23 November 2011 at 8:34 GMT
Italy’s problems, which are very large, have been well-known for ages. Italy is virtually too big to save - albeit there are no quick fixes to its problems; see our
previous theme on PIIGS exposure.
Default risks for major Italian banks at all-time high
In the last month credit default swap (CDS) prices on Unicredit and Intesa Sanpaolo (Intesa) (two major Italian banks) have risen by more than 50 percent (see chart 1). The cost of day to day funding is likely to be the main driver behind the valuation of these large Italian banks going forward. All in all it will be a rough winter for the Italian banking sector!
What might be a serious issue is the risk of mistrust towards the Italian Government's ability to fulfill its obligations as guarantor of deposits. Are bank clients able to consider their deposits as being safe with Italian banks? As the sovereign funding situation worsens the greater the funding costs become for Italian banks. A bank is unable to have a better rating than the country's acting lender of last resort – so there will be a rub-off.
Back to the deposit guarantee – if trust diminishes we could easily see an “old fashioned” run on the banks. Greece experienced this to some extent recently. Will the European Central Bank have to step in to ensure that Italy's banks have ample liquidity?
Overall this is the one of the haywire scenarios currently plaguing the European financial market.
Funding is key and is reflected in valuations
Previously Unicredit has stated it faces Euro 38bn in maturing bonds (the greatest amount of all major European banks) and Intesa said it is looking to refinance Euro 23bn (see chart 2). This will undoubtedly be very expensive due to higher yields which thereby will strike a major blow to the respective banks' core earnings for 2012 and onwards. This concern combined with the risk of the additional need for rights issues have been reflected in the banks' valuations (see chart 3). Basically, Italian banks are not expected to generate enough return to support the cost of equity, making a rights issue a great value destroyer, particularly if repeated capital increases are needed. Furthermore, the valuations indicate that either investors distrust the value of the assets carried by the banks or they believe that the liabilities are underestimated.
Unicredit announced a rights issue of Euro 7.5bn last week (~50% dilution) and just a couple of hours later in its Q3 report declared a goodwill depreciation of Euro 8.7bn, i.e. the net negative effect being Euro 1.2bn with its after-tax loss amounting to Euro 10.6bn.
Slow recovery – if any!
The fundamental dynamics of both Italian banking giants point to a slow and risky recovery (see table 1). To keep the core banking earnings healthy both players need to cut costs to become leaner and more efficient. It will be imperative for these banks to avoid loan growth with resultant increasing funding deficits, i.e. increasing the difference between loans and deposits. Analysts estimate Intesa Sanpaolo will strengthen its funding situation during the next three years whereas Unicredit will be even more exposed to the rage of the credit market (see charts 4 and 5). Furthermore, Unicredit stands out as having a more complex structure with large commitments in Central and Eastern Europe.
