Article / 05 July 2016 at 11:00 GMT

Italian banks need a solution.... quickly

Head of Equity Strategy / Saxo Bank
  • Italian banks in crisis with €400bn in bad loans
  • EBA stress test for banks due July 29
  • UniCredit lacking around €8bn in tangible equity

Fiat 500 in Italian flag colours
"For sale: Looks great, barely runs." Photo: iStock 

By Peter Garnry

The biggest theme emerging in the post-Brexit world is the evolving banking crisis in Italy which has actually been under way since the beginning of the year as the new non-performing exposure rules started to be enforced by the European Banking Authority.

UniCredit (UCG:xmil), Intesa (ISP:xmil), Monte Paschi (BMPS:xmil), Banco Popolare (BP:xmil), and UBI (UBI:xmil) collectively had €119 billion in unprovisioned non-performing loans at the end of Q1 with UniCredit’s exposure being the critical piece in the overall European banking system. 

The Italian banking system has around €400bn in total non-performing loans. The aggregate common equity among Italian publicly-listed banks was around €125B (as of the end of Q1) and around 75% of the uncovered non-performing loans.

Another way to understand the Italian banking crisis is through the lens of the Texas Ratio, which measures the amount of non-performing assets and loans (including loans delinquent for more than 90 days) divided by the bank’s tangible equity plus its loan loss reserve. 

A ratio above 100% is big warning signal.

Stress test looms, banks ill-prepared

Seven out of the 47 banks in the Euro STOXX 600 Banks Index are currently above that threshold with three of those being Italian banks. But just below the threshold two Italian banks – UniCredit and Intesa – follow, showing the magnitude of the Italian banking crisis.

Texas ratio
There is news out today that the Italian government is seeking approval from European regulators to use Article 32 of the EU bank resolution directive that allows temporary state aid if a bank is likely to fail the next stress test by the EBA which would immediately cause an insolvency situation creating a banking crisis that could spiral out of control. 

The EBA stress test is due on July 29. The plan to inject capital into Monte Paschi is through selling of new convertible bonds to the Italian government worth a minimum of  €3bn through state rescue fund Atlante.

On a positive note, improving macro fundamentals in Europe have finally reversed the NPE trend in Italy and it has started to fall. However, profitability is very weak and the market is forcing a margin call on Italian banks, so there is still an imminent need for capital injections. 

UniCredit is lacking around €8bn in tangible equity. The valuation on UniCredit is very attractive and we have a long position in the stock in our equity portfolio.

UniCredit daily share price year-to-date:

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Source: Saxo Bank 

The other euro members will not allow the Italian government to inject capital into its banks other than through Article 32, which only applys to Monte Paschi as of this writing. The rules cannot be bent for Italy despite the magnitude of the problem because of the recent banking failure in Portugal with Banco Espírito Santo where shareholders and creditors took the loss.

Political minefield may trigger ECB action

It is more likely, should the situation deteriorate further, that the European Central Bank will inject capital into Italian banks in return for collateral under the mandate of price stability. An implosion of the Italian banking system would cascade into other European banks and the funding market, creating disorderly markets and lower sentiment causing a slowdown in economic growth and also prices. 

As inflation is already barely above zero, another wave of downward pressure on consumer prices would force the ECB to act. Under such interpretation of price stability, the ECB could become the bailout mechanism for Italian banks, but it would come at a cost to shareholders and creditors.

— Edited by Michael McKenna

Peter Garnry is head of equity strategy at Saxo Bank

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