Big Banks, Small Banks: Monte dei Paschi and Feasible Ways to Deal with Non-Performing Loans

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Big Banks, Small Banks: Monte dei Paschi and Feasible Ways to Deal with Non-Performing Loans

By Anton Nartov

The year 2016 has been full of unpleasant news for the European banking sector. It started with profitability and capital concerns about Deutsche Bank which resulted in its shares hitting an all-time low in September – worse than during the Great Recession. Another issue it related to Italian banks and specifically Monte dei Paschi, whose share prices have not seen steep upward movements since 2014, and whose bailout is to be discussed this weekend. The world’s oldest lender, however, is not the only problem for the Italian banking sector – most of the biggest banks in the country are currently being merged or recapitalized to finance a €360 billion pile of bad loans, which could potentially trigger worldwide economic disturbances via threatening Italy’s Eurozone membership. Analysts are certain that at least some of these banks will need government backing.

In July, the European Central Bank required that Monte dei Paschi reduced the share of non-performing loans (NPL) by around €32.3 billion by 2018, which triggered worries about solvency of the latter and Italy’s banking system overall. The situation is worsened by Matteo Renzi’s defeat at the recent Italian constitutional referendum that resulted in a turmoil of European markets and growing yields of Italian bonds. For Monte dei Paschi, which is Italy’s third largest bank by assets, this means increasing chances of collapse, since an attempt to raise the required €5 billion of additional capital by private sector investments is now likely to fail. Renzi tried to avoid a public bailout by any means, and Monte dei Paschi could have been rescued by such investment banks as JPMorgan and Mediobanca that were prepared to execute the plan. Another option was Qatar’s sovereign wealth fund; however, both plans have been declined due to the current political situation – investors are concerned about the high level of political uncertainty in Italy and anti-euro parties that potentially might come to power. Besides, it is obvious that these resources will be used to cover future losses, which does not make Monte dei Paschi an attractive investment, and this explains the awful share price performance throughout the year.

Thus, the only feasible option to avoid a wider banking crisis after Renzi’s defeat is pumping government money under so-called precautionary recapitalization, which involves a state injection of cash, bail-in of bondholders by converting their bonds into equity, and a set of compensations for small investors. It is worth mentioning, however, that the bailout is a complicated option for Italy, since under the new set European Union rules, bondholders are those to take a hit in case of a public bank bailout, which is introduced as a means to protect taxpayers. The problem is that the majority of bondholders in the case of Monte dei Paschi are individual investors, and a bailout will lead to either breaking the European Union rules and growing levels of budget deficit in Italy, or dramatic losses among investors holding subordinated bonds of the bank, who believed their savings were well protected.

The latest news reports state that Italy is demanding more time to make a €5 billion injection (specifically, until mid-January) in order to protect some bondholders, and if the ECB does not provide time, the bank is likely to be bailed-in in the upcoming days, leading to severe losses among these bondholders (according to EU regulations). Besides, speaking of macroeconomic indicators, Italy is currently facing the second highest debt level in the European Union (followed by Greece), so a government cash injection does not only damage individual investors, but also macroeconomic stability of the country, thus raising concerns about health of the European economy and stimulating safety-seeking behavior among investors. And although other options are being discussed by the press (such as exploring loans with the European Stability Mechanism), precautionary recapitalization is most likely to be undertaken by the government of Italy, although it has been attempted to avoid by any means.

To sum up, in spite of the medium term uncertainties faced by Monte dei Paschi, the main issue is the long run development of Italian banks. If non-performing loans are covered and the bailout is successful for Monte dei Paschi, the current and future issues are not solved completely unless there is a marketplace that can provide liquidity for NPLs, which also implies collateral as a means to compensate investors if the loan is unpaid. The solution of these issues is a topic for a different discussion, and in the nearest future we are likely to see what will be done to resolve some of the largest problems of the European financial sector.