Mon, Jul 11, 2016 - Page 7 News List

Italy’s plan to shore up banks could throw Europe into tailspin

European rules might prevent Italy from bailing out its banks, leading to losses which would make investors wary — prompting them to stop buying debt securities

By Peter Eavis  /  NY Times News Service

Even as Europe grapples with the repercussions of Britain’s vote to leave the EU, a dispute over tens of billions of dollars is also threatening to roil the region’s US$16 trillion economy.

The Italian government, according to some estimates, needs to spend US$45 billion to shore up its banks burdened with bad loans. Fears that European authorities will bar the government from providing that support are adding to the turbulence caused by “Brexit.”

It might seem difficult at first to understand how the lenders of a medium-size country, none of which are particularly large, or engage much in risky Wall Street activities, could be spreading fear through global financial markets.

However, they are, and their problems reveal what can happen when well-intentioned regulations bump into reality —and this is creating tension among the leaders of Europe. The situation might drag through the summer, keeping investors around the world on edge.

So how bad could this get?

The steep declines in shares of Italian banks suggest that a storm is ahead. The stock price of Banca Monte dei Paschi di Siena, one of Italy’s most troubled lenders, is down 80 percent in the past 12 months. Its shares also trade at under 10 percent of its book value — a measure of its net worth — a sign that investors really think that the bank needs new capital. Also, when bank stocks sink that much, banks find it almost impossible to raise new capital in the markets.

The good news is that overall, Italy’s banks do not appear to need an overwhelmingly large sum to get them on a firmer footing. The problem centers on the banks’ approximately 200 billion euros (US$221.01 billion) of bad loans.

The banks have already set aside significant reserves to absorb losses in these loans, effectively valuing them at 40 percent of their original value, according to some analyses. However, investors appear to think that these loans are worth even less.

The theory is that the banks would now have to bite the bullet and value the loans at an even lower level. However, this could produce losses, and some banking experts say 40 billion euros of support is needed to help the banks take those hits.

A simple response would be for the Italian government to hold its nose and plow that sum into the banks, roughly mimicking what the US government did with its Troubled Asset Relief Program (TARP) in 2008.

However, such a bailout might be illegal under relatively new European rules that aim to protect taxpayers and instead force investors in the banks to provide financial support in times of trouble. Investors lend money to banks by buying their debt securities. Under the anti-bailout rules, those securities would be forcibly turned from debt into new equity, which could absorb any new losses taken on the bad loans. Under such a so-called “bail-in,” the equity would in theory be worth less than the debt securities, leading to losses for investors who held the debt.

It sounds straightforward, but in Italy it is not.

FEAR OF LOSSES

Retail investors hold many of those debt securities. According to Bruegel, a research organization that specializes in European economic issues, families own about a third of Italian banks’ debt securities. Not only would bail-ins focus the pain on Italian households, the fear of losses might also prompt investors to stop lending to banks and lead depositors to withdraw their money. This would make a bad, but manageable, situation much worse.

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