Concerns about the EU's economic prospects triggered by the Brexit vote and the erosion of bank profitability caused by negative interest rates have turned Italy's fragile banking sector into a dangerous powder keg. However, due to missing the best opportunity for rescue, Italy, currently in a dilemma, seems to have not yet found a practical way to quickly eliminate the "cancer" of non-performing loans in its banking industry.

The European Banking Authority (EBA) announced the results of the 2016 EU banking stress test on July 29. Under a pessimistic scenario, the 2018 common equity tier 1 capital adequacy ratio (common equity tier 1 capital ratio) of Italy's third largest bank, Banca Monte Dei Paschi Di Siena S.p.A., will be only -2.44%, making it the bank with the lowest expected capital adequacy ratio. According to the requirements of Basel III, banks’ core tier one capital adequacy ratio must reach at least 4.5%.

Banco de Siena has exposed the core crisis of Italy’s banking industry – its massive non-performing loans. A July report from Pacific Asset Management Company (Pimco) stated that as of June 30, the Italian banking industry's non-performing exposure (loans that are at least 120 days overdue) totaled 361 billion euros, while non-performing loans (loans that have defaulted) totaled 210 billion euros. If calculated based on 360 billion euros, the non-performing loan ratio of the Italian banking industry is about 18%, and if calculated based on the 200 billion euros often quoted by the Italian government, its non-performing loan ratio is about 11%.

According to data released by the European Banking Authority on July 22, as of the end of the first quarter, the weighted average non-performing loan rate of the entire EU banking industry was 5.7%, and Italy’s was as high as 17%. Among the 29 countries in the report (28 EU member states and Norway), it was only better than Cyprus (49%), Greece (41%), Slovenia (20%) and Portugal (19%). Although the proportion of non-performing loans in these countries is higher than that of Italy, as the third largest economy in the euro zone, Italy's high level of non-performing loans poses a greater threat to the entire EU.

Compared with the huge number of non-performing loans, the Italian banking industry’s non-performing loan provisions are obviously insufficient. As of the end of the fourth quarter of 2015, the Italian banking industry's non-performing loan provisions were 146 billion euros, accounting for 40.6% of the 360 ​​billion euros of non-performing loans. According to a survey of Italy's largest 25 banks by the Bank of Italy, the recovery rate for all non-performing loans was 41% between 2011 and 2014. Assuming that non-performing loans are sold at 41% of their book value, it would cost approximately 212.4 billion euros to deal with all 360 billion euros of non-performing loans. Based on the current bad loan provisions of 146 billion euros, if the government intervenes to deal with bad loans, it will require about 66 billion euros, accounting for nearly 4% of Italy's GDP in 2015.

In addition, bad loan provisions vary greatly among banks. For example, Iccrea BancaImpresa’s non-performing loan provisions (€780 million) account for 71% of its total non-performing loans (€1.108 billion), which is relativelyIn comparison, Unione di Banche Italiane (UBI), another bank, has reserves (€4.237 billion) that account for only 32% of its non-performing loans (€13.233 billion).

The problem of non-performing loans in Italy has been around for a long time, and it has only become more prominent under the financial market turmoil caused by Brexit. In 2009, Italy's non-performing loan ratio reached 9.45%. Since Italy's sovereign debt accounted for more than 100% of GDP at that time, the Italian government was unable to take care of the non-performing loan problem in its banking industry. In contrast, governments such as Ireland and Spain directly bailed out the banking sector during this period.

For example, the Irish government established a bad bank at the end of 2009 to purchase non-performing loans in its banking industry. The Spanish government also established a bad bank in 2012. According to World Bank data, Ireland's NPL ratio has dropped from 25.7% at its worst in 2013 to 14.9% in 2015, and Spain's NPL ratio has also dropped from 9.38% at its worst in 2013 to 6.26% in 2015.

Gao Bei, a special researcher at the Economic Development Research Office of the Institute of World Economics and Political Science of the Academy of Social Sciences, told Jiemian News that the most important reason for the occurrence of non-performing loans in Italy is the country's continued sluggish economic growth. Italy originally hoped to gradually absorb the non-performing loans accumulated during the 2008 financial crisis and the subsequent European debt crisis through economic development, but unfortunately the Italian economy continued to be sluggish, and non-performing loans accumulated more and more, until it has developed into an uncontrollable situation. Thanks to the support of the Eurozone's loose currency, Italy avoided falling into crisis during the European debt crisis. However, as a result, Italy did not reform its profound domestic structural contradictions. Problems such as high welfare and low labor productivity still plagued the Italian economy. As a result, its economic fundamentals have lagged far behind other major EU countries since the European debt crisis.

In the first quarter of 2016, the GDP growth rate was less than 1.0% year-on-year, much lower than that of the United Kingdom and Germany; the CPI has been negative for seven consecutive months, and the economy is obviously deflation; the unemployment rate of 11.5% is also about twice as high as the United Kingdom and Germany.

For a country like Italy, which is centered on the banking industry, huge non-performing loans not only pose harm to the country's financial system and investors, but also damage the real economy. For years, Italian banks have cut credit to households and businesses, which has had a clear negative impact on production and consumption.

Facing this situation, Italy has taken several measures to solve the problem of non-performing loans. However, due to some shortcomings of the banking industry itself and limitations of external conditions, the effectiveness of these measures is still facing uncertainty.

The disposal of non-performing loans can be roughly divided into bank internal resolution and external rescue. Internal resolution of a bank usually occurs in the early stages of a crisis, while external rescue generally occurs when the crisis is more serious and the bank is no longer able to save itself. Italy has adopted a "bail in" approach to deal with non-performing loans in accordance with the EU's Bank Recovery and Resolution Directive (BRRD).

According to the BRRD, which was officially implemented in January 2015, bank losses are borne by shareholders, creditors and taxpayers; before problem banks receive government capital injections, private investors must share part of the losses, which is called "internal self-rescue"uo;. The new "internal bailout" rules implemented in January 2016 also include bank depositors in the scope of shared responsibility, stipulating that before receiving any public fund bailout, the shareholders, creditors and depositors of the bank in question must first bear 8% of the bank's debt.

In July 2015, Italian authorities used the "internal self-rescue" mechanism for the first time to liquidate Romagna Cooperativa Bank. In November 2015, the Italian government announced another bailout for four regional banks. This action resulted in losses of approximately 4 billion euros and 1 billion euros to stockholders and subordinated bond holders respectively. Because they occurred before the new "internal self-rescue" came into effect in 2016, the two "internal self-rescues" implemented were minimal, that is, they were limited to stockholders and subordinated bond holders.

These two actions also exposed a major problem in the Italian banking industry, which is that one-third of the bonds issued by Italian banks are held by retail investors. According to data from Bank of America, 14.6% of Italian household wealth is related to bank bonds, with a total size of approximately 235.6 billion euros. In comparison, retail investors in France, Germany, the United Kingdom, Spain and other countries hold only 1.5% of their domestic banking bonds. Therefore, even if Italy implements limited "internal self-rescue", it will have a very large impact and may endanger the stability of Italy's political situation. In December last year, an Italian retiree committed suicide after losing 110,000 euros due to "internal self-rescue", triggering public protests.

In addition, "internal self-rescue" may also trigger instability in the Italian financial system, causing institutional investors to further flee Italy, exacerbating the financing difficulties in the country's banking industry. Investors may also demand higher compensation for their investments, which would raise funding costs for Italian banks.

In February this year, the European Commission approved Italy’s government guarantee scheme (Garanzia sulla Cartolarizzazione delle Sofferenze, GACS) to facilitate the securitization of its non-performing loans. Under the plan, the Italian government will provide credit enhancement for the securitization of non-performing loans from its domestic banking sector. Italian banks divest and sell non-performing loans to special purpose vehicles (SPVs), also known as "bad banks". The "bad banks" use these non-performing assets as collateral to issue graded securities to the market. The Italian government will provide guarantees for senior bonds issued by bad banks to increase investor interest and narrow the gap between the book value of bad loans and their market prices.

But the plan also raises a big question: whether the subordinated bonds will attract investors. According to this plan, the government will only provide guarantees for senior bonds, and the premise is that the senior bonds must reach investment grade BBB+, BBB, BBB-. In addition, 50% of the subordinated bonds must have been sold to investors. Even if institutional investors can be attracted by increasing the coupon rate of subordinated bonds, given that more than 80% of Italy's non-performing loans are non-financial corporate loans, compared with civil real estate mortgages, it is difficult for these loans to generate stable cash flow to pay the interest on these subordinated bonds.

Another problem with the GACS plan is that government guarantees are charged at market prices, and banks may choose not to activate this mechanism because the burden is too heavy.

In April this year, the Italian government also established a 5 billion euro protection fund Alante to serve as a buyer of last resort for banks to assist problem banks that have difficulties in equity financing or sell the most risky part of their bad debts. In order to comply with EU regulations on state aid, Atlante was mainly funded by Italy's large banks and private institutions. Among them, Italy's two largest banks, Intesa and Unicredit, injected approximately 1 billion euros, and the other 1 billion euros came from other banks in better condition. 500 million euros come from bank funds, 500 million euros from the state-owned institution Cassa Depositi e Prestiti, and the remaining funds come from several Italian insurance companies.

Gao Bei believes that the Alante fund scale is only 5 billion euros, which can only be said to be a drop in the bucket compared to the scale of non-performing assets in the Italian banking industry. The scale of non-performing assets of one bank in Siena alone reached 46.9 billion euros in 2016. According to Eurozone requirements, the scale of non-performing assets needs to be reduced to 32.6 billion euros in 2018. The capital injection effect of the Alante Fund will be very limited.

In addition, after Brexit triggered a sharp decline in Italian bank stocks, the European Commission approved the Italian government's liquidity guarantee plan with a maximum guarantee of 150 billion euros on June 25. This precautionary measure, which is valid until the end of this year, will only be activated in the event of a sudden lack of liquidity in the Italian banking sector and will only apply to solvent banks. It will not help the recapitalization of the banking sector.

A few days later, Italy proposed an external rescue plan of 40 billion euros to the European Union, hoping to help the banking industry adjust its capital structure through direct capital injections from the government. But the plan was opposed by EU officials and German Chancellor Angela Merkel. Some EU officials believe Italy is trying to take advantage of the Brexit chaos to push for a direct government bailout of the banking industry.

Now Italy faces a dilemma in dealing with non-performing loans: the implementation of "internal self-rescue" will hurt the interests of many retail investors and is not conducive to the stability of its domestic financial system and political situation; the use of public funds to rescue is restricted by relevant EU regulations, and at the same time it is difficult to obtain enough private sector funds to help problem banks adjust their capital structure.

So, what is the solution to the problem of non-performing loans in the Italian banking industry? For the "internal self-rescue" mechanism, a possible remedy is for the bank to set up a long-term special fund to compensate retail investors for their losses during the "internal self-rescue" process. This will not involve state rescue and violate EU regulations, but will also help retail investors reduce losses and buffer the political impact of "internal self-rescue". In fact, this method was used when four banks in Italy went bankrupt in 2015. At that time, Italian banks set up a fund to compensate retail investors for their losses.

Another possible solution is to maintain the status quo and help the banks with the most serious problems first, while other banks will gradually deal with non-performing loans through their own profits. That way, bank investors don't have to bear losses and taxpayers don't have to foot the bill for the banking industry. This is actually what Italy has always done, and it was the best solution before the Brexit referendum.Law. But the risk of doing so is that the non-performing loan problem will continue to hinder the normal operation of banks. If the Italian economy declines or another emergency occurs, the Italian banking industry will still be severely impacted as it is now.

Gao Bei believes that fundamentally speaking, economic development is the direct driving force for solving the problem of bank non-performing loans. Financial problems never exist independently, but are completely dependent on the economy. When the economy develops rapidly, the problem of bank non-performing loans will naturally resolve during the development process. On the contrary, when the economy stagnates, not only non-performing loans cannot be effectively resolved, but more normal loans may become non-performing loans.

Of course, only political stability can lead to economic development. Italy's October 2016 referendum on constitutional reform was more worrying than the instability of its financial system. If the reform bill is passed in the referendum, Italy's political situation will be more stable, and Italian Prime Minister Renzi will be able to pass legislation to improve domestic economic competitiveness. If the reform bill is rejected in the referendum, Renzi has promised to resign, and Italy will return to the political chaos left by former Prime Minister Silvio Berlusconi when he was forced to step down. In this case, all other problems will be out of the question.