The memo that all is well with the world under a Trump presidency has not been received everywhere, it seems. Risks are on the rise, perhaps nowhere more acutely than in Italy.
The Financial Times reported last week that as many as eight of Italy’s troubled banks “risk failing” if prime minister Matteo Renzi loses the December 4 constitutional referendum and resulting market turbulence scares investors away from the urgent need to recapitalize the banks. The latest polls show Renzi losing the vote.
Renzi has promised to resign if he loses and his government would then fall, threatening to end his plan to recapitalize the €4 Trillion Italian banking system. The alternative is a “resolution” under E.U. rules. Resolution is a new regulatory mechanism which restructures and, if necessary, winds up a bank by imposing losses on both equity and debt investors (a so-called “bail-in”). This process would be particularly devastating in Italy where millions of individual investors have invested their savings in bank bonds.
The situation is being closely watched by financiers and policymakers across Europe and beyond, who worry that a failure of Italian banks could trigger panic across the euro zone banking system.
The problems at the banks stem from the Italian economy which has never recovered from the 2008 crisis. Gross domestic product per head is 9 per cent lower in real terms today than it was in 2007 and remains stuck near the level of two decades ago. Italy staggers under an ageing population and the second highest public debt load in Europe at more than 130 per cent of GDP.
Italy’s financial system is based on mutual and co-operative banks which have traditionally put their role in supporting local economies above profitmaking. The country is wildly overbanked, with more branches per capital than any other industrialized country. This structure, and the lack of economic growth, have suppressed profits at all banks, causing non-performing loans to soar. That’s why the market value of Italian banks has fallen by more than half this year.
Furthermore, capital is flooding out of Italy, further depressing bank balance sheets and weakening the economy. The flow of capital within the euro zone is tracked by the ECB’s Target 2 system. Italy is experiencing a run on its capital reserves of alarming proportions. The latest Target 2 balances for September 30, 2016 show a net accumulated loss of €353.9 billion since 2010, up €17 billion in September alone. Carmen Reinhart, perhaps the foremost expert on national debt dynamics, notes that “Italy’s Target 2 deficit is above 20% of GDP, its worst reading to date (see graph below). By some of the standard definitions, these are crisis-level reserve losses (shaded in the figure),” she says.
The market is sniffing out the risks. The spreads on Italian government bonds versus German Bunds rose above 190 points on Friday, a level not seen since October 2014.
Why am I telling you all this? I just want you to understand, dear reader, that all the systemic risks have not been banished by the coming of Trump. Serious problems remain and they will resurface soon enough. Circle December 4 on your calendar. It could be important.