What has gone wrong with the Italian banking system?

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A building that could be a bank illustrates the Italian banking system

The Italian banking system is in crisis – can the EU really afford to cut itself off from London banks, asks James Sproule

There is little doubt that 2017 is going to have its fair share of challenges. While Brexit may preoccupy the UK, the EU is likely to have to prioritise some of its own domestic issues, none more pressing than the looming problem of the Italian banks. So what has gone wrong with the Italian banking system and is it likely to get fixed any time soon?

First off, prolonged recessions of the sort Italy has been suffering for a decade bring a host of ever more intractable problems. Any commercial loan decision is backed by a financial model that makes a number of assumptions about the future growth of that company and the economy generally. But a recession means that while a few companies may grow a little, most do not, and many a business plan has to be reviewed and revised. In such circumstances, borrowers start to break their loan agreements.

When the loan was made, a bank may have demanded that interest payments be covered three times by earnings; but in a stagnant economy this is often simply not possible. So banks either extend the loan’s length, lowering annual repayments and hoping it all comes good in the end (‘extend and pretend’), or they assume against evidence that earnings will bounce back next year. Foreclosure is the last thing they want to do, as that simply transfers a problem from the company to the bank itself. Ultimately the reported figures on non-performing loans in EU banks, particularly Italian banks, are the tip of the iceberg. And banks with balance sheets full of non-performing loans are in no position to finance many long-standing clients, let alone new ventures.

This problem was exacerbated as, in 2007, people in southern Europe started to take the entirely logical decision to move their hard-earned savings to more solvent banks in countries which were less likely to leave the euro and, therefore, to devalue their currency. So far savers see no reason to reverse this decision and, so long as their money is readily available through a convenient cashpoint, their savings are staying put.

How much money has fled in this manner? According to the EU’s Target 2 settlement system, which tracks such things, the outflows from Italy are now approaching a record €400bn (£341bn), around 20 per cent of GDP. It should go without saying that northern EU banks have little interest in using these new deposits from Italian savers to extend lending to southern EU companies while much of that region’s economy, Italy’s in particular, is afflicted by slow growth.

In a system where bank lending is far and away the most common form of corporate financing, to see credit vanish is to guarantee an economic downturn. In looking at these challenges, the question has to be asked, is now really the moment when the EU wishes to cut its companies off from alternative sources of capital available through London’s financial markets?

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About author

James Sproule

James Sproule

James Sproule has been Chief Economist and Director of Policy for the Institute of Directors since January 2014. Prior to joining the IoD James led Accenture’s UK Research and Global Capital Markets Research. He started his financial career as a merchant bank economist working with both Bankers Trust, Deutsche Bank and Dresdner Kleinwort, and eventually helped to found the boutique bank Augusta and Company.

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