Italy fans
Italy fans react after the penalty shootout.
Reuters/Darren Staples
Current concerns over the solvency of Italy's debt are raising concerns over the country's economic and financial stability.

Italy's banking dilemma has caused financial analysts and European policymakers many sleepless nights. Italian banks have approximately €360 billion ($400 billion) in bad loans along with the real possibility that one of the world's oldest banks may collapse due to this crisis. Italy's banking problems not only have economic consequences for the European Union (EU), making up 9 percent of its banking sector, but also political since an upstart Italian party is using this crisis to call for a euro exit and possibly costing Prime Minister Matteo Renzi his job in an October national referendum. The situation is bad and may actually get worse.

Roots of the Dilemma

There are many reasons for Italy's banking crisis starting with Brexit. Brexit has had three key effects on Italian banking. First, central banks have kept their interest rates lower than usual due to the slower economic growth that Britain and the EU may experience due to Brexit. Also, Brexit has caused customers to withdraw their bank deposits due to uncertainty especially from institutions in the very fragile parts of Europe's financial markets. Thirdly, Brexit has caused worries that reduction in trade with Britain will worsen Italy's bad loan situation.

There is also the dilemma of non-performing loans (NPLs) which are loans that borrowers have not made required payments for at least 90 days. NPLs comprise 18.1 percent of all of Italy's banking loans. €200 billion ($222 billion) of these loans are so bad they are no longer considered collectible. NPLs consist of approximately 25 percent of Italy's GDP and 33 percent of the overall NPL exposure for EU nations. Italy's worsening economic situation has increased NPLs thereby making it exceedingly difficult for banks to create private sector loans and reverse the nation's financial fortunes. For Banca Monte dei Paschi di Siena, the world's oldest surviving bank, NPLs are closer to 22 percent and are roughly €47 billion ($51 billion).

Tied in with the NPL problem is lax lending standards by Italian bank managers. In many cases these managers approved loans based on favoritism to borrowers who would normally not been eligible thereby leaving banks unprepared for financial volatility. This is analogous to the zombie loans made by inert Japanese banks to inert companies in the 1990s.

Italian banking also has huge operating costs in which there are over 500 banks that are known to have an exceeding number of branches and employees for their size. Compounding the problem is that many of the banks are too small, outdated, and run inefficiently so that making a profit is extremely difficult.

Italian banking focuses on plain-vanilla lending activities such as taking deposits and then lending those funds to households and firms. This makes Italy's banks heavily reliant on the ups and downs of interest rate trends as opposed to offering multiple financial services to its clients and receiving fee based revenues from such programs as asset management, trust services, retirement planning, and cash management. By diversifying their revenue stream, Italian banks can hedge against prolonged downturns in interest rates regarding lending.

Finally, Italian policymakers deserve a share of the blame for the nation's banking woes. Italian policymakers were not proactive when the macro-economy was healthy in hopes that such things as NPLs would cure themselves rather than taking necessary action. They also had the possibility to restructure the Italian banking system but feared that any necessary and needed changes would expose the true underpinnings of influential lenders and thousands of retail borrowers whether households or small to mid-size businesses.

Conflict of Solutions

In order to solve this crisis, there has been a conflict between the solution posed by the EU and the European Commission and Prime Minister Renzi. Italy's banks are in such bad shape, that direct state assistance could help, but according to current EU banking rules, this is not possible. The EU has very strict rules against state enforced bank rescues, but these regulations have not been tested in an emergency situation involving a major bank. The EU has implemented the Bank Restructuring and Resolution Directive (BRRD) and the State-Aid Rules in which creditors must bear the losses of at least 8 percent of the bank's liabilities before the application of any publicly funded recapitalization measures. Here bondholders and stockholder's investments must cover the bank's losses. Known as a bail-in, this affects one third of Italian households who hold Italian bank bonds. These investors lack the knowledge and sophistication of appropriate risk management capabilities and hedging tools. Compounding this situation are the risks faced by small savers who are expected to support the ailing banks with their deposits and could possibly lose their money.

The Italian government would rather use public funds and minimize the risk exposure of Italian savers and bondholders. Italy has also implemented a new fund called Atlas with the goal of helping banks raise needed capital for banks facing financial difficulties and acting as a lender of last resort. Renzi and the EU have come to blows over these conflicting solutions and must iron out the details.

Conclusion: What next?

The real losers in Italy's banking crisis are pro-EU sentiment and Italy's small savers and bondholders. This crisis along with the Brexit vote, has inflamed anti-EU feelings and made a possibility such as "Quitaly" a reality. Combining this with Italians losing faith in the euro, Renzi risking the loss this fall of a vote on constitutional reform, and the outcry of small savers losing huge amounts of money, Italy's banking crisis will only be the tip of a very large iceberg of trouble.