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19 Jul 2016

Italy’s Bank Crisis Threatens Euro

As Italy frantically tries to save its banks without forcing investors to absorb massive losses, the European Union’s top court ruled that it is not necessary that junior creditors and investors must suffer losses before a bank is rescued.

The court didn’t immediately allow Italy to break with EU rules, but opened the door, which may trigger Italy’s ceasing to ask EU’s permission, prompting it apologize after it saves Italy’s embattled banks which threaten to upend the eurozone.

“Two Lost Decades” for Italy Says IMF 

The International Monetary Fund, (IMF) trimmed its prior Eurozone growth forecast. Before the referendum the IMF had predicted Eurozone growth of 1.7% for this year and next. It now expects the single currency economy will increase by 1.6% this year, contracting to 1.4% in 2017.

The IMF was far more pessimistic about Italy’s projected growth.

It had expected a 1.1% increase, which it trimmed to less than 1% this year, cutting anticipated 2017 growth from 1.25% to about 1%. The third largest European economy, the IMF has said Italy won’t be able to recover to levels seen prior to the 2008 financial crisis (where growth had been at 8%) until around the mid-2020s. By then, it predicts other Eurozone economies will have growth of over 20% larger than they’d had prior to the financial crisis. Italy’s predicted economic slump comes on the back of a decade of contracted economic performance.

The IMF said Italy faced a “monumental challenge”, anticipating recovery to be “fragile and prolonged”. With unemployment at 11%, government debt second to that of Greece’s and a looming banking crisis, the IMF said:

“The recovery needs to be strengthened to reduce high unemployment faster and buffers need to be built, including by repairing strained bank balance sheets and decisively lowering the very high public debt.”

A Summer Haircut for Italy’s Banks

Given sluggish economic growth, Italy has struggled to raise the tax revenue to reduce debt burdens and Italians have been challenged to repay bank loans. Italian banks have a massive problem of bad debts worth €360bn (£307bn). 45% of it is owed by middle-class Italians.

European Central Bank (ECB) President Mario Draghi was governor at the Bank of Italy from 2005 until 2011, when most of the Italian banks made the loans. The world’s oldest bank, Banca Monte dei Paschi di Siena has lost 99% of its value since 2008 and has been ordered by the ECB to shed its €48bn of bad debt by 2018.

PM Matteo Renzi wants to use about $45bn in Italian taxpayer funds to avert a bank crisis. During the 2008 crisis, banks in the U.S., U.K. and elsewhere were rescued with taxpayer funds. Italian banks have yet to recover losses after waiting for their own rescue package that didn’t come.  European Union rules prohibit countries from bailing out their banks, making the banks’ investors pay first- a move known as ‘a haircut’.

For Renzi, that’s political suicide ahead of Italy’s October referendum; it would impoverish investors holding bank bonds who are largely middle-class Italians. He has requested a six-month waiver of EU rules requiring investors to be ‘bailed-in’ for state aid to be given which Angela Merkel hasn’t agreed to. Renzi responded that Italy doesn’t need “a lesson by the schoolteacher.”

Italian Opportunity for Merkel to Demonstrate Flexibility

Renzi has argued with the European Commission previously over budget restrictions, and is likely to choose to break the EU state aid rules rather than risk a banking collapse. His rescue fund, a paltry amount in the face of the gargantuan debt has failed to attract investors.

It’s in the Eurozone’s best interest to negotiate with Italy over the country’s banking crisis. Given the sheer size of Italy’s economy, EU leaders have reason to demonstrate the flexibility they spoke of when absorbing the shock of Britain’s Brexit. An Italian financial collapse would be a Vesuvius event to the vulnerable Euro.