After months of back and forth as well as a highly controversial bailing-in of some Italian bank bonds, the Italian government has finally reached a deal on how to deal with the bad loans plaguing its banks (see chart below via Stratfor).

The aim is to free up the balance sheet of Italian banks and thereby allow them to consolidate and to start providing fresh credit to the economy. However, questions abound over whether it will offer any actual solutions. This is also the first official test of the new Eurozone wide rules for bank resolutions, bail-ins and state aid making it a precedent setter of serious proportions. The indications are that the compromise solution reached could well hit the sweet spot of being both ineffective and legally questionable – not a good start for the new rules.

What is the deal?
The new rules (the EU’s Bank Recovery and Resolution Directive and State Aid rules) mean that a sweeping bad bank plan as seen in Ireland and Spain was not an option for Italy. As such a compromise deal (see here for press release) was reached which involves:

  • Italian banks will be able to package their bad loans into securities and then sell them off to private investors. Loans will first transferred to securitisation vehicle then packaged.
  • The government will help facilitate this by guaranteeing the senior tranches of the securitisations. It therefore only guarantees the least risky tranches and will do so only of investment grade securities.
  • The price of the guarantee “shall be calculated on the basis of single name CDS related to Italian issuers with a risk level equal to that of the guaranteed securities” , thereby attempting to ensure that no unfair state aid is provided as it is based on fair market prices.
  • The banks will pay the governmment a fee for providing the guarantees.


Does this amount to state aid?
While it has been technically dressed up as avoiding state aid, the reality seems to be that state aid is clearly involved, though the exact extent of it remains to be seen. The first point here is that the need for the state guarantee at all highlights that there are risks involved here which few market participants are willing to shoulder. If these could be priced and sold in the market then they would be. The second relevant question is around the pricing of the guarantees. The reports suggest it will based on the credit default swap (CDS) prices for similar securities. But as we know the securitisation market in the Europe is relatively small compared to say the US. Furthermore, these sorts of opaque securities are notoriously hard to price. This will be exacerbated by the fact that the loans themselves are hard to value individually, let alone when they are bundled up together. If the prices are simply based off of broader CDS then clearly it is equally unlikely to be accurate. So the notion that there is an easy market price out there on which to judge and base these guarantees seem to me to be a flawed one.

The final question is around the price at which the loans are transferred to the securitisation vehicle. While it has been widely noted that this system is different to bad banks used in Spain and Ireland, this specific problem is similar and is at the heart of all these interventions. Ultimately, the pricing of the original loan and the value at which it is transferred to the bad bank or the securitisation vehicle will determine the level of state aid involved. It also determines the usefulness of the whole exercise to the banks. If they are transferred at very low prices/values it would limit the state aid but then would impose significant book losses for many of the banks, eating into their capital and possibly making the exercise self-defeating. This then will be the crucial aspect to watch in the coming weeks and months. I don’t expect the level of state aid to be huge but to claim it is not involved seems to me to be a stretch.

Will the scheme make any real difference?
This partly depends on the points made above about the extent of state aid. But given that the guarantees only apply to the least risky tranches and to investment grade securities there is a prevailing view that this won’t make a huge amount of difference (though which will be investment grade is itself is an unknown since credit rating agencies have shown they barely know how to rate this stuff). For example, Italian paper Il Fatto Quotidiano has suggested the plan will only capture around 40% of the non-performing loans given the criteria above. The initial market reaction to the plan was fairly muted while Italian bank shares have resumed their sharp declines today following the trend of the past six months (see chart below).


Furthermore, problems in the Italian banking sector run deep – it is bloated, inefficient, unprofitable and outdated in parts. Consolidation and modernisation is needed but this won’t happen overnight. Not least because the system, often intertwined with regional and local politics encompasses an enormous number of vested interests. Shifting some of the bad loans, if the plan proves to have some success, would be a start but there is plenty more to be done. Of course, the domestic focus of the large majority of the Italian banks means their fates are intertwined with the future of the Italian economy and therefore with the Italian government’s programme of economic reform – itself still a work very much in progress and far from complete. On top of this the wider problems with the country’s legal system and dealing with bankruptcies  and asset recovery mean that souring loans both to consumers and businesses will be a problem.

What does it mean for the future of bad loan and bank resolution in Europe?
This is the bigger and more important question and why the plan has attracted so much interest. It is ultimately the first test of the Eurozone’s new bank bail-in rules which are meant to prevent undue state aid and keep the burden on investors rather than taxpayers. As explained above, it’s hard to see that it meets these requirements. The reason behind this is linked to the public outcry following the bailing-in of some retail investors in regional Italian banks back in November. The lesson many will draw is that, when the rules become politically inconvenient then they will be fudged. This adds to the confusion following the Portuguese decision to bail-in certain specific bondholders of Novo Bank (the good bank part of Banco Espirito Santo) over the Christmas period. Whenever a new banking issue arises it is hard for investors to know which approach will be taken, the exact problem the rules were meant to address.

Could the plan backfire?
Overall, the market seems to be underwhelmed by what is essentially a very limited plan to deal with some very large problems in the Italian banking sector. Additionally, while the plan tries to work within the state aid rules, it is hard to see that it successfully fits with the new legislation on investors not taxpayers bearing the burden. This sets a bad precedent going forward and adds to confusion which is already present given the multitude of ways in which bank resolution issues have been dealt with over the past year in countries such as Portugal and Austria. This all suggests the Italian government should quickly come forward with some further reforms to help address the banking sector issue.  But it also drives home the importance of it moving swiftly ahead with its broader economic and institutional reforms. Without a combination of these reforms the outlook for the Italian banking sector and the country more generally will continue to be mixed.

This post first appeared on Forbes.