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Italy referendum result: What is going to happen to the country's fragile banks? Italy referendum result: What is going to happen to the country's fragile banks?
(about 1 hour later)
The Italian electorate has rejected a major constitutional reform in a national referendum, precipitating the resignation of the Prime Minister Matteo Renzi. The Italian electorate has rejected a major constitutional reform in a national referendum, precipitating the resignation of the Prime Minister Matteo Renzi.
Many eyes have turned to the Italian weak banking sector for market reaction. Many eyes have turned to the weak Italian banking sector for market reaction.
The share price of Italy’s third largest bank Monte dei Paschi di Siena fell sharply when the stock market opened. But it has since recovered those loses. The share price of Italy’s third largest bank Banca Monte dei Paschi di Siena (BMPS) fell sharply when the stock market opened.
The other major listed Italian banks – Unicredit, UBI, Mediobanca and Intesa Sanpaolo – have also bounced back (although they have since fallen again). The other major listed Italian banks – Unicredit, UBI, Banco Popolare, Mediobanca and Intesa Sanpaolo – are also now trading considerably lower.
So Is this a sign that things are less serious than believed? Is Italy facing a new financial crisis? Are traders now assuming Italy will leave the single currency?
Or have the markets misread the situation? We answer the big questions below.
Below we answer the big questions. The fundamental problem is that the sector was never properly restructured and recapitalised in the wake of the global financial meltdown and the subsequent eurozone crisis.
The fundamental problem is that the sector was never properly restructured and recapitalised in the wake of the global financial meltdown or in the subsequent eurozone crisis.
The result is that these banks are now weighed down by a heap of “non-performing loans” with a nominal value of around €360bn – around 16 per cent of the total of all their assets.The result is that these banks are now weighed down by a heap of “non-performing loans” with a nominal value of around €360bn – around 16 per cent of the total of all their assets.
Low interest rates from the European Central Bank and the extreme weakness of the Italian economy in recent years have also damaged the banks’ profitability.Low interest rates from the European Central Bank and the extreme weakness of the Italian economy in recent years have also damaged the banks’ profitability.
They upshot is they urgently need to be recapitalised – either with private or public funds. Monte dei Paschi had planned to begin a €5bn capital raising process this week. They upshot is that they urgently need to be recapitalised – either with private or public funds. Monte dei Paschi had planned to begin a €5bn capital raising process this week.
The size of the total capital hole in the Italian banking sector is estimated by Citi at between €20bn and €40bn, or between 1.2 and 2.4 per cent of Italian GDP.The size of the total capital hole in the Italian banking sector is estimated by Citi at between €20bn and €40bn, or between 1.2 and 2.4 per cent of Italian GDP.
Because the government is a central actor in the bank recapitalisation drama.Because the government is a central actor in the bank recapitalisation drama.
The Renzi government had been walking a political and economic tightrope in recent years. It needs to help recapitalise the banks for the good of the wider economy, but eurozone rules mean all banks can only be bailed out with public money if private bondholders are first “bailed in”, meaning these debt investors have to take losses.The Renzi government had been walking a political and economic tightrope in recent years. It needs to help recapitalise the banks for the good of the wider economy, but eurozone rules mean all banks can only be bailed out with public money if private bondholders are first “bailed in”, meaning these debt investors have to take losses.
This is to ensure private lenders to banks do not get a backdoor public bailout when banks fail, as happened in many Western countries in 2008/09 prompting great public anger. This is to ensure private lenders to banks do not get a backdoor public bailout when banks fail, as happened in many Western countries in 2008/09, prompting great public anger.
The problem in Italy is that several banks flogged around €30bn of their bonds to ordinary Italian households, rather than just sophisticated institutional investors such as pension funds and insurance companies.The problem in Italy is that several banks flogged around €30bn of their bonds to ordinary Italian households, rather than just sophisticated institutional investors such as pension funds and insurance companies.
And these households – though relatively small in number – stand to take disastrous and politically-explosive losses in the event of a bondholder bail-in.And these households – though relatively small in number – stand to take disastrous and politically-explosive losses in the event of a bondholder bail-in.
The government has been working to avoid this outcome, while also putting the banks on a stronger financial footing.The government has been working to avoid this outcome, while also putting the banks on a stronger financial footing.
The Renzi strategy has been to encourage the banks to raise new funds privately first, but if this fails, to prepare to undertake a bail-in recapitalisation with special protection for small investors.The Renzi strategy has been to encourage the banks to raise new funds privately first, but if this fails, to prepare to undertake a bail-in recapitalisation with special protection for small investors.
There have been suggestions that those with less than €100,000 in bonds could be shielded.There have been suggestions that those with less than €100,000 in bonds could be shielded.
On top of this, the Renzi government has been the sponsor of a scheme to package up and sell of the questionable debt on Italian banks’ balance sheets at a major discount to other private investors. On top of this, the Renzi government has been the sponsor of a scheme to package up and sell off the questionable debt on Italian banks’ balance sheets at a major discount to other private investors.
The fall of the Renzi government means this whole delicate bank support strategy is now up in the air.The fall of the Renzi government means this whole delicate bank support strategy is now up in the air.
Without a political backstop some analysts think stricken banks like Monte Dei Paschi could struggle to raise new private capital.Without a political backstop some analysts think stricken banks like Monte Dei Paschi could struggle to raise new private capital.
“The No result in the referendum has undoubtedly made it harder to attract private sector capital to fill Monte dei Paschi’s gaping capital hole,” said Kathleen Brooks of City Index.“The No result in the referendum has undoubtedly made it harder to attract private sector capital to fill Monte dei Paschi’s gaping capital hole,” said Kathleen Brooks of City Index.
“The risk is, that investors lose faith that it will be able to do this, which triggers a run on the bank and a full blown financial crisis.” “The risk is that investors lose faith that it will be able to do this, which triggers a run on the bank and a full-blown financial crisis.”
Largely because the referendum result and the fall of the Renzi government was “priced in” by the financial markets already.Largely because the referendum result and the fall of the Renzi government was “priced in” by the financial markets already.
Opinion polls two weeks ago had pointed to the likely rejection of the reform. Opinion polls two weeks ago had pointed to the likely rejection of the reforms.
And the share prices of Italian banks had already been falling sharply.And the share prices of Italian banks had already been falling sharply.
The sector as a whole has lost nearly half its stock market capitalisation this year.The sector as a whole has lost nearly half its stock market capitalisation this year.
Many analysts predict a caretaker government will be appointed by the Italian President and that this government will still be led by Renzi’s Democratic Party, possibly by the current finance minister Pier Carlo Padoan.Many analysts predict a caretaker government will be appointed by the Italian President and that this government will still be led by Renzi’s Democratic Party, possibly by the current finance minister Pier Carlo Padoan.
This administration could carry on with the previous bank recapitalisation strategy - although there can be no certainty about this. This administration could carry on with the previous bank recapitalisation strategy – although there can be no certainty about this.
Economists at Citi point out that Italian banks hold €400bn of Italian government bonds.Economists at Citi point out that Italian banks hold €400bn of Italian government bonds.
They warn that if traders mark down the value of these bonds in the coming weeks due to renewed political and economic uncertainty that could prompt further falls in Italian banks' stock prices creating a "vicious spiral" of lower bank lending and weaker GDP growth. They warn that if traders mark down the value of these bonds in the coming weeks due to renewed political and economic uncertainty, it could prompt further falls in Italian banks' stock prices, creating a "vicious spiral" of lower bank lending and weaker GDP growth.
“Italy's financial markets, its underfunded banks and its overall economy could suffer unless Italy resolves its political crisis fast,” said Holger Schmieding of Berenberg.“Italy's financial markets, its underfunded banks and its overall economy could suffer unless Italy resolves its political crisis fast,” said Holger Schmieding of Berenberg.
The most dangerous scenario for Italian bank investors is if there are early elections and the populist Five Star movement manages to form a government.The most dangerous scenario for Italian bank investors is if there are early elections and the populist Five Star movement manages to form a government.
Five Star, which is currently the second most popular party and which campaigned strongly for the "no" vote in the referendum, wants to hold a referendum on Italy’s membership of the eurozone. Five Star, which is currently the second most popular party and which campaigned strongly for the "no" vote in the referendum, wants to hold a referendum on Italy’s membership of the eurozone. 
There are big instutitional obstacles to any of this happening - but if Italy voted to leave the single currency the ramifactions would not only be calamitous for Italian banks but also the entire eurozone economy. There are big instutitional obstacles to any of this happening – but if Italy voted to leave the single currency the ramifications would not only be disastrous for Italian banks but the entire eurozone.