Is the Italian banking system insolvent?
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Morningstar's view on an Italian exit from the European Union is similar to its view on the United Kingdom's departure: It doesn't make economic sense.
With Britain's vote to leave the European Union a surprise to many investors, UK bank stocks fell, but Italian bank stocks also collapsed.
We think the latter declined because of investor concerns about whether Italy will hold a referendum to leave the euro, which would significantly destabilise the Italian banking system.
Investors' concerns are valid, as leaving would isolate Italy's economy further from the broader EU, setting back GDP growth prospects for one of the eurosystem's weakest members.
Our view on an Italian exit is similar to our view on the United Kingdom's departure: It doesn't make economic sense.
Still, roughly 40 per cent of the Italian populace views the EU unfavourably, according to Pew Research Center, and the Five Star Movement (which has won 20 per cent-25 per cent of Italian votes in recent years and consists of avowed euroskeptics, or "leavers") won 19 out of 20 mayoral races in June, which is a setback to Prime Minister Matteo Renzi.
Italy will hold a vote in October on several constitutional reforms, and if the vote does not pass, Renzi has said he will step down. In short, the political situation in Italy is already unstable.
We believe investors consider the Italian banking system to be in a negative feedback loop, where no one wants to provide capital to the banks, which means the banks cannot write off nonperforming exposures, or NPEs, making the situation worse and making it even less attractive for third-party capital.
We give Renzi credit for not wasting the Brexit vote, directly afterward seeking EUR 40 billion from EU regulators for the banking system, which was immediately rejected as it violates EU bail-in rules.
At the same time, the EUR 1 billion capital raise for Veneto Banca attracted no interest from private investors, and the bank had to be bailed out by the EUR 4.25 billion Atlas fund, which has now deployed EUR 3.5 billion to bail out three Italian banks.
We expect a second fund to be announced shortly, probably around EUR 5 billion, to be focused on purchasing NPEs.
Resolving Italy's banking issues has become more urgent after Brexit, and we think this will lead to significant changes in the Italian banking system before the year is over.
The EU has substantial incentive to make the UK's leaving as difficult as possible, with the idea of discouraging further departures, and the October vote will provide an important signal to the EU and Italy about the strength and willingness of Italian citizens to pursue this option.
Also, we believe the European Central Bank's stress test results, which will be announced 29 July, will reveal a need for substantial capital by the Italian banks.
Even if NPEs are not assumed to be around 25 per cent of gross value as we assume, we believe the ECB will find substantial enough capital shortfalls to force the banks to raise capital.
The ECB also asked Monte dei Paschi (MPS)--one of the weakest Italian banks--to reduce NPEs by 40 per cent over the next three years.
All of this threatens to further destabilise the banking system, encouraging the banks to act now, and we anticipate events in Italy to move relatively quickly over the next few months.
We believe Renzi will need to balance the needs of retail bondholders, which own EUR 200 billion in bonds (about 30 per cent of the system) that will be wiped out if the banks fail, with the need to recapitalise the banking system.
If bondholders are wiped out, they are likely to vote for alternative political parties, forcing Renzi out, and then seek to exit the EU.
We ultimately believe that a solution will be made up of several options, which are Atlas funds (funded by Italian pension funds, which have EUR 120 billion in capital), third-party private equity investors such as KKR's Pillarstone (EUR 146 billion in European private equity capital), the recently announced government guarantee scheme (known as GACS in Italian), traditional capital raising, and some form of an Italian government bailout.
We consider the most likely option to be expanding the Italian deposit insurance scheme as a mechanism to reimburse depositors/bondholders for their losses using capital raised by the government, potentially from the EU; we wouldn't be surprised to see the Italian debt rating cut a notch but not fall below investment grade.
We would expect a system recapitalisation component to involve third-party capital being injected into the banks (thus avoiding the bailout rules) at the same time the deposit insurance scheme is expanded to cover losses for retail bondholders and depositors.
We think both elements are important because if the system is bailed out while the retail Italian bondholders take huge losses, consumer spending and confidence will take a nosedive, there will be considerable voter anger toward politicians, and we'd have a recapitalised bank facing a likely Italian recession, which would be a brutal scenario.
As the Italian government is not directly providing capital to the banks, we believe it is likely to win EU approval.
Alternative proposals include the Italian government taking a direct (if temporary) equity stake in the banks with conditions that force the banks to address the structural issues they face, or doing a debt for equity swap with bondholders.
German Chancellor Angela Merkel has indicated that the government could provide capital to the banks if needed to make up a capital shortfall due to a regulatory stress test, and the ECB is due to announce its results shortly.
If Renzi can frame this rescue as a political win for his party, we believe Italy is much more likely to remain with the EU.
Otherwise, even a banking system rescue will result in Renzi's departure and a more frustrated populace that will seek to exit the EU in fairly short order.
Italian banking system rated poor for good reason
The Italian banking system has experienced a rocky 2016, with investors seeing considerable volatility. The FTSE Italian bank index is down by half so far this year.
However, we believe the Italian banking system is perhaps the closest it has been in years to embarking on a healthier economic path while undertaking reasonable and much-needed banking system reform.
This should lead to a healthier Italian banking system and economy, benefiting Mediobanca most of all while recapitalising UniCredit and Intesa Sanpaolo.
We believe the system's NPEs are at peak levels today and will decline considerably over the coming years as the system reforms.
Long-term trends as well as recent events have given little comfort to investors. Today, the Italian system has about EUR 340 billion in NPEs, or around 18 per cent of system assets, as banks have delayed writing off bad loans due in part to the years-long bankruptcy and court processes. Over 80 per cent of the loans are corporate loans to Italian firms.
Italian GDP today is still lower than its 2008 peak, real GDP per person levels are lower than in 1999, and at around 2.5 times GDP, the banking system is far smaller than that of Germany (3.3) and France (4.1).
With little growth in the economy, sovereign debt is more than 130 per cent of GDP, sharply constraining the Italian government's ability to stimulate growth via investment.
Italy's core issues are related to extremely low productivity and systematic issues. For example, it is very difficult to start a new business due to taxes and bureaucracy, and the Italian business environment is characterised by a very high number of small businesses.
This market structure means the Italian economy, like many others in Europe, depends highly on banks for growth capital.
Other issues include Italy's taxation structure, which taxes consumption and heavily encourages tax evasion; also, the share of young Italians with a university degree is among the lowest in the world, while about 10 per cent of highly educated Italians live abroad, one of the highest numbers in the developed world.
Several issues caused Italy's productivity struggles over the past few decades, in our view. One was China's entry into the World Trade Organization in 2001.
China's low-cost manufacturing base undercut the traditional low-tech manufacturing efforts of Italy, whose firms were typically too small to take advantage of the growth in exporting opportunities.
Another major issue was Italy's inability to take advantage of the rise of the Internet in the late 1990s and 2000s because of institutional issues such as heavy regulatory protection of labour, high levels of corruption, and low levels of legal rights compared with the averages of other Organization for Economic Cooperation and Development countries; this put Italy at an institutional disadvantage in terms of innovation versus EU peers and emerging-market competitors.
Italy's managers, typically of poor quality, often promoted because of family or personal connections, and the companies did not have the incentives of non-family-owned firms to adjust to market changes, whether it be China or the rise of the Internet.
There are also numerous challenges from a banking perspective. Italy liberalised its system in 1990, and the number of branches has more than doubled since then to more than 33,000; it now has the highest number of branches per capita in the world.
From a cultural perspective, we believe that Italian lenders tend to value long-term relationships in the communities in which they operate, undermining their ability to aggressively address their NPE issues.
Tax incentives encouraged banks to provision loans but not write them off, as they could earn a tax deduction for 18 years (although tax law changes in 2013 reduced this to just five years) and recognise uncollected interest income as accrued interest, and accounting rules do not specify when and how to write off uncollectible loans.
New rules that will be in place in 2018 specify more clearly when a bank can write off a loan.
It also takes more than seven years on average to complete a bankruptcy procedure and three years to foreclose on real estate, and the country ranks near the bottom of the OECD in terms of resolving insolvency and enforcing contracts.
These issues mean it will cost more time and money for the banks to resolve their NPEs.
These structural issues have caused a massive build-up in nonperforming loans, which if left unresolved will mean Italy will struggle for at least another decade, if not outright fail.
Making the problem significantly worse, the Italian government has been far slower to address banking reform than Spain, Ireland and Germany, which directly intervened with various bad-bank initiatives and other guarantees.
The issues are compounded by the fact that the ECB has issued new rules via the Bank Recovery and Resolution Directive (agreed on in 2013 and effective in 2016) limiting direct state aid to the banking system, meaning Italy can no longer pursue the same path that Germany, Spain, and Ireland did to improve their systems.
The rule changes prevent direct government intervention in bank bailouts, meaning senior bondholders and depositors with balances above EUR 100,000 face losses, though the EU has leeway to determine whether proposed plans actually violate the rule.
With around EUR 200 billion in bonds (around 30 per cent of the market) held by retail investors and families due to favourable tax treatment, the Italian government faces a significant political issue if banks require capital.
In 2015, four small banks failed, which caused bondholder losses (EUR 1 billion), shareholder losses (around EUR 4 billion), required banks to pay about EUR 3.6 billion in bailout fees, and generally unnerved the Italian populace.
Government taking baby steps
Over the past year, the Italian government has taken baby steps to address the issues but has yet to produce a comprehensive plan to fix the nonperforming loan problem.
Renzi passed a law requiring that the top 10 largest Italian foundations with combined assets of EUR 500 billion must become joint stock companies by the end of 2016, which is designed to reduce competition in the system, improving profitability, as well as make it easier to provide capital to the industry.
The recent consolidation announcements are positive, yet they also demonstrate just how weak the banking system actually is.
First, the ECB demanded that Popolare di Vicenza (an unlisted mutual bank hurt by a corruption scandal) and Veneto Banca raise EUR 2.5 billion in capital to shore up balance sheets and enable them to better handle nonperforming loans.
Similarly, the ECB forced Banco Popolare, which is merging with the Banco Popolare di Milano, to raise EUR 1 billion in fresh capital, despite passing stress tests recently.
The tougher stance by the ECB will force the banks to address long-standing issues over corporate governance and efficiency levels and reduce the amount of NPEs on their balance sheets versus waiting for Italian economic growth to rebound.
However, investor confidence in the overall system is extremely low, forcing the Italian government to take more aggressive steps as well.
The first was the introduction of a government guarantee plan in January.
The plan is the first test of the new bail-in rules designed to prevent undue state aid and keep the burden of any bailouts on investors instead of taxpayers; however, we think it falls considerably short of addressing the NPE issues.
The plan's basic concept is to close the gap between what the market is willing to pay for a bank's NPEs and what the bank is marking them at on its balance sheet by providing coverage via a guarantee, which in theory should limit bank losses; this should make the plan attractive to banks, since it would reduce the need for or the size of any capital raise.
In turn, the plan should let investors purchase the loans at prices closer to market conditions and earn a respectable return.
Italian banks will pay a fee to the government for the guarantee (based on the price of credit default swaps with a risk level equal to that of a guaranteed security, or investment grade), package the loans into a security, and sell them to private investors.
The guarantee by the Italian government will apply only to the senior tranches of the securitisation and investment-grade securities, which is problematic because it is the junior tranches of the nonperforming loans where the gap between bank marks and market prices is the widest.
To complicate matters, the relatively undeveloped stock market and small size of the securitisation market in Italy make it more difficult to find market clearing prices.
We think the guarantee plan can be improved. The most straightforward approach would be to allow banks to dispose of higher-quality performing loans alongside the struggling NPEs, letting the cash flows from the strong loans make up for the shortfalls on the NPEs.
While this effort runs the risk of depleting the banks of quality assets, we expect that the banks would be able to offload significantly more bad loans using this approach, strengthening the overall balance sheet.
The price for the state guarantee should also be based on market conditions versus pricing of less liquid credit default swaps and cover both senior and junior securities.
In April, the Italian government announced another initiative to address the nonperforming loan issue, which we think is likely to be more successful but is considerably riskier.
The Atlas fund is a EUR 4.25 billion fund capitalised largely by the Italian banking industry in an effort to provide capital for capital raises for Veneto Banca, Popolare di Vicenza, and Banco Popolare and also purchase nonperforming loans. The fund has now invested EUR 3.5 billion in those three banks.
Since the fund is capitalised by the industry, it steps around the new rules limiting direct state aid to the banking system.
The risk is that the fund now makes a few banks' issues systemic ones and weakens some of the system's strongest banks' capital ratios.
Equally important is the commitment by the Italian government to reform its bankruptcy laws, as it currently takes eight years on average to recover Italian bad loans versus two to three years for Europe on average.
Changes here would be immensely helpful; they would improve market prices for Italian securitisations because payments to investors depend heavily on being able to recover debt collateral in a timely manner.
The fund combined with the bankruptcy changes and the guarantees has the potential to make a decent-size impact.
What is the path forward?
Given the nature of the banking system within Italy and the dependence of the economy on small businesses, which in turn depend on bank capital for growth, we need both economic reform and banking system reform for the country's issues to be addressed.
The NPE issues constrain new lending by requiring capital to be held against the nonperforming loans and increase credit costs via higher credit default swap spreads versus peer country banks.
The International Monetary Fund has focused its recommendations for economic reform for Italy on productivity, judicial reform, and labour reform.
The IMF estimates that these reforms could boost Italian GDP by about 9 per cent over five years and 22 per cent over the long run.
We believe the Italian government has made progress on these items recently, particularly judicial reform, and we expect continued efforts on these issues over the next few years, especially as we anticipate continued ECB stress tests will regularly highlight the need to address banking reform.
From a banking system perspective, resolving the capital and NPE issues are paramount, but we also believe the system needs to reduce the number of branches in operation as well as the number of banks.
Improved governance and a renewed focus on cost efficiency would also be welcome.
The planned consolidation of the 10 foundations is the right move for the Italian banking system, provided the government has the political will to see it through.
The consolidation should create Italy's largest bank by deposits at EUR 329 billion, by our estimates, though Intesa Sanpaolo and UniCredit would be larger if we included their international operations.
Some of the benefits include the top three banks increasing their collective deposit system market share to 37 per cent from 29 per cent, opening up opportunities to lower deposit costs, and increasing lending rates as a result of the reduced competition.
Solving the NPE issues and picking winners and losers
With the potential for rapid reform to take place in the Italian banking system in short order, we expect some compelling opportunities with substantially reduced risk in the near future.
We prefer Mediobanca over UniCredit and Intesa Sanpaolo because of its higher-quality loan book and better business mix (more fee-based business lines that diversify away from the difficult Italian lending picture).
Further, with a clean balance sheet and very few NPEs, it will not require a risky and painful restructuring, so we see considerable value for shareholders.
We would caution investors to expect significant volatility in all three banks' stock prices ahead of the ECB stress test results and potential capital raises, likely to the downside.
As we expect the capital raises to be at discounts to the current stock prices for Intesa Sanpaolo and UniCredit, there could be better purchasing opportunities in the short run.
Ultimately, we expect a combination of the guarantee, the Atlas fund, and alternative capital alongside bank restructuring and capital raises to help the system lurch forward.
With the system coverage ratio at around 50 per cent and our estimate for Italian NPE market prices at around 25 per cent, we estimate that the Italian banking system needs about EUR 70 billion in capital to fully recapitalise.
With the Italian banking system earning about a 4 per cent to 5 per cent return on equity on an estimated EUR 130 billion in capital, at EUR 5 billion-6 billion per year, it would take a decade-plus to fully resolve the issues.
We expect the industry to raise about EUR 60 billion in capital while relying on alternative means of capital such as Pillarstone and the GACS and Atlas funds (the Italian pension system has around EUR 120 billion in assets under management that could help with funding) to help close the remainder of the shortfall.
We consider UniCredit to have some of the system's greatest challenges with an estimated EUR 15 billion capital shortfall.
We estimate it will need to raise about EUR 10 billion in capital, with the remainder of the shortfall made up via asset sales and disposals via the aforementioned alternative capital approaches.
We estimate that Intesa Sanpaolo has about a EUR 14 billion capital shortfall. We think it will need to raise about EUR 10 billion in capital, but it is probably more reliant on alternative capital efforts to close the remainder of the gap, as its international bank operations are smaller and thus a meaningful amount of asset sales will be harder to achieve.
If both banks do not pursue asset sales, it is more likely that they will need to raise the additional capital via equity offerings, though organic capital generation will provide a modest offset.
With no capital issues, Mediobanca is in an enviable position. We believe it will benefit from the changes in the Italian banking landscape in several ways.
First, as the system consolidates, it should have the chance to earn advisory and investment banking fees as Italy's largest M&A banker.
Second, we would expect loan pricing to increase and deposit pricing to decline by as much as 50 per cent, similar to what we saw in Spain over the past few years after a similar consolidation.
Third, with the disruption caused by the consolidation of the foundations plus the forthcoming capital raises by its two larger peers, Mediobanca's retail deposit gathering efforts such as CheBanca have the potential to accelerate growth and gain further market share while continuing to lower the overall cost structure.
Fourth, with asset sales likely at somewhat distressed prices by UniCredit and Intesa Sanpaolo, Mediobanca has the balance sheet strength required to acquire attractive assets that fit within its circle of competence, potentially adding to its asset management or other fee-based businesses (where growth is likely to accelerate similar to CheBanca) at a discounted price.
We believe the rest of the banking system needs to raise about EUR 40 billion in capital with about EUR 30 billion in capital related to the consolidation of the foundations (MPS alone requires about EUR 9 billion and is not part of the foundation consolidation effort, though it is well understood the bank is not viable as a stand-alone entity).
The Atlas fund should address about EUR 4 billion in capital needs, leaving about EUR 26 billion for the foundations excluding a separate MPS capital raise.
We believe the GACS effort and alternative funds could eventually remove about EUR 5 billion-6 billion of the shortfall, implying about EUR 10 billion-12 billion in capital.
As the Italian government assists in consolidating the 10 banks, we expect the majority of this work to be completed by the end of 2016, with a likely EUR 20 billion capital raise taking place in late 2016 or early 2017.
We expect this period of turmoil to affect GDP growth in the short run, while boosting confidence that the Italian banking system is taking the decisive steps needed to address its long-standing issues.
We expect GDP growth of around 1 per cent estimated by most observers to be closer to 0 per cent or even negative in 2016-18 as the banking industry restructures, seeks to raise capital, and probably creates consumer confusion and concern over the transition.
However, the banking system reforms plus other potential labour, product, and legal reforms offer the potential for Italy to return to 2 per cent-plus GDP growth over time, as banks are no longer burdened by large capital-constraining NPE portfolios that reduce their appetite and ability to lend.
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Stephen Ellis is Morningstar's US-based director of financial services equity research.
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