How Italy Could Revive Its Banks

It’s easy to get lost in the many headlines proclaiming impending doom for Italy’s banking system (especially following the “No” vote in the constitutional referendum ), or in the complex details of state aid and debt burden sharing. But in our view, the big picture is simple.

Italian banks are burdened by a large stock of bad loans (so-called non-performing loans or NPLs ), which they have valued at prices higher than market participants are willing to pay. In our view, to unblock the situation, the banks need to mark down the value of the loans as well as raise equity to shore up their balance sheets.

Cost to revive banking sector is manageable
We estimate that around €30-40 billion of equity injections are required to bolster Italian bank balance sheets – an amount we think is manageable:

• First, €30-40 billion is not a large number in the context of Italy’s economy. Compared with the banking crisis in Ireland , which cost around 30% of GDP to resolve, and in Spain, which cost close to 10%, the Italian banking crisis likely could be resolved at a cost of around 2% of the nation’s GDP.
• Second, a significant portion of the needed funding could likely be met by the private sector: For example, UniCredit is currently working on a large recapitalization package, which will most likely be covered by new and existing equity investors.
• Third, for the remaining banks with restricted access to public markets, Italy’s taxpayers would need to lend support. However, we believe the final bill could be mitigated by the conversion of subordinated debt into equity. Monte Dei Paschi, for example, could potentially raise more than €4 billion this way.

Taking private sector financing and subordinated debt conversion into account, we think the Italian government can resolve the NPL situation with a taxpayer check of around €10 billion.

Downside risk scenarios
Of course, things could also get worse. Recapitalization decisions could get postponed or cancelled to fit the political calendar. Or fears of subordinated debt conversion could lead people to withdraw deposits from the more troubled institutions, weakening them further. It is also likely that more NPL skeletons will come out of the closet. But given the magnitude of the numbers, it’s hard to see a scenario where things get out of hand.

Investment implications
In light of our outlook on the Italian and broader eurozone banking sectors, we are selective and size positions accordingly. We see value at the bottom of the capital structure in eurozone banks (AT1s and equities), but we acknowledge the volatility ahead.

Second, we tend to favor Spanish and Irish banks over Italian ones. Italy’s NPLs may be manageable in our view, but that doesn’t mean it will be a smooth ride; risks of permanent capital impairments in the weakest banks are high. In contrast, Irish and Spanish banks have been cleaned up and generally benefit from strong macro factors and stable governments.

Philippe Bodereau is a portfolio manager in London and PIMCO’s global head of financial research.