Article / 08 December 2016 at 13:55 GMT

Post-ECB headaches in Frankfurt, Rome, and Siena

Managing Partner / Spotlight Group
United Kingdom
  • ECB scales back QE to €60 billion/month
  • Future of Italy’s weaker banks hangs in the balance.
  • Central bank has options, but politics are the obstacle
Milan's Porta Garibaldi business district: Whatever the ECB's options, Italy's banks are incredibly shaky and the contagion risk relative to Europe as a whole is high. Photo: iStock 

By Stephen Pope

The European Central Bank decided to show its willingness to taper its asset purchase or quantitative easing programme from €80 billion to €60bn/ month. It will buy bonds at the €80bn level until March 2017. However, it added that there would be a reduction in the purchase size to €60bn for the nine remaining months of 2017.

It is a move that has puzzled the forex market as at first it was seen as a gesture that noted hawks’ concerns about ultra-loose monetary policy, but which could also unsettle markets. In an initial response, EURUSD soared to 1.0873 before the realisation that as the programme is to run at least until December 2017, the ECB may actually acquire a greater amount of bonds overall. 

Thus the EURUSD rate eased back to 1.0748 by 13:17 GMT.

The euro is still above levels seen on Monday and this appears to be driven by the thought of euros needed for new Eurozone asset demand as investors ride the coattails of the ECB demand.

The Italian job

Today, ECB head Mario Draghi will walk a tight line after Italian prime minister Matteo Renzi's referendum defeat and subsequent resignation. However, the single currency has shown incredible resilience by rebounding as fears over the political risk factors for Italy appear to have been overstated. 

On this point I harbour great reservations. Indeed, there is an ongoing level of concern over Italy’s ailing banking sector as a whole.

Italy is preparing a taxpayer-funded bailout for Banca Monte dei Paschi di Siena, after the rejection of Renzi’s electoral reforms undermined efforts to find new investors.

This morning, Italy’s government requested more time from the ECB to rescue Banca Monte dei Paschi, arguing that Renzi’s resignation makes it impossible to finalise the rescue more quickly.

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The Tuscan bank is looking to raise €5bn in December to avoid liquidation, but potential investors have so far proven reluctant to commit funds after Renzi’s referendum defeat left Italy with a political vacuum. Renzi has said he will quit, but the country’s president asked him to put his resignation on hold until parliament has approved the 2017 budget. This may happen tomorrow.

The options for BMPS to survive are limited and if the private sector proves unwilling, the flailing and failing financial house must consider the idea of a precautionary recapitalisation that would involve the central government injecting cash. 

It may well be that before business resumes next week, a government announcement authorising state recapitalisation will be in place with its implementation depending on coming political developments.

Rules and regulations

Any proposed state-backed cash injection will, per European Union banking rules, necessitate losses for institutional investors who hold the bank’s junior debt. However, gaining clarity is proving difficult as Treasury opinion and MPs were conspicuous by their absence yesterday when a comment was requested by Europe’s financial press.

Under EU banking rules, it would be just the institutions that take a hit as the smaller, retail investors who are holding €2.1bn of the bank’s subordinated bonds would be either spared or reimbursed.

As the chart above shows, the slow-leaking reports and speculation drove the bank’s shares close to a new all-time low in Milan. The prospect of Rome and Brussels cooperating to avoid a disorderly resolution of Monte dei Paschi, however, has lifted the shares of all of Italy’s other large banks.

Of course, these are thin markets and the rules would allow any political solution to be shelved if share price volatility means that it proves too tricky to construct a sensible deal.

A migraine for Mario

Italy’s banks are, to be blunt, buried in nonperforming loans. Data from the Banca d’Italia places the total amount of NPLs at approximately €200bn, i.e. 8% of the total loan exposure carried by the banks. 

Still, this may be just the start of the trouble as another €160bn worth of loans may be headed for NPL status. That would create an NPL/total loan ratio of 15%!

The ECB did ask BMPS earlier this month to reduce its gross nonperforming loan exposure from €46.9bn in 2015 to €14.6bn by 2018. 

That can only be done if state aid and potentially even ECB assistance is offered.

This would naturally heighten worries about tension between hardliners in the ECB and the president, who as an Italian has to feel a certain tug on his heart strings...

It's that sort of country. Photo: iStock 

There would also be a showdown between the European Commission and the Italian government... but who speaks for the government now, given that Renzi has resigned?

At the heart of the issue are EU restrictions on government bailouts of the financial sector. Europe is now reaping the seeds of turmoil for not having carried out brutally honest stress tests early enough in the past. The hard-hitting test back in August came far too late to eradicate the idea that business as usual cannot carry on.

The EU is watching Italy closely as it is wary of more state aid following the rescue of four smaller banks last December. Of course, after last Sunday’s result the EU must also be concerned that after the UK, another major economy could be losing its faith in the idea of ever more Europe. 

So, do they dare treat Italian banks harshly? Any state aid will require a long arbitration process and may only be able to partially offset the loss to bondholders.

Draghi cannot simply wade in and use the ECB balance sheet to explicitly save BMPS, however, he will be acutely aware that there is a risk of bank runs in Italy if the case of BMPS is not contained.

The level of NPL means that the Italian banking system is leaning over like the famous tower in Pisa and it is not ridiculous to suggest the system in Italy is heading toward collapse. If that were to happen, then the ECB would face an almost insurmountable challenge to prevent a financial panic across the Eurozone.

Italy has the third largest economy in the Eurozone and is part of the G7. The level of country's debt-to-GDP ratio is currently sitting at about 133%. I am no Cassandra, but let us not mince words here: there is no way that Europe has the resources, the ability or political will to handle a systemic failure of Italian banking.

Unfortunately, that is precisely what is happening, it is like watching a car crash in slow motion. Italian banks are absolutely drowning in non-performing loans, and represent a clear and present danger to an overburdened European financial system. 

Sadly, the most powerful Italian operator in Europe will be unable to prevent it. It is not that ECB is out of ammunition; rather, the mood across Europe will oppose it.

European Union parliament
The cultural and historical climate is simply not favourable for centralised, 
transnational institutions at the moment. Photo: iStock 

— Edited by Michael McKenna

Stephen Pope is managing partner at Spotlight Ideas
Alessandro Milesi Alessandro Milesi
This wlll be euro positive despite all the attempts to further boost equity markets


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