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Why Italy has so much bad debt

The mood in Europe has noticeably shifted this year as a combination of populist defeats at the ballot box and an improving economy has given rise to a feel-good factor. Unemployment, at 9.3% in May, and Q1 growth of 0.6%, suggests that the euro area, after almost seven years of stagnation, is turning the corner.

But recent developments regarding Italy’s banking system ought to give pause for thought.

The ECB is concerned about bad debt in the banking system and its concentration in Italy. And they should be. While lenders across the euro area directly supervised by the ECB are exposed to sour loans worth €915bn, or about 4 per cent of total exposure, Italian banks alone have €326bn of exposure to non-performing credit.

To attempt to address this problem the ECB recently called for banks to cover the unsecured portion of all bad debt within two years, and for all of it within seven years. This will raise the cost of holding debt for banks, as only around half of Eurozone bad debt is covered by borrowers’ collateral. The likelihood of fire-sales of NPLs risks reducing banks’ capital ratios and thus lending.  The Bank of Italy and former PM Matteo Renzi have complained that these measures threaten Italy’s fledgling recovery.

Italy’s fragmented banking system

With over 400 national and regional players, Italy’s banking sector is highly fragmented and localised. This has created a source of systemic risk in Italian banking as many of these lenders have opaque and politically-influenced lending practices, with prudence often taking a back seat.

According to ECB and IMF research, even as Italy holds a third of the eurozone’s NPLs, a much higher rate of bad debt is held in banks in the south of the country than in the north. It is alarming that the problems that have surfaced to-date – in banks such as Popolare di Vicenza, Veneto Banca and Banca Monte dei Paschi di Siena – are situated in Italy’s industrial north than in the old Bourbon states of the south, where credit allocation is more suspect. The same IMF study found that three-quarters of Italy’s NPLs are related to the corporate sector, with the construction, services and ‘less technologically intensive sectors’ most badly affected. These are typically industries that are more localised and more ‘southern’.

To understand why Italy is in such a pickle today, it is worth looking at some recent history.

After a social pact in 1993, promising to coordinate the country’s industrial, labour and financial systems, Italy had an opportunity to become a German-style economy. But these reforms were watered down and basically abandoned after Silvio Berlusconi came to power in 1994. Instead, Italy remains stuck as a state that relies heavily on the government to keep the social peace by compensating losers and strong political actors. Banks are merely one of the tools at its disposal.

Historically, Italy has had a financial system that was largely based on patient capital especially at the SME level. The country’s corporate structure is marked by ‘pyramidal ownership’ that allows families or other entities to control large parts of Italian industry with relatively small ownership stakes. Families develop long-term relationships with banks, which in theory should lead to system that is relatively stable and low-risk. However, the state has always had a great degree of influence over the allocation of capital across the financial system, and that remains despite waves of bank privatisations since 1979.

Today, politicians exert influence in Italy’s financial system through the system of ‘foundations,’ opaque, non-profit bodies that were set up in the 1990s to ensure lending remained in the ‘public interest’. Foundations own just 23% of Italian banking assets but control the boards of the country’s largest banks. In Unicredit, foundations own just 9% of stock but control 84% of seats on the Board of Directors. Almost half of foundations are elected by local authorities, and 60% of the seats on the board of Foundazione MPS and 55% at the Fondazione Cariplo (Intesa) are held by local politicians.

Italy’s banking crisis in context

But there’s a bigger problem here, and it relates to the political economy of the Eurozone. In the euro area there are two groups of economies, export-led economies in the North (such as Germany, Belgium, the Netherlands and Austria) and demand-and-credit-led economies in the South (such as Greece, Italy, Spain and Portugal).

States in the north steadily gained competitiveness vis-à-vis the South in the early 2000s by holding wages down and cutting unit labour costs through improvements in products and processes that raised productivity. Coupled with low domestic demand, particularly in Germany, this created a situation of excess savings in the euro-North (Germany) that were channelled into the euro-South (Italy) and established the trade imbalances that underpinned the first euro crisis.

Because the EU’s institutions place constraints on national economic and fiscal policy, and because member states do not have their own currency, southern states, including Italy, used their leverage on banks as a partial substitute for tools it would typically use to keep the social peace. These states were helped along by low interest rates and risk premia that were more relevant to Germany than to countries like Italy.

Credit growth, supported by capital inflows and implicit bailout guarantees, replaced fiscal management as an engine powering domestic demand growth in the euro-South. It also turbo-charged imports of the high value-added goods from the North that countries in the South did not produce itself, leading to large trade deficits. German credit was squandered on businesses and projects that were low-value and often non-tradeable, merely serving to raise inflation and sustain the competitive trade imbalances that drove the credit flows in the first place. This is the reason why Italy today has so much bad debt. It’s a combination of the design of the euro area and problems within Italy’s political economy.

Deeper levels of scrutiny that are typical within systems with more capital depth were absent, making southern European states more exposed to financial risk than other countries that had high trade deficits, such as the UK and USA. It was these self-fulfilling fears of insolvency that originated mainly in the poor state of private credit markets, and the tight link between the health of national banking systems and public sector liabilities, that led to the sovereign debt crises of the 2010s.

Necessary reform

It now appears that officials in the ECB realise that the Italian banking system needs to be reformed, not just to isolate the mountain of bad debt and to prevent another financial crisis, but also for long-term reasons. There needs to be more accountability and transparency too.

Part of that involves bank consolidation. Consolidation has worked for Spain, which has reduced the number of its savings banks (cajas) from seventy to 12 since the financial crisis, with the Spanish economy growing strongly on the back of investment and exports. Consolidation with regulation that ensures that no bank becomes too big to fail is needed to improve the Italian and wider European banking system.

With the euro-area enjoying a sustained economic recovery, the last thing its leaders want is fears of another banking or political crisis to weigh it down. The price to pay in the short-term might be a hit to the Italian economy, but this perhaps is a price worth paying, both for Italy and the wider euro area.

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