Investors should watch this space carefully As readers must know, we are currently in the midst of a back and forth between the Italian state and the ECB in terms of the recapitalization of Italian banks, and more importantly stabilization of confidence in the banking sector, across all of Europe.

The first thing I ask myself when I started looking at this sector is why is it so bad, the answer is nonperforming loans, and imprudent lending practices by Italian banks over a long period of time. What this means is lending money to companies and individuals that do not pay it back. Politics, cronyism, corruption, all have played a role.
But more importantly what it means is that there has been a shift in the attitude of banks towards not lending to any small and medium-size businesses in Italy and focusing only on the bigger institutions. This is reminiscent of what happened in Europe notably in the UK post Lehman Brothers the question I ask myself is why is it happening now almost 8 years after Lehman’s bankruptcy. The real shame is that small developing businesses cannot borrow money in Italy from banks. The reason that it is important to sort out this problem is because you will only stimulate GDP growth and business overall through the transmission mechanism of lower rates to banks, banks lend to businesses, businesses grow and develop as a result of freely available capital.

There is currently a government plan to recapitalize Italian tide banks using a funding vehicle called ATLANTE this has been used “successfully” in the past to fund banks and increase their tier 1 capitalization ratio, there is a proposal for a second version of this Atlante 2 however it has no money as of yet, i.e. has yet to be capitalized and therein lies the problem. Capital for this vehicle which will be used to bolster bad banks tier 1 ratios comes from, you guessed it the banks themselves. The first vehicle which has been totally expunged has €1.6 billion left in it. And it has made little to no difference to the banking sector and has failed to stabilize confidence in it.

What we really think needs to happen is a liability management exercise (LME) to reduce the amount necessary in equity as a result of the bad loans being taken off the balance sheet. This of course enters the domain of whether the LME exercise can remain domestic or whether it needs to become an ECB directed and run program.

Monte Dei Paschi has become the poster child for what not to do. Currently Monte’s market cap is approximately €800 million however over the past few years the bank has received capital injections of €8 billion therefore it has become clear that there needs to be a segregation between nonperforming (NPL) and performing loans.This is commonly referred to as good bank bad bank, and the idea is quite simple if you separate out the nonperforming loans the capital injections can go towards helping the banks and helping their tier 1 capital ratios.

If you do not segregate out the bad part of the bank i.e. nonperforming loans prior to capital injections then the capital is wasted as it simply goes towards plugging the black hole of nonperforming loans. These loans are typically 10-40 times as large as the capital base of the bank itself.

However the formation of a good bank bad bank structure is a highly politicized one and likely cannot happen without the involvement of the ECB. In the case of Italy the current administration wants to solve the problem without the involvement of the ECB and the ECB would insist on liability management exercises (LME). Put politely that means bondholders would likely have to absorb significant losses, in the order of seniority in the capital structure.
This is deeply unpopular, with the government’s domestic investors as many of these bonds are held internally in Italian institutions. And of course we now enter the domain of domestic politics, where what needs to happen and what is likely to happen are miles apart. The solution of trying to plug the hole with fresh capital without restructuring the banks for Italian investors avoids bondholders incurring massive losses. However what most investors believe needs to be done involves bringing in the ECB, and having a proper liability management exercise, and a segregation of performing and nonperforming loans into a bad bank

Watch Italy carefully as it is a great case study in the dynamics between what is acceptable domestically, and what is required and best-of-breed in terms of solutions and involvement of European central government and institutions.