The emergence of Italy as the center of the coronavirus epidemic in Europe has raised a familiar question: is its banking sector strong enough to withstand the economic shock?
Banks around the world have seen their share prices widen as investors fear that a spike in loan losses due to the closings – and new accounting rules that force them to be recognized earlier – will hurt the profitability and make a hole in the balance sheets of lenders.
These fears are particularly acute for investors in the Italian banking sector, which has unique challenges linked to the country’s high debt level. Before the epidemic, Italy’s debt-to-gross domestic product ratio was around 135%, the second highest in Europe after Greece.
An aggravating factor is that a large part of Italy’s sovereign bonds are held by national lenders, thus creating a “loop of fate” where the fortunes of the economy of the country and its banks are more inextricably linked than it is generally not the case elsewhere. Whenever Italian borrowing costs skyrocket, such as during the 2011 sovereign debt crisis or when populists took power in Italy in 2018, the loop of fate – and the risk of spreading contagion throughout the euro area – come back to the fore.
The FTSE Italia All-Share Banks index was down 43% from a month ago, when the Italian government quarantined more than 50,000 people in 11 thriving northern municipalities. These measures have since been implemented across the country, placing the country of around 60 million people in an effective lock-in zone.
“The situation is dire,” said Lorenzo Codogno, former chief economist at the Italian Treasury, who now runs a consulting firm. Without the policy of the European Central Bank, which has kept interest rates in negative territory since 2014, “Italy would already be in default,” he added.
Christine Lagarde, the recently installed President of the ECB, fueled investor fears this month by warning that the central bank was “not there to close the gaps” between the cost of borrowing from the various countries in the zone euro.
His comments led to an immediate widening of the spread between 10-year government bonds (BTP) and the German Bunds, which climbed to almost 320 basis points. Lagarde then apologized for the comments and the ECB announced plans to buy an additional € 750 billion in bonds. Since then, the spread has narrowed to 191 basis points.
Even after Ms. Lagarde’s botched messages, the gap was much narrower than during the 2011 sovereign debt crisis, when it widened to 560 basis points. At the end of 2018, fears about the spending policies of the then populist Italian government led to spreads of more than 300 basis points.
However, this month’s brief tantrum reminded investors that the fate loop is still a problem for Italian lenders. National banks have reduced their holdings of Italian public debt to 380 billion euros from a peak of 413 billion euros in early 2015, but they still hold around a fifth of the total stock.
“The loop of fate is still there,” said Codogno. “If there is a widening of the spreads, then immediately the banks will fall into trouble.”
Filippo Alloatti, senior credit analyst at Federated Hermes, said Italian banks’ exposure to public debt is “still in place”. Although the big banks like Intesa Sanpaolo “have diversified a little”, the Italian construction companies still represent “the majority of their bond portfolio”, he added.
Some economists and investors also fear that the Italian government’s introduction of an indefinite moratorium on loan repayments to businesses and consumers affected by the virus may worsen an existing problem: bad debts.
Italian banks have made progress in reducing their exposure to NPLs, which are classified as such when payments are more than 90 days past due. By the end of last year, the ratio of NPL loans to total loans net of provisions – a measure closely watched by investors – had fallen to 3.3% from 9.8% in late 2015.
But the economic damage caused by the coronavirus could increase the ratio.
“There is clearly a lot of pressure because the government has decided to suspend mortgage payments, so non-performing loans will start to increase,” said Codogno. The question of whether the banks can bear the pain “largely depends on the duration of the problem,” he added.
Investors and executives have long agreed that consolidating the fragmented Italian banking market could help solve some of its structural problems.
A few days before the government quarantined the north of the country last month, Intesa Sanpaolo launched a daring hostile takeover bid – worth 4.86 billion euros at the time – for her little rival UBI Banca. However, as the virus has gotten worse, some fear it will be delayed or even derailed.
A shareholder of the two banks expressed concern about the conclusion of a side agreement between Intesa and BPER Banca, which agreed to buy up to 500 branches following the main transaction in order to respond to fears of a reduced competition. BPER plans to issue new shares to finance the purchase of the branches, which would be a major challenge if market conditions do not improve, said the investor.
Intesa and BPER modified their agreement last week to reflect the impact of the coronavirus, but the small bank still has to raise around 440 million euros through the sale of shares – around a third of its market value – according to BNP Paribas analysts.
Intesa and BPER plan to continue the agreement, according to two people informed of their plans.
Even if the coronavirus completely derails the Intesa-UBI merger, investors say the economic response will make Italian bank mergers more, not less, likely. “The fact is that the loss of profitability for the banks will be so pronounced that it will make the case for consolidation even more important,” said Mr. Alloatti.