Another summer, another credit crisis in the Eurozone

There is a new crisis brewing in the EU, tough this time it has failed to generate the mainstream coverage that was afforded to Greece when their tragedy was at its climax last July. With attention on Brexit, terrorism and a full calendar of sport, the fact that Italian banks are teetering on the brink of collapse has certainly not been ignored, but still is not headline news. However, this crisis is as potent as Greece in being a potential major disaster in the making. Maybe the lack of attention is simply down to the fact that, no matter how much the EU and its institutions will have to bend their own rules, we all know deep down that this will not be allowed to put the project in danger. Just as Greece, the birthplace of democracy, saw the will of the people ignored to postpone the inevitable default of the Greek state, so we can expect Italian banks to be rescued. For now.

In fact, Italian bank shares have been selling off for a long time, and they are approaching the levels seen at the height of the European sovereign debt crisis four years ago. They are suffering because the Italian economy – the 8th largest in the world according to the IMF – is in trouble. Growth is anaemic; real GDP is at the same level as it was 15 years ago. This has led to a credit crisis, with about 8% of Italian bank loans officially classified as non-performing – though other estimates put the number as high as 15%, equivalent to €360bn. Siena-based Banca Monte dei Paschi is the worst hit, counting an astonishing 35% of its loans as non-performing.

On July 29th the European Banking Authority released results of stress testing of 51 of the regions lenders. The test itself is ridiculous: it ignores sovereign defaults (bank regulation has always regarded OECD sovereigns as risk free, so it is no surprise) and a prolonged period of negative rates (which is a surprise, since it is virtually guaranteed to happen and is already impacting banks’ profitability). The actual leverage ratio requirement which forms the basis of the test is also questionable; at only 3% it is hardly sufficient to sustain a major shock. A research paper by Viral V. Acharya, Diane Pierret, and Sascha Steffen applied US regulatory stress scenarios to the 51 banks and found that they need €123bn in fresh capital. Anyway, even a flawed test produces results, and in the ECB’s Monte dei Paschi was the only bank to fail. They promptly announced a rescue package aimed at raising €5bn of capital. It won’t be enough. Unicredit, Italy’s largest bank, also fared poorly in the test.

Trust politicians and bureaucrats to come to the rescue. A few weeks back ECB chief Mario Draghi, himself a former governor of the Bank of Italy, pre-emptively endorsed the idea that governments could bail banks out of their troubled non-performing loan (NPL) portfolios, in strict violation of EU state subsidy rules which were tightened significantly after everyone but Italy recapitalised their failing banks back in 2009. In a round-about way Mr Draghi pulled NPLs into the ECB’s remit by suggesting that problems in banks would lead them to restrict lending, thereby impacting the effectiveness of the ECB’s monetary policy.  Of course he never mentioned Italian banks specifically, but Italy’s prime minister Matteo Renzi has already indicated that he wants to go down this road, petrified as he is of letting creditors “bail-in” the banks when they inevitably fail. His fear is reasonable, not only depositors but also subordinated debt holders will be hit, and Italian retail investors hold large amounts of Italian bank sub debt. Italy will sink when the bill has to be settled.

The path should be clear as well. The main opponent of state subsidies, Germany’s chancellor Angela Merkel, is weakened by the refuge crisis, and in any case she will fall in line when it becomes evident that Deutsche Bank – estimated by Acharya, Pierret and Steffen to need €19bn of new capital – is in trouble. There is room within EU rules anyway, as they allow a “precautionary” government rescue without putting banks into bankruptcy, if needed to preserve financial stability. Trust this cop-out to be interpreted widely and used liberally when required.

So it all points to a classic fudge, billions will be spent kicking the can down the road. And the road ends in disaster. Added to the already enormous sovereign debt problems, the problems in Europe’s banks can’t be solved without some severe pain, something which politicians simply won’t admit. Pain is a poor re-election strategy. So we will watch this crisis temporarily patched up and wait to see which bubble pops next summer.

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