Italian banking is the next shoe to drop

Scott Sumner refers to The Second DominoVia Kevin Drum, the WSJ reports:

In Italy, 17% of banks’ loans are sour. That is nearly 10 times the level in the U.S., where, even at the worst of the 2008-09 financial crisis, it was only 5%. Among publicly traded banks in the eurozone, Italian lenders account for nearly half of total bad loans.

This is potentially a bigger story than Brexit, as it has the potential to bring the entire eurozone to its knees.  The notion of a bail-in already has been discarded, with Merkel’s blessing, as most people realize that would lead to unmanageable runs on eurozone banks.

Italy is the third largest economy in the eurozone, and so it is not so easy to bail out on a large scale.  Germany and France have elections pending, and they are not keen to put in money in any case, not after the Greek debacle.  In terms of per capita income, Italy has not seen real growth in over fifteen years, and so a bigger than expected bank bailout would be tough for them to swallow.

Here is Zero Hedge for one of the more dramatic views.

In principle an Italian wealth tax could pay off the implied debts, but that is probably unacceptable; an attempt at such a tax was repealed rather rapidly a few years ago.  Otherwise Italy is short of money and Germany doesn’t want to be left holding the bag, with that commitment being tougher to swallow once various country “exits” are on the table.  In terms of politics, Italy is possibly facing a constitutional crisis and governance vacuum of sorts, with a pending referendum and no option in sight to make the people happy.

The key is to avoid potential bank runs and Italy and elsewhere, but how?  It’s not that hard or costly to switch money from one eurozone bank to another, and the Italian government is counting on a lot of inertia here.  So this is a tough one.


"Here is Zero Hedge for one of the more dramatic views."

You don't say?


The trigger warning is appreciated, as I suspect there are some gentle souls at MR that might be prone to selling everything, buying gold and hiding in a bunker. Marginally gentle that is.

From too big to fail to too big to bail.

you win the internet of the day

"From too big to fail to too big to bail"

You're thinking of Deutsche.

Never let a crisis go to waste. In Italy, Brexit is the pretext for bailing out Italian banks rather than forcing the stakeholders (i.e., the owners of the banks and bank bonds) to bear the losses as contemplated under the anti-bailout rule adopted by the EU in 2014. Of course, there's always a good reason for bank bailouts, although with each financial crisis there's one less. How many good reasons are there left before markets are allowed to do what markets are supposed to do? Bailouts vs. financial Armageddon. Not a great choice. WWTCD.

Yes, but.

To deal with the obvious thing first, let's at least note the connection between European dysfunction and Brexit. While Brexit might have short term costs, it has to be balanced against a multitude of errors. I personally find that confusing. Perhaps the best thing would be a reasonable Union. But perhaps that isn't going to happen.

In terms of what markets are supposed to do ... is dealing successfully with negative interest rates one of them? We are still in a funny global trend toward ever lower interest rates. This has implicates beyond the EU, but of course the EU must deal with negative rates in their context.

"In terms of what markets are supposed to do … is dealing successfully with negative interest rates one of them?"

Markets are supposed to set interest rates, too, in which case they would not be negative.

Really? What should market interest rates look like today?

Markets should never(!) set negative real rates. Er, except for now.

A free market would look remarkably different from what exists today. First, there would have been a substantial amount of capital disappeared in 2008-2009. The remaining would be worth more.

Second, government bonds would be priced on ability to meet debt obligations as opposed to the ability of the Central Bank to magically make money appear to look after them. A failed bond auction would be a failed bond auction, not an opportunity for a few well placed words and purchase post to keep the price high.

Third, the zero interest rates are simply a shuffling of the costs of capital to someone else. Because capital is worth something. Where is it being shuffled? Ultimately it gets shuffled to the tax payer. Italian banks are broke, taxpayers will end up bearing some of the cost. Because they lent money below cost.

Fourth. The value of the capital gets paid in other ways. The low interest bonds are used essentially as safe cash to pursue other deals. As collateral for some investment that is far more than zero return.

Fifth. Cash is dangerous to have, and one way or another some government agency will grab it either through some legal thievery or bail-in scheme. Owning businesses, property, or other assets leaves you wide open to the various levels of government using you as a piggy bank. But if you own their debt, they leave you alone because they desperately need to float more of it next week and they don't dare give the impression that they will steal it from you. Otherwise they will have to pay far more than zero to borrow.

Italy, like Greece, is facing a long run demographic collapse.

The median age in Italy is 45. In Florida, America's retirement haven, it's 40.

Nearly 18% of Floridians are senior citizens (65 or older). In Italy it's 21%. By 2040, over 1/3 of the Italian population will be older than 65.

Since 1993, there have been *only 2 years* in which Italian births exceeded Italian deaths. The cumulative deaths over births has been nearly 800,000. Only modest immigration is keeping the population from falling.

In 2015, there were 485,780 live births but 647,571 deaths. One third more people died than were born! (In Florida, by contrast, 19% more people were born than died last year)

The fertility rate has been below replacement since 1978 and with the economic crisis, fertility rates are starting to fall even further. The average woman in Italy can expect to have 1.4 children, a full 1/3 less than is required to maintain a stable population.

Show me where the tax revenue is going to come from to pay for medical care, pensions and nursing homes for all these Italians. This is a slow motion catastrophe that shows no signs of getting better.

Of course the Italian banking sector is in trouble. They're lending money at interest to a shrinking workforce in a shrinking economy with stagnant productivity growth.

Considering that old people can either live or die, your comment sets up an interesting dilemma:

If a high percentage of the population being over 65 is bad, then a high death rate of old people, leading to population decrease but a better age balance, is good.

The question is, would we rather have a population decline or an excess of old people?

Depends on which 'we' you ask, doesn't it?

Really? Is someone actually calling on old people to die?

"If a high percentage of the population being over 65 is bad, then a high death rate of old people, leading to population decrease but a better age balance, is good."

This is a false dichotomy. Just raise the retirement age.

True, but the marginal productivity of most 65 year olds seems quite low.

Citation needed.

Times have changed. When I look at my dad, coming up on 70, or my older colleagues, they're near the peak of their market value. That's something that used to occur between 40 and 50.

Admittedly, they are knowledge workers. I'm certain the same doesn't apply to ditch diggers. And of course, some decline in productivity because of health, but that's pretty unusual these days at 65.

TC has written on the benefits of the Black Death as well as the ravages of war. TC, a kinder, gentler, well-intention-ed merchant of death!

Dust off your Malthus.

And Italy's demographics (along with Japan's) presage the whole world's some decades down the road. It's going to be 'interesting' to say the least.

What? America and the rest of the Anglosphere have had wealth, female education, blah blah blah for decades and never seen TFR anywhere near 1.4. Why should I assume the middle East, Latin America, and Southeast Asia should be like Japan and Italy.

And sub-Saharan Africa is holding steady at 4-5 tfr. So it's not the whole world.

Even there it's coming down, used to be 7-8 tfr. It's almost an immutable law.

Um, hello bigot? As if Europe won't experience a HUGE baby boom once all the European women start marrying all those neurosurgeons, machinists, and architects from the Middle East and North Africa and give birth to all their genius mixed race children? And that's not even accounting for all the creativity yet to be unleashed by the 4+ TFRs in Afghanistan, Yemen, Liberia, et al.?

Go back to reading Steve Sailer in your mom's basement, you horrible, horrible man.

Oh ye of high IQ, the strength and quality of your associations and changes of topic draw me to your loin chops. A Ferari would be nice too.

Italy's unemployment rate is 11.5% and for young people it is much higher. It shows they're not short of workers yet.

They need some structural reforms of their labour market. If they liberalized their labour market and the economy became much more dynamic, Italians might have more children.

We borrow money today to fund investments that will produce wealth tomorrow. We expect that future generations will be richer than us and thus able to both cover the interest payments and continue to fund new investment. When incomes, profits and populations are growing, this all works out quite nicely.

But if the expectation becomes that tomorrow will be worse than today, we stop investing. Cash sits idle, wage growth goes into reverse and the backlog of debt becomes unserviceable.

Italy invests 30% less than it did in 2007. Companies see a declining economy into the future and feel no urgency to invest scarce capital to meet future demand. Unemployment has become self reinforcing.

None of this is fatal. You don't invest as much for the future? That potentially frees up resources to improve the present. Unemployment shouldn't be required.
It does hurt that Italy cannot control its own monetary policy, though.

This has been the Keynes sneak for decades. Increasing G just reduces S and I an provides the equivalent of a reduced efficiency C (because incentives and preferances are real and government spenders share none of the electorates'). This is age old wisdom often described in terms of seed corn allocation.

" the backlog of debt becomes unserviceable."

The Italians know the answer to that: just repudiate the debt. No problem.

Makes you wonder why Italy ever agreed to join the Eurozone in the first place. Did they really think the ECB was going to let them inflate away their debts and uncompetitive wage structure every decade or two?

If you really want to know, Italian historians and politicians wonder the same: why did they go to Maastricht to tie down their own hands?
The most accepted answers is that either they did it for prestige, and never expected to have to abide by the rules (they were mostly right), or that they thought that tying the hands of future Italian politicians was the best possible thing for Italy. Strict rules would have forced reform, kicking the can down the road. Unfortunately those structural reforms never came, and now one of the founders and the largest economies is always one step removed from collapse.

Peldrigal, another reason to add is the huge interest savings on its debt the Italy could have got and indeed obtained. Italy had always paid high interest rates on its Italian Lira debt: not only because debt was high, but also for its economic history of high inflation and currency devaluations:

In the end during the worst period of the recent sovereign crisis, the BTP-Bund interest rate differential was back to the normal level before the convergence a few years before the adoption of the EURO.

Assuming Florida is just a big retirement villa reflects a certain NY-centric view of the world that may or may not coincide with reality.

I picked Florida because it has one of the oldest median ages in the country and it's a large state.

No problem. ECB can just print.

I don't understand "Otherwise Italy is short of money..."

Italy can borrow at negative rates for 3 years (free money) and can borrow 10 year money at less than 1 1/4% (almost free money.)

They should do what we did, on a much, much smaller scale than we did - borrow money and recapitalize the banks. They just need Frau Merkel to give them the ok.

"They just need Frau Merkel to give them the ok." - it's insane that they would need her approval at all for this. But hey, this is the EU.

Considering the quality of European Leaders I suggest they'd come to the right conclusion (do what ever it takes to save Italy, that is), just shortly after its too late.

Which is especially sad, because the current Italian government seems to be the most reasonable they had for generations.

You seem overconfident that there is a clear "right conclusion". It looks like a nearly intractable mess to me.

That depends on whether they can pass the necessary enabling legislation without triggering bank runs and implement some rapid therapeutic processes.

1. A general bank holiday.

2. A mass write-down of delinquent loans during the holiday. Every one is charged off.

3. For a selection of banks, convert their outstanding bond issues to equity stakes.

4. For more troubled banks, convert their bond issues and a slice of their outstanding commercial paper and uninsured deposits to equity stakes.

5. Sort the vault cash into locally printed and minted material and external printing and mintingns. Send the latter to the central bank in return for reserves on deposit. Stamp the domestic bills as a mnemonic.

6. Convert all deposits and unsecured domestic debts from Euros to a revived Lira at a one-to-one ratio.

7. Institute exchange controls for a period of about 15 months, with tranches of foreign exchange distributed through monthly auctions with an official exchange rate adjusted accordingly.

8. Suspend principal retirements on public debts denominated in foreign currency if necessary.

In fact, the Italian banking and fiscal crises are far bigger economic problems than Brexit (which is only as big a problem as the EU decides to make it, depends on Brussels' desire for revenge vs self-interest) AND were quite evident LONG before the UK move was even a serious issue. Brexit has been more of a distraction from the more serious problems of banking and fiscal mismanagement and unlimited immigration of the unskilled.

As rayward notes above, the answer is to show some spine for once and let them fail. Let the markets do their thing and STOP giving perverse incentives to financial industry managers to take risks.

No, high debt is not a morality play. The British had Greek style high debt to GDP back in 1800 (the Industrial Revolution saved them) and the US had high debt-to-GDP after WWII (Baby Boom saved them, as well as innovation). What we need is a combination of higher growth and debt forgiveness. Notice that non-performing loans 'leveled off' in all countries (including Greece) in 2013. Arguably, the worse is over.

I think that was because of the costs of the Napoleonic war and American revolution. The conclusion of both is what ended the need for high debt.

On twitter Tyler said today "This time around, it is falling rather than rising yields that are the sign of a financial crisis."

On the one hand, yes yields have been falling since ~1980. On the other hand "crisis" has kind of a short term meaning. I don't think this Italian bank problem, banking problem in a low interest regime is a "crisis," perhaps unfortunately. Crises are brief.

Who is buying? Is it the ECB or other monetary source that recognizes an issue, injects cash in an attempt to stem market reaction?

Graphs of global income, wealth, and money supply show steady increase. The "giant pool of money" still seems real. I would think it more a cause of falling rates than a result of them.

That doesn't explain exactly what these bad loans are though, what bad premise they were based upon.

I really don't understand the compatibility between two of the most confident and repetitive claims on this blog:

1. The Eurozone is a self-defeating suicide machine that is always on the brink of bringing financial catastrophe to the economy and broader institutional structure of the EU.

2. Brexit voters are irrational and racist. Leaving the EU is not only ignorant, it is fundamentally inhumane.

The UK gets many of the benefits but avoids many of the major costs, most of all by staying outside the eurozone.

The benefits do not include full sovereignty or control over your borders.

The reply is appreciated, but I think you have just explained why adopting an institutional structure that avoids subsidizing Eurozone countries is in the rational best interest of the UK.
I thought the point was that Brexit is bad for the UK and its economy, not that it represents an opportunistic shirking on charitable obligations. You can't be an irrational free-rider.

Now, free-riders may sometimes deserve moral rebuke. But not in this instance, since the Eurozone consists of rich countries that miscalculated the benefits of a currency union. There are not good theories of redistribution that focus on ameliorating the mistakes of the rich.

Lastly, the basis for the claim that Brexit enables substantial free-riding on the benefits provided by the EU is not obvious itself, since those benefits are largely excludable to non-members.

I believe Tyler's claim is that Britain had the best of both worlds, getting many of the benefits of EU membership without one of it's primary drawbacks (the Euro). So he feels Brexit was on balance a mistake, not a path to free-riding.

That's a fair point, and I may have misread.

Clearly a premise for Brexit making sense has to be renegotiation back into the free trade area. If they remain completely isolated that would be unwise. However, as far as I can tell that is irrelevant to the question of EU membership, since Norway and others have such an arrangement.

The main issue is that the optimal level of coordination between the UK and EU seems to be close to the Norway arrangement. There is no reason why Brexit can't be interpreted as a (somewhat rocky) step in that direction. And, the costs of the Eurozone imploding on the scale that is being predicted would likely be externalized to other EU countries, which it is prudent to want to avoid.

If 1. is true, the UK did not need to leave the EU. It would have fallen apart on its own without anyone being able to blame the UK.

While a Remain voter, I can easily see that in such a case you would witness a vast flood of people out of the Eurozone and into the UK.

I don't know any way to form a decentralized currency union without allowing member countries' banks to convert dodgy local assets into union-wide liabilities. The essence of modern banking is to take collateral rights in return for the fungible liquid money of demand deposits, and if those are in the common currency of a union, and if enough collateral goes bad that a country can't make good its bank deposits, the union takes the hit either by bail-out or crisis contagion or both.

Many Europeans and Americans imagine that a U.S-style fiscal union solves the problem and is the crucial component that the Euro Area lacks. But we don't really do much locale bailout. The crucial differences are our federation-wide banks and our FDIC. Doing similar in Europe would be harder even than a fiscal union.

That is nearly 10 times the level in the U.S., where, even at the worst of the 2008-09 financial crisis, it was only 5%

No, loan delinquencies for commercial banks stood at 7.4% of portfolios, during the 1st quarter of 2010. Charge offs peaked the last quarter of 2009 at an annual rate of 3.14%. Currently, delinquencies are running at 2.17%, and charge-offs at an annual rate of 0.44%.

The share of loans which were non-performing has been elevated for most of the last 20 years. It's only in the last 3 years that it surpassed the 1998 peak. Its stabilized in recent years.

If you could pull it off, a bank holiday wherein a debt-for-equity swap was implemented would be a solution for many banks. The sum of bond issues of Italian banks do exceed the value of their delinquent loans.

My prediction: In 10 years there will be something called the "MR ZeroHedge indicator", sort of like the Time Magazine cover indicator for economic trends or the Sports Illustrated Cover curse. The indicator is triggered when an end-of-the-world Zerohedge story is plausible enough to get linked to from MR.

Somewhere there is a market either peaking or bottoming. Not sure which.

This blog has always had a bit of a -geddon streak: swine flu, collapse of Europe, bird flu, China collapse, etc.

So now we should look at the data points in history, when MR armageddon overlapped with ZH armageddon...

my first finding:
"The Italian 10-year bond yield was up from 6.38 to 6.66, death spiral territory" (2011)

+1 for "team bottoming"

Or maybe German banking... ?

Britain jumped just in time?

I wonder if there's a hard to translate term in German that means, roughly, deja vu every other week for seven years and counting.


I think that's it...Good work...

That goes with..."Merkeln," a new verb meaning to do nothing or fail to make decisions ...

Don't experts say procrastination is sometimes the best strategy? Time heals, and if you take the cynical view that nothing a government does is of much use, it's not a bad strategy.

.. and who knows, the horse might sing.

Certainly lazy experts say that.

Or they will at some better time in the future.

I guess people are getting over her Western civilization ending decision to admit another 0.2% or so to the population of Europe to help out some Semitic people who are fleeing war?

You mean the civilization that fought two world wars in a thirty year period in which 80 million or so people were killed, and that tried to rid the earth of Jews and Gypsies?

A wealth tax might be disregarded right now but it might happen, as it already did one stormy night between 9 and 10 July 1992:

Nothing new regarding Italian banks (well, I'm Italian): they have been underperforming their European peers for a long time. In 2014 they were among the worst in the EBA stress tests (based on end of 2013 data); since beginning of this year they have lost almost half of their value, even before Brexit. Main problems: low profitability and high NPL levels. They are mainly due to a combination of:

1) poor performance of the Italian economy: low productivity, low competition, etc. etc., therefore low growth (well actually no growth at all).

2) bad lending choices: the banking system is still very much intertwined with the political system. Until 1990, more than half of the Italian banking sector was somehow public; the EU forced the privatization of the sector, but Italian creativity managed to keep a strong connection between politics and the lending activity, especially (but not only) for smaller banks which now are struggling a lot. And the biggest banks are called to step in to share the burden. Italian politicians pretended everything was fine at the beginning of the crisis and now are screaming against the EU because they are not allowed to increase the already high Italian debt in order to put money in the banking system. Capital increases and earning retention are also hindered by the willingness of the so-called “fondazioni bancarie” (politically-charged semi-public institutions owning most of the Italian banking sector) to keep their control and the money flowing for their expenses, hoping in the final intervention of the State or the EU to foot the bill in the end. More on “fondazioni bancarie”:
Italian regulators were also happy to turn a blind eye on all the troubles of the Italian banking system. Luckily ECB and EBA are now involved and are not complacent – unfortunately a bit too late.

3) very long recovery process, thanks to a incredibly slow judicial system: it takes on average 6-7 years to work out a bad loan in Italy, against the European average of 2-3 years (there’s an excellent study from the ECB I think on the topic, but I cannot find it now).

The Italian economist Silvia Merler has a good series of posts in English on Italian banks in the Bruegel’s blog:

Apologies for the long comment!

The EU looks increasingly like a bunch of aging social democracies trying to live off each other.

After the Brexit vote, someone I think on twitter said in addition to Grexit, we can look forward to Departugal, Finish ... and Italeave.

I know this is primarily an economic blog so that colours the way many things are viewed, but the thing is - Europe (and Brexit) are political and philosophical issues, not economic ones. Getting caught up in speculation about banking and bail-ins/outs etc. misses the point. In particular, crises in Europe are features, not bugs - as observed many years ago:

“Europe will be forged in crises, and will be the
sum of the solutions adopted in those crises.”

We must go deeper.

Why are there so many non-performing loans? How were incentives improperly aligned? Did central banking policy somehow precipitate this? Was it EU regulations in some way? Were the loans sold from the originators? If so was the market faulty in some manner? How?

Of course the resolution of this many non-performing loans, if the statistic is correct, will be brutal. While the EU could absorb such a shock, it will be difficult politically. Especially if the underlying reasons are not well understood.

Moral hazard, a venerable economic concept which is strangely absent when the topic is central bank policy.

> Here is Zero Hedge for one of the more dramatic views.

"by Tyler Durden"

'as it has the potential to bring the entire eurozone to its knees'

Finally, this time, eurogeddon will appear.

It only has to happen once

8 years in court to cash a non performing loan is central in the issue. If you have 8 years in front of you when you stop paying, it is very tempting to stop paying.

How did Iceland recover from it's banking crisis?

Iceland's rapid return to health hinged on a series of measures that Nobel laureate Paul Krugman later referred to as "doing an Iceland." Krugman, an admirer of Iceland's dramatic comeback, has recommended a similar policy cocktail for other nations in crisis. The rules are as follows: Allow your ailing banks to collapse; devalue your currency if you have one of your own; introduce capital controls; and try to avoid paying back foreign debts.

That may sound like an extremely self-serving recipe -- and it was. Whereas billions of public money was pumped into the banking system in Ireland so that financial institutions could pay back their creditors, Icelanders voted against this route in two separate referenda. They couldn't see why they should pay for the greed of foreign investors who followed the Siren song of high interest rates to the island nation.

Jónsson only shakes his head wearily when asked if he has a guilty conscience. He claims to have been one of the few who warned of the currency bubble long before it burst. Now, he is excited about the country's new opportunities, which are remarkably similar to the ones it has always had. "A hard-working populace. A healthy democracy. A high level of education. Tourism. Natural resources, such as wind, hydro-power and geothermal energy. And fisheries. What would we be without the fisheries?"

While I think there are a lot of merits to Iceland's approach, Paul Krugman would probably hate the results if the behavior became widespread. Lending to nations that had defaulted would quickly become much more expensive. I'm sure Krugman would be the first to decry all the "extortionist" rates that lenders would demand in the future to compensate themselves for the higher risk.

I think that more worrying that 17% NPL is how they got there. Doesn't such a high level of NPL imply that a lot of Italian enterprises have been running their businesses, not earning enough to cover their costs and investments, and drawing down credit they now cannot pay back?

And if that is so, what has changed? Has Italy started to become more competitive? It won't make much sense to bail out the Banks if the overall economy is still running at a loss.

John, there are a few reasons why:

1) Italy hasn't grown for a very long time.

2) A very long bankruptcy process: it takes more than 6 years on average, therefore bad debt keeps accumulating quite quickly; banks are also reluctant to sell NPLs as their balance sheet value (which should be based on recovery expectations) is very far from market values (which incorporate a huge discount for the long recovery process). Italian banks are also very thinly capitalized, therefore selling NPLs at lower prices would force them to raise new capital. Additionally, until recently an unfavourable tax system made very punitive to recognize impairments.

3) The Italian banking system is very intertwined with the local political system. Most banks, especially the smaller ones, are owned and managed by so-called "bank foundations", semi-public entities owned by municipalities and local public administrations. Local politicians use them to control the lending activity of the banks in order to promote their own interests. Lots of money is lent to the wrong people, companies and projects. Useful readings:

4) Italian regulators have turned a blind eye, because of political influence. Finally now the ECB and the EBA are involved in the supervision and are forcing a change - unfortunately a "bit" too late!

Comments for this post are closed