Strict adherence to the EU bail-in rules and ensuing losses to retail investors would hit our consumer spending outlook, the main plank of the recovery, and could be sufficient to trigger a short-lived recession during late 2016 and the first half of 2017.
IHS Markit perspective | |
Significance | Italy's already fragile economic recovery could be extinguished should a state recapitalisation of its banking sector trigger substantial losses for retail investors, with main mechanism being a further unwinding of the consumer confidence gains during 2015. |
Implications | Italy is pleading to the EU that unhindered state intervention is justified given the exceptional events "that threaten systemic stability" and because of a "serious disturbance in the domestic economy." The main goal is to provide taxpayer support to its banks, while protecting both senior and subordinated retail bondholders. |
Outlook | The risks to growth in the latter stages of 2016 and 2017 could be notably higher should a state rescue of troubled banks follow stringent EU rules. Indeed, Italy could be tipped back into recession; our projected quarterly growth profile is already uncomfortably close to zero during the next few quarters. |
Italy continues to explore possible routes to inject taxpayers' money to recapitalise parts of its banking sector. The situation is pressing; Monte dei Paschi di Siena (MPS) is likely to need a significant capital injection, with estimates ranging from EUR3 billion to EUR6 billion likely to be identified by the new European Banking Authority (EBA) banking stress tests set to be published on 29 July. The new stress tests will not tag banks as pass or fail but identify their potential capital shortfalls in stressed conditions, and banking analysts suggest the tests will make uncomfortable reading for some Italian banks.
Prime Minister Matteo Renzi is advocating a proposed state injection of equity capital totalling EUR40 billion (USD45.4 billion, or 2.5% of GDP) to be financed by issuing government debt. The whole process would be overseen by the EU Bank Recovery and Resolution Directive (BRRD) but rules apply. Any state plan to help stressed banks needs to win approval from the European Commission to ensure no violation of its antitrust legislation, and that it addresses the new "bail-in" rules introduced in January 2016, which want to shift the burden of bank rescues away from the state and on to investors. Specifically, it stipulates that state intervention can only occur after 8% of the bank's liabilities have been absorbed with the largest burden falling on unsecured senior bondholders and large corporate depositors, also known as bail-ins.
A full-blown bail-in scenario would represent a major knock in confidence in the Italian financial system, and trigger serious losses for numerous retail investors, and could bring about a catastrophic slide in consumer confidence. The incidence of retail losses at this stage is difficult to quantify given the mix of bonds at each bank. Importantly, junior and subordinated bonds offer higher yields but are exposed to losses before senior bonds which are accompanied by lower interest rates. Still, the backdrop is fraught with risk, with the IMF reporting that Italian banks had issued EUR663.8 billion of bonds by mid-2015, with senior retail investors owning around a third. They also own half of an estimated EUR60 billion of subordinated bank bonds. In addition, nearly half of most junior ("subordinated") bonds issued by Italian banks are owned by 60,000 retail investors (Financial Times). And, before a bank receives help, "subordinated debt must be converted into equity", according to point 44 of the 2013 EU rules on state aid, and undermine confidence in the banks. Overall, the IMF calculates the 8% requirement would hit the majority retail subordinated debt investors in the 15 largest Italian banks. In addition, losses would be imposed on some senior debt holders in a resolution in two-thirds of those banks. Clearly, with increasing evidence of a slowing economic recovery alongside facing his own awkward referendum on the constitution reform next October, Renzi is sensitive to the political fallout and public hostility should thousands of savers lose their money as a result of following stringent EU rules.
Outlook and implications
Italy's already fragile economic recovery could be extinguished should a state recapitalisation of its banking sector trigger substantial losses for retail investors, with the main mechanism being a further unwinding of the consumer confidence gains witnessed during 2015. The government endued a sneak preview of the potential carnage and public hostility when rescuing four troubled lenders last November wiped out some EUR430 million of junior debt held by 12,500 small savers, with many retail investors not even aware of this risk to their savings. Despite the Brexit vote bringing about a more challenging environment, we continue to assume the main growth narrative during 2017 remains a further improvement in consumer spending, but at a less pronounced rate than previously anticipated. In our July assessment, we expect private consumption to expand by 1.2% (down from 1.3%) in 2016, 0.9% (from 1.1%) in 2017 and 1.2% in 2018. But we acknowledge the increasing risk to this narrative, should Italy be forced to adopt "bail in" rules as a prerequisite of banking sector recapitalisation, damaging household wealth and confidence. Clearly, this would overwhelm some Italian households, and negate the benefits of the current supportive backdrop, led by recovering real household incomes is a result of marginal consumer price developments, low energy costs, and the abolition of property tax on primary residences.
According to our July assessment, overall, Italian real GDP is expected to expand by 0.8% in 2016 (down from 0.9%) in 2016, 0.5% (from 1.0%) in 2017 and relatively unchanged at 0.96% in 2018. But the risks to growth in the latter stages of 2016 and 2017 could be notably higher should a state rescue of troubled banks follow stringent EU rules. Indeed, Italy could be tipped back into recession with our projected quarterly growth profile already uncomfortably close to zero during the next few quarters. We anticipate real GDP growth to slow from an estimated 0.2% quarter on quarter (q/q) in the second quarter of 2016 to average around 0.1% q/q during the latter half of 2016 and 2017. Even before the UK EU vote and intensifying banking sector woes, Italy's recovery appeared to be under great pressure, struggling to shake off some lingering downturn characteristics from its last recession. The strict adherence to the EU bail-in rules and ensuing losses to retail investors would hit our consumer spending outlook, the main plank of the recovery, and could be sufficient to trigger a short-lived recession during late-2016 and the first half of 2017.
Not surprisingly, Italy is pleading to the EU that unhindered state intervention is justified given the exceptional events "that threaten systemic stability" and because of a "serious disturbance in the domestic economy." The main goal is provide taxpayer support to its banks, while protecting both senior and subordinated retail bondholders. Even if the impact on retail investors is limited to just subordinated bonds, the impact on consumers and the resilience of the recovery to the Brexit vote shock could be fatal. In addition, the political fallout could go even deeper, with the bail-in retail losses damaging Renzi's chances of winning the constitutional referendum in October. He will step down if he loses the referendum vote, throwing Italy into political turmoil at a time when the recovery is likely to grind to a halt.