Italy's banking crisis has gone largely unnoticed in the financial world over the last 6 months. As I see little gain in holding stocks (NYSEARCA:SPY) except to trade volatility of late, understanding a crisis such as the one approaching Italy is necessary. The details of Italy's crisis are unique, interesting and at the same time, both concerning and unimportant to the wider investment community. It is a story of systemic problems in the banking sector around the world, a unique set of circumstances that has resulted in Italy becoming the most recent "head on the block."
Italian banks are finding it difficult (read, impossible) to raise money. With new EU bailout rules, specifically, the Bank Recovery and Resolution Directive (BRRD), which banned the bailout of the banking system without first bailing in creditors, non-performing loans have been on the rise since the GFC. Furthermore, governments cannot step in until a percentage, at least 8% of total liabilities, has been bailed-in. Herein lies the crux.
Many Italian retail holders own those bonds. Estimates show retail investors hold one-third of bank bonds. As the bail-in would come almost solely from junior debt, the junior debt holders are likely to be completely wiped out. Not an 8% loss, but a 100% loss. Furthermore, as much as half of junior subordinated debt is held by retail investors. This changes the rules from bailing in the wealthy to bailing in the middle class - bringing a politically charged argument to bear. After the bail-in of four regional banks had resulted in default on subordinated debt, it showed some unexpected consequences of the BRRD. The Telegraph summarized the event succinctly:
"The banking squeeze has become politically explosive in Italy after thousands of small depositors were wiped out at four regional banks late last year. They were classified as junior bondholders, even though most of them were just ordinary savers who did not realize what was being done with their money."
For anyone who wants to argue that the retail holders knew the risks when they signed up, this is easily disproved. Some of these bonds had a minimum investment of 1000 euros and sold to depositors within their local branch.
The Side Effects Of "Strengthening" The Banking Sector
In effect, the new EU rules on bank "recovery" guarantee that Italy's banks are going to need one. There is talk of banning junior debt from being purchased by retail holders, who currently own half of the subordinated debt. The political side effects of a bail-in of everyday retail owners would be disastrous, and thus the government is unlikely to force it. No money is waiting around the corner for cash injections as the banks get closer to the brink.
As EU rules meant to harden the bank sector begin to have unintended consequences, Italy searches for a solution. The problem is likely to be magnified in smaller banks, a significant portion of which fund themselves from funding sourced from retail investors in the form of subordinated debt. There is no clear out; the government needs to choose between the EU and Italian citizens. Either EU rules become flexible, or the Italian government will eventually need to bail in retail holders - All but guaranteeing a national backlash and consequent referendum on EU membership.
Could Brexit Save The Italian Retail Holder?
Brexit may have done retail holders of Italy, and consequently the Italian government, a huge favor. In an attempt to prevent the growth of Euroscepticism, Brussels may allow a broad interpretation of the rules that allow government intervention in extenuating circumstances. A bailout could come in the traditional means used before the new banking laws. Bad debts may yet be ring-fenced from the major banks and the banks recapitalized.
As with anything, it is hard to estimate the effect this will have on the world economy and the investment community. Due to the investment practices incentivized by Italian law encouraging everyday citizens to hold bank bonds the bailout is more politically relevant than many previous crises. To follow the law to the letter would set the stage for Italy's referendum on membership. To allow Italy to circumvent the laws would tell other EU countries that they can do so in a crunch. Unfortunately, any solution concocted without the ring-fencing of bad loans, or guarantee of small retail bond holdings, only kicks the can down the road for the next year.
Of all outcomes, the most likely will come from a mix of subordinating senior debt, clever cash injections and EU assistance. If Brussels flexes their muscles in Italy to force a bail-in of retail investors, they could see exit number two around the corner. Hence, this will not happen. Italy's banking crisis is going to come and make a big flurry in the markets, and then it will go. A week after it's over, most of the finance world will forget until it rears its head again. At that point, we can expect another Band-Aid solution to a systemic problem. For now, Italy's banking crisis is the proverbial storm in a teacup.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.