The Italian political crisis has sparked fears about the fate of European banks. Market watchers are concerned that after years of austerity and shoring up capital the institutions are still weak, and failure to unify the region's disparate banking system will result in a financial crisis.
The Euro Stoxx Banks index is down 9.72 percent this week following Italian President Sergio Mattarella's move to block the formation of an anti-establishment government. This week, the country's two largest parties, the left-wing 5-Star Movement and the right-wing League, tried to appoint an anti-European Union politician as finance minister, but it was vetoed by the country's president, who then appointed a new euro-friendly prime minister.
Those two groups reached an agreement to form a new coalition government on Thursday in which the little-known economics professor from the University of Rome, Giovanni Tria, will be the Minister of Finance. The Italian President Mattarella approved the new cabinet, which will be sworn in on Friday.
Last week in Spain, the country's ruling party was found to have been involved in an illegal kickbacks scheme, while a former treasurer and close friend of the president was convicted of fraud and money laundering and sentenced to 33 years in prison. Spanish Prime Minister Mariano Rajoy on Friday became the first leader in Spain's modern democracy to lose a vote of no confidence in Parliament.
While both countries' issues contributed to the recent market turmoil — the S&P 500 is down slightly and the MSCI Europe Financials (EUFN) has fallen by 5 percent in the past week, through May 30 — Italy's issues are far more damaging to the EU's future. Both 5-Star and League want to leave the euro zone, even though they're on opposite ends of the political divide. While a majority of Italian citizens want to say in the EU, with both parties running on anti-union mandates, and receiving large portions of the March vote, an EU exit is certainly a possibility.
A health check on European banks tells the story. While these institutions appear to be in a more stable position than they were in 2016, they still suffer from undercapitalization, the burden of non-performing loans and low profitability.
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A huge balance sheet cleanup remains unfinished with $938 billion of bad loans —a large portion in Italy — still sitting on bank balance sheets, according to the European Banking Authority. That's because institutions are still laden with government debt and their capital buffers are not sufficient to tackle the problem.
Hopes were that European bank fortunes would greatly improve this year thanks to overhauls by the European Central Bank and rising interest rates. But now political winds have shifted.
Italy is home to one of Europe's most problematic banking sectors. Italian banks have been steadily restructuring and shedding bad loans. Last April, the government rallied bank executives, insurers and investors to put €5 billion ($5.57 billion) behind a rescue fund for its weakest banks. The Atlante fund is designed to buy so-called bad loans from lenders and invest in their shares in the hope that the re-energized banks will lend more to businesses and spur growth.
According to Eurostat, Italy today accounts for 15.4 percent of eurozone GDP and 23.4 percent of the bloc's public debt. For comparison, Greece contributed 2.6 percent to eurozone GDP upon the start of the Greek crisis in 2009 and today accounts for 3.3 percent of the eurozone's pile of public debt. Germany earns 2 percent of its GDP by exporting goods to Italy while linkages through the banking system tie Italy closely to its European partners.
With the chances of an Italian bankruptcy rising no one can ignore the impact in the euro area banking system. Italian 5-year credit default swaps (CDS) jumped to 251.4 basis points on Thursday, according to data from IHS Markit. The CDS traded at 122 bps at the start of last week.
Among the European banks, Italian institutions face the biggest risks. The six largest Italian banks – UniCredit, Intesa Sanpaolo, Banca Monte dei Paschi di Siena, Banco Popolare, UBI Banca and Banca Nazionale del Lavoro — together have 143 billion euro ($165 billion ) Italian debt securities on their balance sheet. Systemic banks in the rest of Europe have 137 billion euro ($158 billion ) of Italian debt on their balance sheet. According to the Bank for International Settlements, this debt is mainly in France ($63 billion), Spain ($44.9 billion ) and Germany ($38.8 billion).
Exacerbating the problem is the fact that Italian 10-year bond yields are close to 3 percent, making it costlier to refinance Italian debt. According to Harvinder Singh Sian, managing director and global head of G10 rates research at Citigroup, 3.5 percent to 4 percent yields will frighten many holders of Italian assets as above this level it's unlikely that Italy can run a primary surplus (i.e. budget balance net of interest payments) large enough to offset the interest rate costs. Maintaining this level of interest rates for a long time could lead to a self-fulfilling crisis.
Currently, Italian debt exceeds $2.3 trillion. To service it Italy, needs to pay almost $80 billion in interest every year, nullifying its efforts in producing constant primary surpluses.
In this turbulent period the European Central Bank is running a health check to determine if there are capital shortages at the eurozone's 33 largest banks including BNP Paribas, Credit Agricole, Deutsche Bank, Societe Generale, Santader and Groupe BPCE. It will publish the results on Nov. 2.
The participating banks are expected to send to the supervisory authorities a first submission of results in early June and a second submission in mid-July. The final data submission will be in late October.
The problem is that "the review reflects the balance sheets of banks as of the end of 2017," said an ECB spokesperson who spoke to CNBC. It is assumed credit risk and market risk has skyrocketed over the last several weeks. That means there is a possibility that Italian banks assessed will appear to have smaller capital requirements then what's required.
ECB stress tests have been increasingly used in recent years by regulators to foster confidence in the banking sector by not only increasing its resilience via mandatory capital increases but also by enhancing transparency to allow investors to better discriminate between banks. In the case of the current tests none of these purposes will be served, especially if the Italian crisis spreads.
Financial crises are typically characterized by heightened uncertainty about the quality and hence valuation of assets held by banks. This can have negative implications for even sound banks' access to and cost of funding, as markets may not be able to properly discriminate between good and bad banks.
In the recent past, the EU stress tests have attracted criticism for not being as rigorous as their counterparts in the U.S. and UK. Critics say that the tests rely on risk-weighted measures of bank capital ratios that have been shown to be less predictive of bank failure than unweighted leverage ratios. They are also concerned about the fact that there is no pass or fail — instead banks' results are meant to simply "inform" discussions with supervisors about the right level of capital.
The Italian crisis demonstrates that the supervisors in Europe are still far from being ready to face black swans that threat the eurozone's viability.