Italy’s Banks Are in a Slow-Motion Crisis. And Europe May Pay.

Peter S. Goodman

Victor Massiah has grown weary of talk that the Italian banking system is so threadbare and stuffed with terrible loans that it threatens Europe with another financial crisis.

The mansion that serves as local headquarters for the bank he runs, UBI Banca, one of Italy's largest lenders, does not feel like a place on the verge of running out of money. An inlaid marble fireplace sits in a conference room beneath wooden beams worthy of a castle. A statue of the Greek goddess Athena stands triumphantly over a staircase.

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"As you can see," he says, sweeping a hand across the scene, "we're not necessarily bankrupt."

Among policy makers alert for signs of the next financial disaster, Italy's mountain of uncollectable bank debt is a subject discussed in tones ordinarily reserved for piles of plutonium. Its banks seem at once too big to fail and eminently capable of doing so, menacing the global economy.

For years, Italian lenders have muddled through, hoping time would cure their afflictions. But Italy's economy has been terminally weak, not growing at all over a recent 13-year stretch. Bad loans have festered. Good loans have deteriorated.

Italy's problems are Europe's problems. Nearly one-fifth of all loans in the Italian banking system are classified as troubled, a toll worth 360 billion euros, or nearly $400 billion, at the end of last year, according to the International Monetary Fund. That represents roughly 40 percent of all the bad loans within the countries sharing the euro.

In recent weeks, the world's focus has shifted to Germany's largest lender, Deutsche Bank, on fears that it could be forced to seek a rescue. But if Deutsche has become the crisis of the moment, Italy is the perpetual threat that could, at any moment, present the world with an unpleasant surprise potent enough to send legions of officials descending on Rome to try to contain the damage.

The Italian government has sought to spend more money to spur the economy. But European leaders, led by Germany, have enforced rules limiting budget deficits. And Italian banks have held tight to cash and are reluctant to lend, starving an already anemic economy of capital.

All of which leaves Italy and Europe, and to some extent the global economy, with a formidable conundrum. Europe may never regain economic vigor so long as Italy's banks are a slow-motion emergency. But Italy's banks cannot get healthy without growth. And Italy's economy can't grow without healthy banks.

Mr. Massiah has no patience for stories that cast banking as the source of danger. A few irresponsible cases aside, Italy's lenders are not the cause of trouble, he insisted. Rather, they are the victims of their times.

A recession that lasted seven years wiped out nearly a quarter of Italian industry. The unemployment rate sits above 11 percent. The population is aging, and too few women are working, limiting spending power. Too many Italian businesses are small operations that are especially vulnerable to globalization. Family-run craft and apparel makers have been destroyed by low-cost competition from China. Negative interest rates maintained by the European Central Bank to encourage lending have cut into bank profit margins.

"This is a bank-centric country, and there was a huge crisis," Mr. Massiah said. "When the tide goes out, you don't see everything nice in the sea."

‘A Symptom, Not the Cause’

European Central Bank (ECB) President Mario Draghi
Sean Gallup | Getty Images

Italy's banking pain is a symptom of an Italian business style that has traditionally favored relationships and community ties over a dispassionate analysis of the bottom line — a perception the nation is eager to alter. To visit senior Italian officials in their offices decked out like personal versions of the Sistine Chapel is to hear a recitation of complaints that reforms have gone underappreciated. They betray resentment that Italy continues to be caricatured as the reckless debacle at the center of European economic decline.

The comically ineffectual former prime minister Silvio Berlusconi — a fiercely tanned media magnate — has been dispatched to history. At the controls today is the young technocrat Matteo Renzi, who has delivered a spate of politically perilous reforms long sought by solemn-faced officials in Brussels.

Under Mr. Renzi's direction, Italy has made it easier to fire workers. This has somewhat diminished a major disincentive to giving people jobs — the not-irrational fear that problem hires will stick around forever, like grown children tethered to the refrigerator. Italy has also sped up civil processes in its notoriously inefficient courts.

The prime minister is now seeking a constitutional change that would refashion the entire legislative process in an effort to break a logjam in the upper chamber of Parliament. He argues it would eliminate obstructions to further pro-growth measures.

Italians vote on the amendments next month. If they reject the proposal, Mr. Renzi has suggested he may step down.

Yet in the telling of some economists, the reforms are a sideshow: The trouble lies with the banks. They prop up so-called zombie companies that will never repay their loans, extending just enough credit to keep them current on their debts.

Suggest this to the man in charge of the system, Ignazio Visco, governor of the Bank of Italy, and he recoils as if someone has thrown an offensive object on his elegant silk carpet. The bulk of Italy's bad debt is backed by collateral, he said. Most of the remainder has a solid chance of turning into collectible debt, provided that economic growth returns.

"It is the result of bad economic conditions, seven years of almost continuous recession," Mr. Visco said. "Banking is a symptom, not the cause."

Banking is also an activity that in such conditions seems equal parts math and hope.

Mr. Massiah, the man heading UBI Banca, confronts a contradictory set of imperatives. His bank is strong in northern Italy, home to some of the most productive industrial areas in Europe. If he frets too much about limiting risk, he may deprive the companies that could build a more vibrant future. But if he lends too aggressively, he risks creating more bad loans.

He is putting stock in Darwin. "The weaker companies are dying," he said. "The survivors will be of higher quality."

Cemeteries of Industry

If natural selection is playing out, workers in the industrial enclave of Nave fear that they are threatened with extinction. A speck of a town carved into the foothills of the Alps some 60 miles east of Milan, Nave has long drawn sustenance from its steel mills.

Now many of those plants are abandoned, their concrete walls disintegrating, their windows broken. Locals call the old factories "the cemeteries."

Outside the Stefana steel mill, beyond the shuttered gates, idled workers hold vigil, waving placards at the occasional passing vehicle in the hopes that their presence will somehow translate into a resumption of their jobs.

Stefana's business has disintegrated in the face of a global glut of steel and the disappearance of construction projects in Italy and Spain. In late 2014, workers began hearing that management was having difficulty paying for gas and electricity. For two weeks, the plant shut down, then work resumed.

Then, UBI and other Italian lenders stopped delivering bank loans. The end came in June.

Most of the workers used to earn about 1,800 euros a month (about $1,964), plus pension and other benefits. Now they get half that via state aid and a local emergency fund. The company sits in legal limbo as a judge sifts through claims from creditors.

Twenty years have passed since Fabio Stefana (no relation to the plant owners) moved out on his own, courtesy of the wages he earned making steel. When his wages stopped in June, he found himself asking his parents for help with groceries.

His father worked at the mill and retired from there. Now the father's pension payments are supporting his 39-year-old son.

"I have to have lunch with my mother," said Mr. Stefana, who frequently goes home for meals as a way to save money. "It's not the right reason to eat with your parents."

Mr. Massiah acknowledges the pain when his bank stops lending, but he does not dwell on it. The son of Libyan Jews who fled to Italy in the early 1960s, he favors pinstriped suits and round tortoiseshell glasses. He looks at once like the University of Rome graduate student in economics he used to be, and the head of a bank large enough to be regulated by the European Central Bank.

"You have winners and losers," he said. "Some of the steel companies are doing very well, because they are more sophisticated. They do specialized stuff. And others that were not managed in a proper way went bankrupt."

UBI may be the quintessential large Italian lender.

It is not a grandiose disaster like Banca Monte dei Paschi di Siena, which Mr. Renzi tried to resuscitate by injecting public money. But new European rules prohibit taxpayer-funded bailouts. The bank is now laying off staff members and shutting branches in a desperate bid to win private investment.

Nor is UBI like UniCredit, the one Italian financial institution large enough to be deemed systemically important on a global scale. Though UniCredit also feels pressure to raise capital, it has a portfolio stocked with choice assets it would most likely be able to sell.

UBI was created by combining local cooperative lenders — institutions meant to aid local merchants, not churn out profits for investors. It reflects a spirit of collective undertaking that has made Italy a beloved vacation destination and trusted source for food and fashion. People paying a premium for a bottle of Italian wine may savor the idea that the vintner feels a kinship with the people harvesting the grapes.

But such emotional dealings do not generally produce positive results when it comes to managing money.

Since becoming chief executive of UBI in 2008, Mr. Massiah has sought to inculcate a modern banking culture. He has been in the socially awkward position of having to honor the sense of community while saying no to people who feel entitled to hear yes.

"We say, 'Let's sit,'" he said. "'Let's see the business plan. Because if it's not feasible, we are just making your agony longer.'"

The bad loans on UBI's books dropped to €8.3 billion from €9.3 billion at the end of last year.

Yet UBI, too, faces allegations of wrongdoing. On Thursday, Italian prosecutors announced they had concluded an investigation finding evidence that Mr. Massiah and 38 other bank officials obstructed Italian regulators who had been looking into claims that the company had improperly elected a supervisory board in 2013. Those accused have three weeks to prove that they do not deserve to be charged.

Mr. Massiah dismissed the prosecution as the outgrowth of a highly politicized battle for control of the bank following a merger.

Under the rules that had governed the entity, then a cooperative, the new board was formed through an election in which all individual shareholders had equal votes, regardless of how much of the bank they owned. When a group of investors holding less than 1 percent lost the election seeking board seats, they accused bank executives of rigging the outcome, Mr. Massiah said.

"The people who lost were saying the bank was influencing the people who went to vote," Mr. Massiah said. "It's absolutely not true. They are doing this because the ones who lost were trying to take control of the bank. There's no accusation that we mismanaged one single euro. It's not a money story."

Mr. Massiah added that he and the board ultimately changed the structure of UBI to ensure transparency. Votes are now apportioned to the size of the investment.

Mr. Massiah spends hours with his branch managers, counseling them on how to more intently scrutinize balance sheets while delivering bad news. Even when they face a clash between cold numbers and what he calls "the important values of life" — a young couple wanting a mortgage, for example, so they can buy a home and start a family.

"It's difficult for the people to manage the emotional part of the story," Mr. Massiah said. "The guys that we do have at the branch are human beings and feel bad. It's terrible to say no, in particular in our culture. In a way, in the Anglo-Saxon culture, there is a more direct way to interact. Our culture is less straight. Our culture is less confrontational."

But Italy is awash in the expensive consequences of social graces governing banking.

"Sometimes a 'no' is protecting somebody," Mr. Massiah said. It's a polite way of saying to a young couple, "I'm killing you, accepting that mortgage. Please rent a house for the moment, and then when you earn more you can buy a house," he said. "We have to understand that we have to live at the level that we can allow."

Damping the Flames

Sometimes "no" is just another word for not knowing how to assess the deal. This is Marco Rossi's takeaway, as he looks back at his futile effort to pry loose a loan.

Mr. Rossi had been working as a business consultant when, six years ago, he stumbled on an opportunity of his own. A German pharmaceutical company was in the process of merging with an Israeli firm. The two companies needed to sell some overlapping operations. One unit sold over-the-counter drugs like aspirin. Another owned a respiratory drug.

Mr. Rossi purchased the two units for the grand total of nothing. He merely agreed to take responsibility for paying 80 workers along with their pension obligations. He negotiated a deal with the union, agreeing to eschew layoffs. And he bought licenses from other Italian pharmaceutical companies enabling him to sell additional drugs, seeking to squeeze more revenue out of his sales force.

In his first two years of existence, he doubled his revenue to €12 million from about €6 million.

But achieving profitability required that he increase his sales further. Mr. Rossi purchased a license to sell a new cholesterol drug, but he needed funds to buy it wholesale.

All he needed was €300,000, he said. "That was the last piece of the puzzle."

UBI had always seemed keen for his business, Mr. Rossi said. When he started the company, he had promptly deposited €2 million in his account. "They were very happy about that," he said.

Mr. Rossi went to his local branch in central Milan and sought a loan. They asked for collateral, and he presented invoices worth €2 million. But the bankers were unimpressed. "It was not a building," Mr. Rossi said. "It was not something solid. It was paper."

The local branch sent him to a central office, which told him there was no guarantee his business would continue to grow.

"They said, 'Give us your balance sheets for the last three years,' and I told them that I only had two," Mr. Rossi said. "They said, 'Oh, you're a new company.'"

This was not a good thing to be.

"I had to face ignorant people," Mr. Rossi said, fuming. "They refused me the loan."

Desperate, Mr. Rossi tried another bank, Veneto Banca. Its bankers were prepared to extend a loan — with one major catch.

"They said, 'You need €300,000. We are prepared to give you €600,000,'" Mr. Rossi recalled. "'But you have to take the extra €300,000 and buy the bank's stock.'"

That would have doubled his payments while placing a sizable bet on a dicey bank. If it failed, he would still be responsible for the loan. This seemed dangerous and unsavory.

"The next step is the Mafia," Mr. Rossi said.

His reluctance was ultimately validated. This summer, as Veneto Banca teetered toward collapse and was eventually bailed out by a private investment fund, depositors yanked money out of branches and shareholders' savings were wiped out. In August, the Italian authorities arrested a former chief executive of the bank on allegations that the bank had lent customers cash so they could buy company shares.

For Mr. Rossi, his inability to borrow stopped his expansion plan. In January 2013, he sold the company for €3 million, he said — 10 times what he had been seeking to borrow.

He rented a ballroom at a local hotel and gathered his entire staff. There, he delivered the grim news: Sixty people — three-fourths of the work force — were losing their jobs, though the sale enabled him to pay severance and maintain pensions.

"I wanted to grow in Italy, and the support that I received was zero," Mr. Rossi said. "This is a country where we have a huge unemployment rate. We have a lot of skilled people. We have smart people with ideas. Why don't we create something?"

Mr. Massiah of UBI listened to this account with a pained grin. "No one ever tells the story of the bad idea that we didn't give money to," he said.

And yet, he offered, maybe his bank is overdoing it. Maybe, in their understandable eagerness to avoid a future with more bad loans, his bankers are being so conservative that they are perpetuating a long and lean present.

"I could be wrong and overshoot it," Mr. Massiah said. "We are asking ourselves always if we are doing something wrong."