11/29/2016 08:16 am ET Updated Nov 30, 2017

Will Italy provoke a systemic financial crisis afterDecember 4?

Italy is on the cliff of a major debt and budget crisis.
The Italian economy has been in a virtual recession while its public debt increased to 2,273 billion euros representing 132.7% of its Gross Domestic Product, despite a monetary policy that pushed interest rates at a record low. The effect of this situation on Italian banks has been to accelerate the deterioration of their loan portfolio.
Boosted by the negative interest rate policy, the current indebtedness has been bearable so far. However, the possible increase of Euro interest rates could accelerate the budget deficit of the country and increase the cost of the Italian debt. Since the bottom of mid-July, the interest rates of 10 year sovereign Italian bonds has increased from 1.09 to 2.10 %.
This in turn will increase the cost of long-term financing of Italian banks. Italy is a $2,273 billion time bomb and nobody knows when the markets will decide to stop trusting Italy. As experienced in most financial crises the timing of such change of opinion is both immediate and brutal. At that level of debt, there is no rescue possible.
The Constitutional Referendum: a political gambling a la Brexit?
To address the notorious inefficiency of Italian politics, Prime Minister Matteo Renzi launched a national Referendum on constitutional reform scheduled for December 4, 2016. There is some similarity between this referendum and Brexit that was supposed to be won and was having a considerable influence on Europe.
Meanwhile, the worst crisis of its banking system threatens the financial stability of his country. With Italy's banking sector still weak and unsteady, a defeat in the December 4 referendum could deal another blow to political and economic confidence in the eurozone, and cost the 41-year-old Renzi his job and political career.
In any case, if the people reject the reforms, Prime Minister Matteo Renzi committed to step down. Some say this could lead to the end of the euro, as populists' voices eager to realize that are then given free play.
The Italian banking situation: why markets do not trust Basel III capital ratios.
The Improvement of the capital adequacy ratios of the Italian Banks gives a rosy picture of Italian Banks that must be questioned. The capital Adequacy ratios of Basle III have indeed three major weaknesses:
• At BBB level, the private loans require a 100 % capital adequacy ratio. For sovereigns, they are 0%, creating a favorable distortion in favor of sovereign borrowers.
• The Risk Weighted Adjusted assets contain an important part of national or bank assessment that exclude for instance the impairment of 17% of NPL loans.
• The capital increases are by definition based on the equity contribution to then balance sheet.
Markets judge them as irrelevant: the deterioration of the value of the equity as assessed by the stock value of the banks. MPS lost, since the beginning of 2016, 84% while Intesa San Paolo "only" lost 30%. The market has discounted the value of assets and the low profitability of the Italian banks despite the fact that under Basle III, the equity was continuously increasing. It is important to look at the elements of disconnection between the official numbers and the market reading.
Over-dependency on sovereign bonds
One of the explanations of the overbanking of Europe is the presence of massive -portfolios of European sovereign bonds in the portfolios of banks. As this chart demonstrates, Italy is the European champion of sovereign holdings. It is the European-record of BBB- debt holding - which is the minimum investment grade enjoying the Basel III privilege that frees these holdings from equity requirements. Matteo Renzi refused a European initiative to cap own country sovereign bonds at 10% of total assets!
Excessive Non-Performing Loans
The largest problem of Italy's banking sector is, however, their loan books: its banking sector is extremely vulnerable to Non Preforming Loans that built especially after 2010.
The amount of Italian banks' troubled loans is equal to about a quarter of Italy's gross domestic product. Lenders have lagged behind their European counterparts in reducing bad loans since the 2008 financial crisis as the country's longest recession since World War II left businesses and households struggling to repay debt.
The amount of NPL is concentrated in seven banks. Several Italian Banks have recently suffered from a serious deterioration of their results and equity: we will look at some of them in more details since they are the most threatening situations, and will need to find additional resources as a matter of urgency.
The rescue fund: Atlante
Italy's strongest banks, insurers and asset managers have agreed to create a €5bn backstop fund to bail out weaker lenders in an effort to calm growing investor concern about the stability of the banking sector of the Eurozone's third-largest economy. The rescue fund, announced by prime minister Matteo Renzi and finance minister Pier Carlo Padoan on Monday night after a six-hour meeting of financiers, regulators and ministers in Rome, comes after a plunge in the value of Italian bank shares this year on growing concerns about the effect of €360bn of non-performing loans on Italy's financial stability.
Atlante 1 was mainly setup to rescue Banca Popolare di Vicenza and Veneto Banca and is now pushing for their merger. Atlante 2 is aiming at buying 2.4 billion euros of bad loans from MPS. They have no intention to become shareholders of Monte dei Paschi. While officially not funded by the Italian State, the Atlante Funds were owned by the Government-owned savings banks.
The failure of ECB supervision
The ECB, the supervisor of MPS, has not initiated any procedure to the Commission to initiate resolution. If such a dramatic case is not sufficient to initiate this procedure, we need to ask ourselves if it will ever been used. Unless of course, political interventions influenced the decision not to initiate this procedure. This is as much a SRM credibility issue as it is a serious flaw of governance.
These provisions do raise an important question: it is only when the Resolution procedure has been put in place that the resolution funding can be activated. This also means that the European Supervisory Board will only "assess the resolvability" of the bank after the procedure has been launched. This is a provision that raises fundamental questions on the operability of the SRM. The assessment of the resolvability should happen as soon as the ECB faces alarm signals from its ow stress tests. Otherwise they become meaningless.
This is probably the biggest flaw of the SRM. It is unthinkable that the execution of the Banca d'Italia could be trusted since the European mechanism will only be initiated in cases where the central bank as regulator has failed, as the Banca d'Italia did in the case of MPS and other Italian banks.
Banca d'Italia in denial
The denial of Italy's central bank - Banca d'Italia - Governor Ignazio Visco is in line with a tradition of the Italian central bank governors. He has been with the Banca d'Italia for 26 years. One could not expect from him unorthodox initiatives.
The Italian central bank is responsible for the complete deterioration of non-performing loans as well as for approving the Antonveneta acquisition by Monte dei Paschi. It threw the banking system in its current situation.
Following the worst stress tests for Italian banks, here was his atatement:The results of the EU-wide stress test show that notwithstanding the long and deep recession of the Italian economy, most of the largest Italian banks would be resilient to further hypothetical shocks to macroeconomic conditions.
The ECB funding of Italy is not transparent
Consistent with its tradition, the European Central Bank refuses to disclose the geographic breakup of its exposure to Italy under its various interventions. The current QE facility of the ECB primarily benefits Italy, but the numbers are not published. My estimate is that every month, over 10 billion euros of Italian sovereign and corporate debt is bought by the ECB, favoring ridiculously low interest rates for the borrowings of a BBB- country with 2.3 trillion of debt representing 132.7 % of its GDP.
Whether my suspicion of Italian favoritism is right or wrong will only be dissipated by a transparency of the ECB over its traditional centralbancology .
More worrying is the absence of any positive effect of the largesse of the ECB to Italy. Despite low rates, Italian lending still contracting, new loans down 6.6% in first 7 months of year. Writes Il Sole on September 19, 2016.
National Government bail out
The EU Commission stated that EU regulations prohibit Italy from using its state funds to shield investors and shareholders of banks from losses, unless there is risk of "very extraordinary" systemic stress. Rather, the EU has adopted a bail-in strategy. The European Commission insist that Rome must stick by the rules and enforce a bail-in of junior creditors before resorting to a bailout.
Such interventions are now regulated in a much stricter way. The European Commission accepted a few cases in April 2016 but is still striving with the notion of an ECB non-performing loan back stop facility.
The systemic risk
The Italian banking sector, backed by an over indebted country, might create a systemic banking crisis. The recent initiative of the Bank of England to ask its banks to report their exposure to the Italian Banking Sector is one of the most recent indicators of the nervousness of the world in front of this fragility.
The reasons why the BRRD has not been applied have never been elaborated by any documents for the ECB or other European bodies. It is in direct contradiction with the transparency of the process. The exposure of the ECB to the sovereign debt of Italy and to Italian Banks is an essential element of the appreciation of the risks associated with the country and its banks.
This experience should lead the Eurozone authorities to review the detailed provisions of the BRRD to streamline the procedure, simplify the bail-out or bail-in mechanisms and de-dramatize the decision of non-viability and systemic risk.