Italy: Pride before a fall?
Efforts in the past year such as NPL reform and the launch of the Atlante fund raised hopes that alternatives to bail-outs/ins could be found to address capital pressures facing Italian banks — but then Brexit struck. Neil Day reports.
Italy’s Ministry of Economy and Finance has over the past 18 months been running a Twitter campaign using the hashtag #prideandprejudice, aiming to highlight a purported gap between perceptions of Italy’s economy and the reality. A March presentation from the Ministry on the topic was sub-titled “Something that no-one is saying about Italy”.
While the Ministry has a right to feel aggrieved about ill-informed opinions, it may itself have spoken too soon about one of the points it highlighted as a virtue: a lack of state aid for Italian banks. In its presentation it noted that in the 2007-2014 period German banks received Eu262bn of state aid and UK banks Eu207bn, but Italian banks just Eu4bn — which as of March had fallen to Eu1.1bn.
Unfortunately, since the UK vote to leave the EU on 23 June, almost all discussions about Italy’s economy have centred on the Italian government’s efforts to find a way to support its banks, possibly to the tune of Eu40bn.
Within a week of the UK referendum the European Commission had approved use of an existing, precautionary scheme for up to Eu150bn of government guarantees for Italian bank debt — admissible under the Bank Recovery & Resolution Directive (BRRD) as “extraordinary public financial support”. The move came as Italian bank shares tumbled after the Brexit vote and while the Italian government reportedly negotiated with the Commission about ways in which it could recapitalise its banks — with the latest European Central Bank stress test results looming on 29 July.
False dawns
Any state aid would be a last resort given Italy’s previous efforts to address the problems its banks are facing — notably the impact of non-performing loans NPLs) on their balance sheets.
“In the first phase of the crisis in Europe a number of countries put a lot of government money on the table through state aid to the banking sector,” says Lorenzo Codogno, visiting professor in practice at the London School of Economics’ European Institute and founder and chief economist of LC Macro Advisors, who was formerly chief economist and director general at the Treasury Department of the Italian Ministry of Economy and Finance. “Then the Commission decided that enough is enough, so they introduced state aid rules with a transitional period until mid-2013 offering a last window of opportunity, and Italy decided at that time not to take it — contrary to many other countries.
“Then NPLs started to rise and in late 2014 Italy decided that it was about time to do something about it, and to introduce a bad bank. There were then very difficult and lengthy negotiations with the Commission lasting more than a year, and they resulted in a very modest outcome, which is basically that Italy was not allowed to introduce a bad bank, but was allowed to introduce guarantees for the most senior tranches of NPLs securitised into vehicles that banks can pay for only at market prices.”
Since 2007 the stock of NPLs in the Italian banking system has quadrupled, with the deterioration mainly coming during the second leg of the financial crisis, from 2011 onwards, notes Codogno.
“Non-performing loans have mainly increased for two reasons,” he says. “One is the depth of the recession, which inevitably caused problems for companies and increased the non-performing loans. And secondly, the length that it takes for banks to recover the credit in case of insolvency. In Italy insolvency procedures take much more time than in many other countries. Effectively for a bank to recover the collateral on a non-performing loan takes between six and eight years. And so inevitably with this situation, the stock of non-performing loans tends to rise.”
Moreover, another observer points out that until recently Italian banks were not incentivised to properly provision NPLs by an extremely long tax amortisation period. As part of a package of Italian government reforms, this has now changed, although new more favourable measures will only impact new NPLs and not the existing stock.
“Why are NPLs so important?” adds Codogno. “Because clearly they absorb capital, they reduce profitability of banks, and they keep them busy with this rather than with providing new financing to the economy.”
In February — as another element of its package of reforms — the Italian government introduced a scheme, Garanzia Cartolarizzazione Sofferenze (GACS), whereby banks can pay a fee for guarantees of investment grade senior tranches of securitisations of NPLs in which at least half of the junior tranches have been sold by the bank to other investors.
However, this was viewed as a bit of a non-starter by many.
“The perception is that it is not going to be particularly effective,” says an analyst. “At the margin, it is probably a positive move, but in itself is not hugely effective, because it basically touches only on the senior tranche of securitised NPLs, and of course you need to sell the junior tranche first.”
Twofold mission
On 11 April came an announcement that was touted by proponents as a break-through, but which was also been met with a large dose of scepticism in some quarters due to its limited size.
Quaestio Capital Management, an asset manager, launched an alternative investment fund backed by state bank Cassa Depositi e Prestiti, national champions Intesa Sanpaolo and UniCredit, and a variety of smaller banks, insurance companies and other investors, including some from abroad. An announcement two weeks later confirmed its size at Eu4.249bn.
Named Atlante (Italian for the Atlas of Greek mythology), the fund’s aim has been twofold: resolving the NPL problem; and ensuring the success of capital increases required of Italian banks by acting as a backstop.
The latter came onto the agenda thanks in part to the transformation into joint stock companies of the country’s 10 largest cooperative banks (banche popolari) by the end of this year (alongside the consolidation of smaller cooperative banks — banche di credito cooperative — into larger groups). Despite being another well-intentioned element of the government’s reform programme, the initiative forced some of Italy’s banks to come to market to raise capital — to address their deteriorating balance sheets and meet European Central Bank requirements for CET1 ratios of 10% or more — at an inopportune time: Banca Banca Popolare di Vicenza and Veneto Banca were each due to raise Eu1bn-plus by May.
“In February we had this very difficult situation of low stock market values for most Italian banks,” says a banker in Milan, “which triggered a lot of concern for these two IPOs. In absolute numbers those are not big transactions, but it was pretty evident that it would have been very difficult if not impossible to launch them.”
Another notes that Banca Popolare di Vicenza faced uncertainty due to a mis-selling scandal involving the equity of the bank itself being sold to retail customers — another deterrent to investors.
As expected, the ultimate failure of Banca Popolare di Vicenza’s IPO resulted in Atlante underwriting the entire Eu1.5bn capital increase and becoming 99.33% owner of the bank, and then at the end of June the fund became 97.64% owner of Vento Banca after its Eu1bn offering suffered a similarly disappointing fate.
Codogno says that given what was at stake, the industry had no choice but to support Atlante’s interventions.
“The government cannot put in money and private investors are not willing to invest,” he says. “So you have two choices: either close down the bank — which would be extremely risky given that under BRRD you have to bail-in bondholders and potentially retail investors. Or arrange some kind of private support for the banks, and this is exactly what Atlante did.
“Without its intervention, the failed IPO could have triggered a bank run, not only for Popolare di Vicenza, but maybe for a number of other weak banks in Italy.”
Moody’s reacted to the announcement of the fund by deeming it credit positive for weaker smaller and mid-sized banks in Italy, but less positive for stronger banks.
“For weaker banks in Italy, the new fund would help them improve their solvency and avoid a bail-in of bonds, including those held by retail investors,” said the rating agency. “However, for healthier banks, the fund may create an expectation of ongoing support to weaker banks in the system, thus creating contingent liabilities.”
However, proponents of Atlante point out that institutions such as Intesa and UniCredit would have been on the hook for the failed IPOs and any other aftershocks, while the banks themselves have highlighted the longer term benefits of the NPL initiative in combination with other government-led reforms.
“A comprehensive structural solution to the NPLs of the banking system may be reached through the introduction of measures, announced by the government, aimed at halving the NPL recovery time, bringing this into line with the European average,” Intesa said when announcing its participation in the fund.
“The strengthened solidity of our country’s banks, resulting from this solution, will allow them to provide more support to the real economy, increasing lending availability to households and businesses. It will also dispel the unfavourable perception of the market as to the stability of the banking system, which is detrimental to the savings of Italian people.”
Shouldering the burden
While Atlante may have averted disaster on the capital-raising front, its contribution to these exercises was seen as diminishing its firepower for addressing the NPL problem.
“The fund is large enough to support cash calls,” said one analyst, “but does not have the scale to tackle the banks’ enormous NPL problem.”
However, others have argued that it could still leverage the circa Eu1.75bn left after the Popolare di Vicenza and Vento Banca capital increases to support buying of Eu30bn-Eu50bn of gross NPLs. This assumes an equity tranche of the NPL ABSs of 20%-35% (with 65% senior and potentially the balance mezzanine) and the originating banks taking 49% of the equity tranche.
Crucially, it also assumes valuing the NPLs at a price of around 34 cents to the euro. The Milan banker points out that although Italian banks have provisioned NPLs at an average of around 40 cents to the euro, a precedent of 18 cents was set by transactions last year.
“Then question is then, is the correct price 40 cents to the euro or 18 cents to the euro?” he says. “The 18 cents to the euro was a precedent that was set last November using a precedent of last summer, so in a very, very thin market there is one price set for a very, very illiquid and difficult category composed of NPL positions extremely diversified in nature.”
“Now, since then there have been quite a few things done that would justify a modification in the price for NPLs.”
The Italian government has undertaken a series of legal initiatives aimed at accelerating and simplifying enforcement for NPLs, with further insolvency reforms on the way.
“There has been an unprecedented number of legislative initiatives in 2016 aimed at helping banks to repair their balance sheets, including changes to improve the work-out of impaired loans,” commented Fitch. “This shows the authorities are committed to tackling the problems.”
This, alongside the GACS scheme could help Atlante engender a virtuous circle for NPL prices, helping both banks that wish to dispose of NPLs and that those that will keep them on their balance sheet.
Although a figure of as much as Eu350bn has been touted for Italy’s stock of NPLs, the volume of truly distressed loans is some Eu210bn before taking into account provisions, according to the banker.
“If you value those at 40 cents on the euro, we are talking about some Eu85bn and if you consider that you have firepower of Eu30bn to Eu50bn, it’s actually not a small number,” he says. “You could move the market.”
Contagion or confusion?
Such calculations could now prove academic. Whereas pre-Brexit discussions centred on potentially increasing the size of Atlante or on Atlante II, post-Brexit talk has turned to a government-backed fund directly run by Cassa Depositi e Prestiti as being one of the options on the table.
“The key issue here is that in order to provide state aid, and to be compliant with the BRRD, there must be a restructuring plan by the bank involving some kind of bail-in,” says Codogno, “probably not in the form of bail-in of depositors — because it is perceived to be systemically dangerous, and we have already seen that in Italy — equity investors will definitely be hit and I think the degree of involvement of bondholders is up for negotiation.”
Fitch was quick to highlight the difficulty of finding a satisfactory outcome acceptable to all.
“Measures that would strengthen asset quality or capital without triggering bail-in could be positive for Italian banks’ Issuer Default Ratings,” it said. “But the impediments under EU legislation to using public funds will make a solution difficult to achieve.
“We believe it will be difficult to reach the political consensus necessary to inject public funds as equity under Article 108 of the Treaty on the Functioning of the EU, which would be exempt from EU state aid rules, at least in the short term,” it added.
However, others argue that rather than the folly of Brexit, those involved in Italian banks would be better advised to focus on the British wartime slogan to “keep calm and carry on”. The Milan banker points to the successful outcome, just ahead of the UK referendum, of a Eu1bn Banca Popolare capital-raising undertaken to prepare for its merger with Banca Popolare di Milano.
“We don’t know what would have happened if Brexit hadn’t occurred,” he says. “Possibly you would not have had such an issue with the banks. And you really have to wonder what the direct link between Brexit and the banks is.
“So I am a bit confused by the signals the market is sending out. My reading is that Italian bank equity is one of the ways in which you can take a position on the market, being liquid and accentuating overall market trends. But it doesn’t seem to me that the banks have lost access to the market.”