In another wave of anti-establishment protest, Italian citizens decided to reject by a large majority the constitutional reforms introduced by the Government and strongly backed by the Prime Minister, Matteo Renzi, thus forcing him to resign from his office. What is the link between a referendum on the implementation of significant amendments to the Italian fundamental law, and the systemic failure of the country’s banking sector?

Italian banking sector has been under significant pressure for a long period of time, some claim even before the outburst of the financial crisis in 2008.

Italy’s stagnant economy is experiencing a period of moderate recovery – its GDP is expected to grow of up to 1% this year, after having been substantially flat for 2015 -. b-italiaHowever, since 2008, Italy’s banks incurred more bad debts than their counterparts did in other countries. The amount of gross non-performing loans (NPLs) held by the banks increased 85 per cent to €360 billion in the five years to 2015, to reach some 18 per cent of total loans. Of the €360 billion of exposure, €200 billion are loans to creditors already deemed insolvent, and of these €85 billion are not already written down on banks’ books. As recognized by the Bank of Italy, Italian banks’ share prices have been dampened by the large volume of NPLs.

Total stock of bad debts (the most distressed part of the pile) more than doubled over the same period. Construction and real estate have played a huge role in Italy’s banking problems, and these sectors still have a long path towards recovery (Italy and Cyprus are the only countries in the EU where house prices have fallen in 2016).

The instability brought by the referendum has further increased the pressure on the banking sector, and on the Italian burgeoning sovereign debt.

One of the largest U.S. Credit Rating Agencies, Moody’s downgraded the long-term outlook for Italian public debt from neutral to negative. Also the Finance Minister, a rumored prime-minister-to-be, is expected to ask the European Union a €15 billion loan to bail out the Monte dei Paschi di Siena bank (MPS), as well as other troubled banks.

mpsMPS is the country’s third-largest bank – and the world’s oldest. In October 2016 the bank put forward a restructuring plan that moves €28.5 billion in NPLs off its books into a “securitization vehicle”, at 1/3 of their gross book value. This instrument is backed by the Government and other financial institutions, and the final aim is to sell it to the market. If successful, the percentage of NPLs on MPS’s balance sheet would be reduced to 16.3 per cent (currently, it is 43.6 per cent), if MPS can raise from the market a further €5 billion in new capital. A condition which, following recent political turmoils, is likely to fail.

If the European loan is approved, funds will come from the ESM funds. Such a loan, substantially similar to that negotiated by Spain in 2012 (but significantly lower in the amount) would be conditional to Italy implementing significant reforms. For instance, Spain agreed on a substantive and comprehensive reform of the banking sector, and significantly improved bank governance. It is questionable, however, if the newly appointed Italian government would be able to make such a bold commitment, in a period close to general elections, and with the 2017 economic budget already under observation. It is also questionable if such commitment would be taken seriously by European financial authorities.

Finally, the very same possibility to substantially “bail-out” these banks is jeoardized by the EU Bank Recovery and Resolution Directive (BRRD – Directive 2014/59/EU) – entered into force on 1st January 2016 -, which requires that the institutions include a “bail-in” clause in a wide range of their agreements governed by a third country, and to attempt bail-in restructuring procedures before committing public money to banks’ rescues.

To add further complexity to the matter, injecting capital into the banking sector may not represent a wise long-term strategy. Loans need to be repaid, in an economic context characterised by weak growth and global uncertainties.

Things would look better if Italy had an efficient secondary market for distressed credits, as well as a better performing insolvency system. While the country has implemented several piece-meal insolvency reforms in the field in the last few years, a lot still need to be done to build a functioning and efficient restructuring framework. The AC 3671 bis Bill, a systemic reform of Italian Insolvency Law – currently debated in the Parliament – is certainly promising, since it addresses some of these concerns. However, it is questioned whether reform of insolvency laws will feature among the priorities of the next Government.