Bankers are running out of private-sector solutions for Monte dei Paschi di Siena and have told the Italian lender to prepare for a state bailout this weekend after prime minister Matteo Renzi was felled by a referendum defeat.
While financial markets responded relatively calmly to the referendum result, people briefed on the situation said the political upheaval made it "more difficult" to secure a 1 billion euro investment from Qatar on which Monte dei Paschi's 5 billion euro capital-raising plan hinges.
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Senior bankers fear that a failure to shore up the bank, which was the worst loser of this summer's European bank healthcheck, could damage already jittery investor confidence about Italy's overall banking sector, which is hobbled by 360 billion euro of bad loans and weak profitability.
JPMorgan Chase and Mediobanca, advisers to Monte dei Paschi, have been working with Pier Carlo Padoan, Italy's finance minister, to persuade the Qatar Investment Authority to pump money into Italy's third-largest lender. But hope is fading that they can secure a deal by this week's deadline.
Without the cornerstone investment from Qatar, the other parts of the complex plan to fill the bank's €5bn capital shortfall are likely to collapse.
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Senior bankers said there was still uncertainty over who would replace Mr Renzi at the head of the Italian government and whether there was political appetite to take a majority stake in one of the country's biggest banks. "Everyone is in standby waiting for a new government," said one person directly involved in the plan.
The person said that if the private-sector solution proved impossible, the bank and its supervisors at the European Central Bank were likely to favour a "precautionary recapitalisation" — involving an injection of state funds and the conversion of subordinated debt into equity.
"Whatever solution is found for Monte dei Paschi, I believe there is a significant risk of contagion to other Italian banks in particular," said Megan Greene, chief economist at Manulife Asset Management.
To avoid the politically unpalatable option of imposing losses on the 2bn euros of retail bondholders in Monte dei Paschi, a plan is being drawn up to guarantee full repayment of the first 100,000 euros to every junior bondholder, according to senior bankers.
Senior bonds and deposits would be left unscathed. The bank is also likely to press ahead with plans to hive off €28bn in soured loans to a securitisation vehicle supported by a government guarantee.
Shares in Monte dei Paschi, which are down 86 per cent over the past year, fell 4.2 per cent on Monday amid volatile trading after the Italian referendum result. The bank, which has a market value of just 570 million euros, has burnt through 8 billion euro raised in the past four years.
Other Italian bank shares took a hit, with UniCredit down 3.4 per cent and Banco Popolare falling 7.4 per cent.
"If Monte dei Paschi's plan fails, then that spells bad news for the other Italian banks that need recapitalising," said Patrick O'Donnell investment manager at Aberdeen Asset Management. "If Italy can't sort out its banks, then they will be in a real mess. Once again Europe finds itself in a position where politics, the ECB and the banks are dangerously entwined."
MPS said on Friday that it had raised at least 1 billion euros from a voluntary swap of subordinated debt into equity.
Shares in Italian bank stocks led a sell-off in European markets in early morning trading, with the FTSE all-share banking index falling 4.8 per cent at one point before recovering to close 2.2 per cent down on the day. Italy's benchmark 10-year bond yields ended the day up 8 basis points — making them the worst performer in Europe.
Expectations that Mr Padoan would remain as finance minister or even replace Mr Renzi as prime minister was helping to limit concern, senior bankers said.
"They are desperately seeking to accelerate a solution but it is being done too late. This problem should have been resolved months ago," said one large investor in Italian banks. "If Monte Paschi's deal fails, you are only going to see prices going down across the sector," this person added.
Under that scenario bankers see an expected €13bn equity raising at UniCredit, Italy's largest bank, being priced at a low valuation, and midsized lenders Carige, Banca Popolare di Vicenza and Veneto Banca potentially struggling to raise the at least €3.5bn in additional capital they need.