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Italy's €750B COVID-19 guarantee poses operational, 'doom loop' risk for banks

The Italian government's announcement of a €400 billion loan guarantee scheme puts the country's banks squarely at the heart of the response to the economic devastation caused by the novel coronavirus outbreak. But it is not without its risks for Italian lenders, many of which are already in a fragile condition.

Italy has been at the center of the pandemic, with more than 23,000 reported deaths as of April 20, according to U.S.-based Johns Hopkins University. It has been on full lockdown since early March.

The European Commission approved the loan guarantee plan, aimed at staving off economic collapse, on April 14. Under the legislation, the Italian government will provide a guarantee of up to 100% on emergency loans given to businesses to help them stay afloat.

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This, combined with plans proposed by the government in March under the "Cura Italia," or "Heal Italy," decree, means the Italian government is prepared to provide guarantees on up to 750 billion of bank loans.

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But the banks face a major operational challenge when it comes to getting the money out to the struggling businesses who desperately need it.

The massive state-backed guarantees could also add to Italy's public debt woes. If the loans guaranteed under the scheme default, they will automatically convert into public debt. Italy is already shouldering a heavy public debt burden, which stood at 137% of GDP at the end of the third quarter of 2019, and is projected to rise to 161% in 2020, according to a March 24 forecast by Goldman Sachs.

This again creates a potential risk for Italian banks, which tend to hold large amounts of their own country's debt in the form of sovereign bonds. This so-called doom loop means that the fortunes of Italian banks are inextricably tied to the health of the sovereign, and could leave them exposed in the event of a public debt crisis.

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The government guarantees are good news for Italy's financial sector on one level, as they will shield banks from large defaults if companies that borrow under the scheme go bust, Barbara Casu, professor of banking and finance at Cass Business School, City University, London, said in an interview.

Crunch time

But while banks are largely protected from an uptick in nonperforming loans, the state has passed a lot of operational risks on to the banks.

Banks will have to apply to the government for the guarantees, and will have to brace themselves for "a big operational challenge," Casu said.

Some banks have expressed concerns about legal risks arising from the government guarantee scheme. These include the risk of harming other creditors by keeping an unviable business alive, according to a lawyer speaking to Reuters.

Nicola Nobile, lead economist for Italy at Oxford Economics, said his initial concern is that banks might not be able to get loans out to businesses quickly enough.

"The main risk we see there is that this procedure will not be quick enough to give credit in time for business and companies, so there is a risk that by the time the money will be available companies will already suffer liquidity problems. On top of that banks are not running at full capacity at the moment, so there is a risk that the procedure will be even slower because of that," he said in an email.

Companies in need of loans are starting to complain about the slowness of the process, according to Alessandro Missale, professor of economics at the University of Milan.

"Firms that need liquidity now are complaining about bureaucracy," he said in an interview.

The debt profiles of Italian companies are a very mixed bag, with some relatively well-placed to weather a prolonged shutdown and others highly vulnerable to cash flow problems, Casu said.

Midsize enterprises tend to bank with a lot of different lenders to spread risk, and many will have come into the crisis with undrawn credit lines that they can make use of, she said. But small and micro enterprises tend to lean heavily on debt and are likely to find themselves in a precarious position.

A recent study from a Milan think tank, La Fondazione Claudio Sabattini, suggests that many larger Italian companies are actually sitting on fairly large piles of cash and undrawn loan facilities, giving them wiggle room to deal with the crisis.

Italian companies with more than 50 employees have an estimated €140 billion of immediately available liquidity between them — that is to say, from cash deposits — according to the study. When this is combined with other potential sources of liquidity such as trade and other receivables, larger Italian companies could have a potential buffer of as much as €528 billion, according to the report.

The Italian business of French fashion house Chanel has already said it can afford to continue paying its staff, and that it will not be taking advantage of any of the government schemes, according to Italian newspaper La Repubblica.

But small and medium-sized enterprises, which account for 78.5% of all employment in Italy according to the European Commission, are likely to be a pain point when it comes to liquidity issues.

Doom loop

Missale said that when he heard about the scale of the guarantees that the Italian government was offering, he was worried.

"If firms can't repay these loans to the banks, then that debt will become government debt. That's a concern because Italian public finances are not all that sound to begin with," he said.

"This raises concerns about the doom loop, as Italian banks already hold a lot of government debt.

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"Under normal circumstances, I would have been concerned about such a policy. But these are not normal circumstances, and the government has to take measures in order to keep the productive economy alive."

Out of Italy's five largest banks, Banca Monte dei Paschi di Siena SpA has the highest percentage of Italian government bonds relative to total assets at 31.66% as of the second quarter of 2019, according to data from the European Banking Authority's most recent EU-wide transparency exercise.