With Britain's vote to leave the European Union a surprise to many investors, United Kingdom banks fell, but Italian bank stock prices also collapsed. The banks declined, in our view, as a result of investor concerns over whether Italy would be the next to hold a referendum to leave the EU, which would significantly destabilise the Italian banking system.
Investors' concerns are valid, as leaving would isolate Italy's economy further from the broader EU, setting back Italian GDP growth prospects for one of the euro-system's weakest members. Our view on an Italian exit is similar to our view on the U.K.'s departure; it does not make economic sense.
Still, roughly 40% of the Italian populace views the European Union unfavourably according to Pew Research Centre, and the Five Star Movement, which has won between 20% and 25% of Italian votes in recent years and consists of avowed Eurosceptic, or "Leavers", won 19 out of 20 mayoral races in June, which is a setback to Prime Minister Matteo Renzi. Italy is holding a vote in October on several constitutional reforms, and if the vote does not pass, he has said he will step down.
Italian Banks in Trouble
In short, the political situation in Italy is already unstable. For the Italian banks, we believe investors consider the system to be in a "negative feedback loop”, where no one wants to provide capital to the banks, which means they cannot write off nonperforming exposures, as it stands, the banks have delayed writing off nonperforming loans because of the years it takes to close out a loan via bankruptcy court, making the situation worse and making it even less attractive for third-party capital.
However, we give Renzi credit for not wasting the Brexit vote, seeking €40 billion from EU regulators directly afterward for the banking system, which was immediately rejected, as it violates EU bail-in rules. At the same time, the €1 billion capital raise for Veneto Banca attracted no interest from private investors, and Veneto Banca had to be bailed out by the €4.25 billion Atlas fund, which has now deployed €3.5 billion to bail out three Italian banks.
We expect a second fund to be announced shortly, likely in the €5 billion range, to be focused on purchasing nonperforming exposures. With Brexit, resolving Italy's banking issues have become more urgent, which we think will lead to significant changes in the Italian banking system before the year is over.
The European Union has substantial incentive to make the U.K.'s departure as difficult as possible, with the idea of discouraging further departures such as Italy, and the October vote will provide an important signal to the EU and Italy about the strength and willingness for the Italian citizens to pursue this option. We also believe the European Central Bank's stress test results, which will be announced on July 29, will reveal a need for substantial capital by the Italian banks.
According to the ECB, its adverse "scenario implies a deviation of EU GDP from its baseline level by 3.1% in 2016, 6.3% in 2017 and 7.1% in 2018. The adverse scenario also includes a shock in the residential and commercial real estate prices, as well to foreign exchange rates in Central and Eastern Europe. Cumulative GDP growth in the advanced economies, including Japan and US, would be between 2.5% and 4.6% lower than under the baseline scenario in 2018.
Among the main emerging economies, the total GDP would stand between 4.5% and 9.7% below the baseline projections in 2018, with a stronger impact for Brazil, Russia and Turkey."
Even if NPLs are not assumed to be around 25% of gross value as we assume, we believe the ECB will find substantial enough capital shortfalls to force the banks to raise capital. The European Central Bank also asked Monti dei Paschi, one of the weakest Italian banks, to reduce NPLs by 40% over the next three years.
All of these events threaten to further destabilise the banking system, encouraging the banks to act now, and we anticipate events in Italy to move relatively quickly over the next few months.
