Italy, Stuck in So Many Ways, Tries Imaginative Finance

Pity Matteo Renzi.  As Italian Prime Minister, he knows that his country’s banking system needs immediate support and fundamental reform, so much so that his nation’s nascent economic recovery faces a considerable threat.  Yet, Italy’s own financial weakness and European Union (EU) rules severely constrain his options.  Not all the news is bad.  His financial people have come up with an imaginative response to the country’s bank problem with what they call the Atlante Fund.  But this answer has its own limits.  Italian economics and finance, and by implication European economics and finance, remain precarious.

Renzi’s problems are indeed severe.  Past regulatory oversight or maybe just negligent private management have left Italian banks with a huge overhang of questionable loans, much worse than elsewhere in Europe.  According to the European Central Bank (ECB), Italian banks, even after writing off some €85 billion in bad loans, still have on their books €115 billion in loans to insolvent borrowers.  The Bank of Italy estimates that some €360 billion in total will fail to repay in full.  It classifies some 17 percent of all Italian bank loans as non-performing, more than twice the next worse in Europe, Spain, where the figure verges on 8 percent, and many times worse than the stronger economies, such as Germany, where questionable loans amount to a mere 2.7 percent of total loans outstanding.

The danger from Renzi’s viewpoint — and the viewpoint of policy makers throughout Europe — is less that potential losses threaten bankruptcy, though they do, and more that the existence of so many bad loans could undermine depositors’ confidence in Italy’s banking system.  Should such a loss of confidence become widespread, depositors would transfer money from Italian banks to banks elsewhere in the Eurozone.  The shift would starve Italian finance of liquidity, even among the better-managed banks, and almost surely put the economy back into a deep recession.  And because Italy amounts to fully 16 percent of the Euro-zone’s overall gross domestic product (GDP), such a prospect threatens the overall European economy as well.

Tentative signs of such a loss of confidence have already emerged.  To be sure, the country to date has avoided street scenes in which lines of depositors form in front of banks, looking to withdraw their funds, as people witnessed in Greece not so long ago.  But Europe’s interbank lending figures paint an ominous picture.  These so-called TARGET2 balances suggest that Italian banks are already drawing heavily on the rest of Europe to maintain liquidity.  The most recent data in fact indicate Italian dependence to the tune over €250 billion, the highest level ever recorded.  This deficit compares with Germany’s surplus of almost €650 billion.  Those close to this data suggest that the figures yield to a number of explanations, but the trend nonetheless points to trouble.

Certainly, Italian depositors have reason to worry.  Italy’s Interbank Deposit Protection Fund (FITD), the repository charged with insuring deposits of  €100,000 or less, hardly looks strong.  Its assets on hand amounted at last measure to about €2 billion, a mere 0.4 percent of the €500.7 billion in outstanding Italian bank deposits.  In contrast, the comparable fund in the United States, widely characterized as inadequate itself, holds assets amounting to 1.0 percent of all U.S. deposits.  And even if these smaller deposits could count themselves secure, those with deposits above the €100,000, often the working capital of Italian businesses, have no such guarantee.  On the contrary, EU rules threaten these depositors by forbidding any public assistance to banks until after larger depositors, shareholders, and subordinated creditors take losses.  It would hardly surprise in the circumstance if these larger Italian depositors are already transferring funds, and act that might account for part of the TARGET2 deficit.  Should such a flight of large deposits become widely known, smaller depositors would almost surely follow suit.

The severity of the situation, combined with EU constraints, has prompted Minister of Economy and Finance Pier Carlo Padoan to come up with a truly imaginative rescue device.  Calling it the Atlante Fund, after the mythological Titan who supported the heavens, it would draw on funds from stronger banks to buy questionable loans and other assets from weaker financial institutions and so, in Padoan’s words, “ringfence” the troubled assets.  Rome hopes that the relief will secure confidence among depositors while the fund’s use of private monies can sidestep EU rules against public assistance.

In the protean world of finance, many strange vehicles have come into existence.  Italy’s new Atlante Fund may not count as the strangest, but surely it ranks high on the list.  But not all such vehicles, imaginative though they have been, succeed in their purpose.  The jury is still out on the Atlante Fund.  For one, the EU and the European Central Bank (ECB) have begun to question whether it constitutes a subterfuge of the rules, a judgment that would cause them to reject its legitimacy.  Even if it passes muster in the halls of European power, there is no assurance that it will grow to its planned size or, if it does, whether it will answer to the needs of the situation.  After all, its goal is for €5 billion in equity.  Even if used very effectively, this base is small next to the face value of questionable loans outstanding, though purchases will surely occur at a discount.  If the effort fails, the burden will fall first on the Italian economy, but then, in the nature of finance, it will raise doubts about stability elsewhere in the Eurozone.


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