The Italian Connection

It is no secret that the Italian banking system is on life support. Reports suggest its bad loans could amount to 360 billion euros, which is an astronomical 17% of its loan book. At the worst point in the financial crisis, the U.S. banking system had 5% bad loans. Though this problem will need to be addressed at some point, for European leaders, that point has always been in the distant future.

No more, as Brexit just brought the distant future to the present.  

But a simple answer for Italy’s banking woes may be hard to find. The European Union (EU) is afraid a banking crisis in Italy could lead to wider financial contagion and thus weaken the general economy. However, EU laws prevent the Italians from bailing out their banks without forcing losses on equity holders and Italian depositors. Italian Prime Minister Matteo Renzi will not commit political suicide to appease the Germans, nor is he willing to reduce his chances of carrying October’s referendum on constitutional reform – which is fast becoming a vote of confidence in Italy’s membership in the Eurozone. 

The usual solution when the EU faces a crisis is to amend the laws and spend as little as possible in order to kick the can down the road. We think this is the likely outcome for Italy, and could occur as early as before the anticipated release on September 29th of the stress test on Italian banks. Unless, of course, they postpone the release. 

Since our portfolios are conservatively positioned, as this sad movie plays out we will be able to stay in our seats while others are rushing for the exits.   

Source: WSJ, NYT, Financial Times, European Banking Authority, GaveKal Research, Geopolitical Futures