Will Italy’s failing banks trigger financial collapse across Europe?

When Japan’s banks collapsed in 1998-99, the effect was only felt domestically. Something similar in Italy could cause a domino effect across Europe
Banca Monte dei Paschi di Siena, Italy’s oldest, predates Romeo & Juliet by a century, but is struggling to survive now.
Banca Monte dei Paschi di Siena, Italy’s oldest, predates Romeo & Juliet by a century, but is struggling to survive now. Photograph: Bloomberg/Getty Images

Established 125 years before Shakespeare penned Romeo and Juliet, the Banca Monte dei Paschi di Siena was founded in 1472 to help finance the city state of Siena, as well as its artistic renaissance. For more than 500 years the world’s oldest bank has operated successfully, through wars, revolutions and other political upheavals. In the 1990s it was Europe’s most profitable bank.

How things change. This week the European Central Bank agreed the financial details of (another) bailout package for the banca, which was previously rescued in 2013. Its financial prospects, along with those of the Italian banking system, appear to be deteriorating. One of the main credit rating agencies just put the country on negative outlook – a warning of worsening economic prospects.

Italian banks have amassed £290bn in bad loans – around 18% of all loans in the country and one third of bad loans in the euro area. More than 75% of these are loans to companies. Banks cannot write these off, as it would render many institutions insolvent – they do not have sufficient capital to clean up their balance sheets.

Regulators, chiefly the Banca d’Italia, are aware of the situation, but are faced with cumbersome corporate restructuring and insolvency procedures, as well as long judicial processes and tax rules that discourage rapid write-offs. Critics point the finger at regulators they say have been too slow to act, and to “evergreening” – the process by which bad loans are rolled over in the hope they will eventually be repaid.

So the country has a problem. Italian economic growth has barely moved over three years and is likely to remain the slowest in Europe. GDP per capita – an indicator of individual prosperity – has fallen significantly and the north-south divide seems to be growing. This again is reflected in the banking system. Southern banks typically have more than 20% of bad loans on their books. Hardly any banks are making returns greater than 6% to 7%.

Until reforms are pushed through, the prospects of Italy emulating the bad experiences of Japan in the 2000s increase. To recall, Japan had a banking collapse in 1998-1999, following years during which the authorities and banks knew there was a problem but, for various reasons, were slow to act.

The Japanese authorities’ failure to act was party to blame for a decade of economic stagnation.
The Japanese authorities’ failure to act was partly to blame for a decade of economic stagnation. Photograph: Toru Hanai/Reuters

The Japanese crash resulted in major restructuring, including bank mergers and capital injections. Poorly performing banks were shut or absorbed. Various “bad” banks were set up by the state to take the bad loans away from banks and enable them to clean their balance sheets.

In Japan these actions occurred through 2000-02. The upheaval had a serious, negative impact on the economy. Growth collapsed, interest rates fell to near zero, and the government and monetary authorities engaged in unorthodox policies to boost the economy – namely quantitative easing – where the central bank created new money to buy back bank assets.

The outcome was that Japan’s banking system hardly grew in the following decade, nor did its economy. The longer it takes the authorities to act in Italy, the greater the likelihood that something similar to the Japanese disaster could play itself out.

In Italy’s case, however, there will be one crucial difference: while Japan’s experience was wholly domestic, an Italian banking collapse would likely have a strong contagious effect, spreading to other European countries with serious bad loan problems, such as Austria, Greece, Spain and Portugal. UK banks are less vulnerable as they have already reduced their exposure in Italy and have relatively low bad loans.

There are moves to improve the Italian insolvency system and these changes need to be hurried up. There are also plans to incentivise the sale of bank bad loans through investment vehicles and other initiatives. These reforms will yield benefits over time, but the speed of implementation is critical. Banks need stronger incentives to clean up their balance sheets, while unviable banks should be removed from the system. Industry restructuring should be forced and corporate governance shaken up.

None of this will be easy, but if action is not taken, Italy could become the new Japan.