burden. One option would be to extend the maturity of existing long-term loans from various EU stability mechanisms by another 20 years or so. For as long as Euro interest rates remain low, that will ease the debt service requirements by shunting repayments of principal into the Neverland of the very long-term.

How bad is it?

Europe has been mired in crisis for years – in fact it has become habituated to living on the edge. So there are those who will shrug their shoulders and suppose that Europe will somehow muddle through (as the English do); as well as those who will see that the hour of doom is come.

Young Neapolitans and Athenians, with very little career prospects regardless of their educational attainments, vote with their feet and head North.

Europe’s fundamental problem – particularly in the South – is that it has not been able to generate sufficient growth. All European countries (including the UK) have been performing at well below their long-term trend growth rates since the Credit Crunch. This could be due to cultural and societal factors, though I doubt that. It is more likely that, as American economists Carmen M Reinhart and Kenneth S Rogoff have argued, the volume of debt in the economy has crowded out investment. Further, the management of the single currency has resulted in huge imbalances between surplus countries (Germany and the Netherlands) and deficit countries (much of the South). Such trends are self-reinforcing. Young Neapolitans and Athenians, with very little career prospects regardless of their educational attainments, vote with their feet and head North.

At present there is no prospect that these trends will be reversed. There is no agreement on structural reform at the European level and there is no serious alternative political class ready to take over, in Italy at least. (Sorry, Signor Grillo). So it’s bad; and it is likely to get worse.

What are the policy options available to the ECB and European governments?

Italian government expenditure already accounts for more than 50 percent of the country’s GDP. So there is little scope for the government to stimulate the economy by increasing state spending further. Increases in tax would take spending power out of the economy. The fiscal options for any new Italian government are very limited and no one can agree on what measures need to be taken to stimulate growth, though Signor Renzi was at least trying. A caretaker Prime Minister will be unlikely to initiate reform.

In terms of monetary policy, the ECB is already printing money like crazy with a bond-buying programme amounting to some €80 billion per month, and interest rates, as we know are negative, meaning that banks have to pay the ECB to hold overnight funds.


The only practical action that the authorities can take in order to forestall an imminent banking crisis in these conditions would be to impose restrictions on deposit withdrawals, as happened in Greece in the summer of 2015. European depositors are already facing increasing tariffs for even the most basic banking transactions. They could wake up soon to find that the cash machines can only dispense maybe €50 per day. Southern Europeans use cash more than the credit card-carrying Northerners, so they will be disproportionately affected.

How can savers and investors in the UK best protect themselves?

I wrote about this in my piece on Financial Armageddon in the November edition of the MI magazine. We should always be aware of which of our cash deposits are protected by deposit insurance schemes. The UK banks, although well capitalised (save RBS (LON:RBS), or so the stress tests tell us), will be hugely impacted by any banking crisis in Europe. Since the return on cash is effectively zero, you should only hold as much cash on deposit as you need to. Another reason to buy gold, perhaps.

Crisis investing

There is a school of thought amongst master investors that a crisis is the best moment to make a killing – and not just by shorting stocks and bonds that are about to crash. In the confusion and shock after a crash many sound assets become undervalued. Agreed, this is not a great time for those who aspire to a quiet life.

[i] Se WSJ, 15 October 2016: http://www.wsj.com/articles/italy-unveils-2017-budget-plan-1476558935