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Is the Italian Banking System Insolvent?

Reforms are finally coming, but at a stiff price.

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With Britain’s vote to leave the European Union a surprise to many investors, U.K. bank stocks fell, but Italian bank stocks also collapsed. We think the latter declined because of investor concerns about whether Italy will hold a referendum to leave the euro, which would significantly destabilize the Italian banking system. Investors’ concerns are valid, as leaving would isolate Italy’s economy further from the broader EU, setting back GDP growth prospects for one of the eurosystem’s weakest members. Our view on an Italian exit is similar to our view on the United Kingdom’s departure: It doesn’t make economic sense. Still, roughly 40% of the Italian populace views the EU unfavorably, according to Pew Research Center, and the Five Star Movement (which has won 20%-25% of Italian votes in recent years and consists of avowed euroskeptics, or “leavers”) won 19 out of 20 mayoral races in June, which is a setback to Prime Minister Matteo Renzi. Italy will hold a vote in October on several constitutional reforms, and if the vote does not pass, Renzi has said he will step down. In short, the political situation in Italy is already unstable. We believe investors consider the Italian banking system to be in a negative feedback loop, where no one wants to provide capital to the banks, which means the banks cannot write off nonperforming exposures, or NPEs, making the situation worse and making it even less attractive for third-party capital.

We give Renzi credit for not wasting the Brexit vote, directly afterward seeking EUR 40 billion from EU regulators for the banking system, which was immediately rejected as it violates EU bail-in rules. At the same time, the EUR 1 billion capital raise for Veneto Banca attracted no interest from private investors, and the bank had to be bailed out by the EUR 4.25 billion Atlas fund, which has now deployed EUR 3.5 billion to bail out three Italian banks. We expect a second fund to be announced shortly, probably around EUR 5 billion, to be focused on purchasing NPEs.

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Stephen Ellis does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.