Our Global Strategist says the crisis in Italy’s banks is caused by a system with many interlocking rings – including banks, voters, politicians and regulators – that pass stress from one to the other. This could have dire consequences for both Italy and Europe.
Like every other economy, Italy has a series of "Borromean" interlocking rings that link its banking sector to its government, economy and consumers. When one ring moves or becomes stressed, other rings rattle or vibrate, causing the kind of declining investor confidence we've seen hit Italy's banks this year.
Italy's issues could trigger another euro-zone financial crisis that, unlike the Greek or Cyprus crises, cannot be swept under the carpet; Italy is too important to the EU
With these Borromean circles breaking badly in Italy and playing out real-time in the markets, there could be dire consequences for Italy's economy, confidence and financial-system stability. It could also affect Europe, which has been on a long journey toward fiscal and monetary union. The banks' lack of capital solvency – not to mention the country's general policy uncertainty and ongoing political troubles – suggest that Italy could further undermine European regional confidence, which has already been falling since the Brexit vote. This could bring about yet another euro-zone financial crisis that, unlike the previous crises in Greece and Cyprus, cannot be swept under the carpet; Italy is too big and too important to the EU and sovereign-bond markets. As a result, political and banking volatility from Italy will remain elevated through the rest of 2016 – with further important elections looming on the horizon in Holland, France and Germany.
Ring 1: Italy's bank ownership of government debt
Even before the Global Financial Crisis (GFC), Italy's banks were large holders of the country's sovereign bonds. After the 2010-2011 euro-zone crisis, these institutions were further encouraged by the European Central Bank (ECB) to use cheap long-term repos to ride the yield curve and boost their profitability, which they did in spades.
Yet the recurring crisis in Greece – which savaged that country's banks – and the shift of regulatory control to the ECB has now led to a more hostile environment. The ECB wants to break the "doom loops" between the euro-zone banks and their governments – the kind that has been so evident in Greece.
The "doom loops" in Italy and Greece are a global financial repression issue: Governments are actively encouraging their banks to buy their own countries' bonds
At the same time, it is not just Italy and the euro-zone that are exposed to these doom loops; given the ongoing financial repression dynamic, this is a global issue, with governments the world over actively encouraging their banks to own their countries' bonds. In Italy, however, the problem is particularly acute because the government there is already very highly leveraged, with a debt-to-GDP level of approximately 135 per cent. The GFC exposed the post-Lehman fragility of the global banking system, with banks encouraged by local regulators and central banks to take counterparties exclusively within their own borders.
The bottom line: The circularity of Italy's banks owning its bonds – which illustrates a government that is over-extended and, by European Union (EU) law, cannot provide state aid to recapitalize its banks – creates the most obvious fault line for the EU's economy and finances.
Ring 2: Ownership of bank bonds by Italy's savers – and voters
As the crisis in Greece became more acute, Italy's banks saw their nervous depositors moving out of their local accounts to those in Switzerland and Germany. The banks responded by offering very attractive retail bonds that locked in Italian depositors again, thereby reducing the need to access more expensive money market funds. Phew!
Renzi knows it's not politically sensible to follow the ECB's new bail-in regulations as he seeks to recapitalize Italy's insolvent banks
But in 2016, the EU changed the "bail-in" rules for all EU financial companies, penalizing bondholders first, ahead of depositors and taxpayers, when banks need additional capital. The ECB then moved swiftly in January to bail-in Portuguese and Italian banks' retail-held bonds, and this has had serious political repercussions: The depositors are also Italian voters and believe they were misled about the safety of these bonds. The result is that Italy's prime minister, Matteo Renzi, thinks it will not be politically sensible to follow the new bail-in regulations as he seeks to recapitalize the insolvent banks. Yet as discussed in the previous ring, the EU sees direct Italian aid as state aid and considers this proposal illegal, leaving Renzi with the choice of aggravating his electorate or bedevilling Brussels.
The bottom line: With huge amounts of private wealth now invested in Italian bank bonds, Renzi is caught between a rock and a hard place. Moreover, he faces an October referendum on constitutional reform, and the outcome may ride on his solution for Italy's banks. The vote may also be a litmus test on Italy's desire to be an EU member, particularly given that Italy's populist Five Star Movement is riding high in the polls and wants to leave the EU.
Ring 3: TARGET2 participation
The ECB does not work like the US Federal Reserve in terms of balance settlement: In the European Monetary Union (EMU), the ECB's branches do not settle balances each year, although they had never needed to do so before the GFC hit.
Italy does not have the cash to pay for TARGET2 advances, so Germany has become a huge creditor and is not certain it will recover its money
Now, however, there is a huge loan balance, known as the TARGET2 balance, of approximately EUR 650 billion; the stronger central banks in Germany and Luxembourg have loaned it to the weaker peripheral EMU members, and Italy now owes around EUR 250 billion. Because Italy does not have the cash to pay for these advances, Germany has effectively become a huge creditor, and Germany is not certain it will recover its money – which in good times did not matter.
These TARGET2 balances are from time to time a serious political issue – especially in Germany, where they cause a bone of contention between the old Bundesbank and the new ECB. With Germany's growing discomfort over ECB policies, and especially over negative interest rates, the current situation needs only to get a little bit worse for this to snowball again and make new headlines – further undermining confidence in the ECB, the euro and the EU.
The bottom line: Because of the way the ECB works, there is already a huge transfer of credit under the surface of the ECB, moving from Germany to the weaker peripheral banking systems. This could become political if an EMU member threatened to leave, since this transfer currently assumes no credit nor currency-repricing risk.
Ring 4: Italy's constitutional reform referendum in October
Renzi might resign if his proposed reforms are not approved in October, which makes Italy's upcoming referendum yet another high-risk event for the markets
In October, Renzi will seek to renew the decision-making process of the Constitution of Italy so that his proposed reforms can be more easily implemented. These reforms are sensible and, were it not for the intemperate environment in Italy, would be relatively straightforward to approve. The issue is that the Five Star Movement has been doing well in recent local polls and capitalizing on not only on Italy's poor economic situation, but on the growing anti-EU feelings that are being fuelled by the African migrant crisis affecting southern Italy. Renzi has also effectively suggested that he might resign if these reforms are not approved; that makes the October referendum yet another high-risk event for the markets, especially coming on the heels of the Brexit surprise.
With the EU trying to forestall Renzi's recapitalization of Italian banks with state funds, he may now face his own political crisis, which links to previous rings: Do right by the Italians or do right by the EU's rules and regulations. If Renzi loses in October, Italy may hold a general election that could bring about an anti-EU government inclined to leave the euro and EMU.
The bottom line: European political uncertainty is rising: Italy, Austria and Hungary all have elections or referendums in October, which could produce negative EU news or policies. In the UK, on the other hand, the high point in the political cycle has arguably passed now that the Brexit vote is done.
Ring 5: 20 per cent of Italy's GDP is in non-performing loans
As was the case in many banking systems before the GFC, Italy's banks actively lent to corporations and consumers alike; unlike in the US, however, this built large asset books that were not securitized and sold into Italy's markets. As a result, when the GFC and ensuing recessions hit, Italy's banks had insufficient capital to write down their troubled loans and stave off insolvency.
Troubled loans in Italy now total around 20 per cent of Italy's GDP – around EUR 400 billion.
Troubled loans in Italy now total around 20 per cent of Italy's GDP – around EUR 400 billion. Yet for five years, the Italians, aided by the Bank of Italy looking the other way, "extended and pretended" that their loans were good – conveniently ignoring the fact that all bad loans fester and die. During this time, the ECB's lending programs – which were designed by the former chair of the Bank of Italy, Mario Draghi, who now heads the ECB – tried to provide free money to Italy's banks so they could use the profits to write down those bad loans. However, this has taken substantial time, which markets, policy makers and governments do not control; in the meantime, the tide is going out, and only then do you see the quality of the swimming trunks!
As a result, earlier this year, Renzi created a bad bank – the Atlante fund – to help arrest the declines in Italian banks. Unfortunately, unlike the Troubled Asset Relief Program in the US in 2009-2010, which forced all banks to take up equity, the Atlante fund is too little, too late and too reluctantly funded by stronger Italian banks – which would like to see their competition die.
The bottom line: An insolvent banking system cannot perform its basic economic function of creating and lending credit into the economy, and insolvency can only be restored by clearing losses and by injecting adequate equity capital – both of which are hugely dilutive to existing shareholders. As a result, Italy's banks are inhibiting the country's economic growth.
Ring 6: Negligent management, oversight and auditing standards
Bank management teams around the world, driven by their own personal survivor bias, have been in denial about their industry's post-GFC state and future prospects – this despite central banks globally going all-in to save the system in the short term, juxtaposed with much more aggressive regulatory and political regime changes.
At the same time, although Italian banks have seen many management changes, there have been no injections of external new blood to help them rethink the old dysfunctional business model, which is why nothing significant has truly changed. This stasis has been exacerbated by the inadequacy of the auditing profession, which has represented management and regulators, not shareholders.
With many banks still too big to fail, manage, break up or regulate, the world is as vulnerable to crisis as it was eight years ago.
Regulators and central banks also have not wanted to show in public that their charges, the banks, were in dire disarray both before and after the GFC – and this still holds true across the euro zone. Despite this widespread failure, the sector's political influence, monetary clout and economic importance has made many banks too big to fail, manage, break up or regulate. As a result, the world is as vulnerable to another GFC as it was eight years ago. Clearly, more regulation does not work: Banks must be allowed to fail like ordinary companies.
The bottom line: Europe and the ECB are increasingly embarrassed by the complicity of the central bank and its poor regulation of this industry, both of which are hindering any type of sustainable economic recovery.
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What are you reading this summer? Our Global Strategist shares a curated list of books that address some of the biggest issues facing investors today, from politics to disruption.
With much of Europe and the US on their summer holidays, many of us are planning to spend time “chillaxing” on the beach or in our gardens – that is, when we’re not being entertained by the Olympic Games in Brazil. So I have once again curated a list of books that I’ve enjoyed and that address some of the key issues facing investors today, grouped into themes so you can “pick and mix” accordingly.
Crippled America: How to Make America Great Again, by Donald J. Trump
The business and political phenomenon that is Donald Trump presents the key issues he believes are facing America today – issues that he has clearly managed to turn into soundbites to capture US voters’ attention as they head to the polls this November.
Winter Is Coming: Why Vladimir Putin and the Enemies of the Free World Must Be Stopped, by Garry Kasparov
Kasparov outlines how the West has acquiesced in the ascent of President Putin and his cronies, giving Russia’s leader the ability to grow into an ever more powerful threat to local, regional and global affairs.
World Order: Reflections on the Character of Nations and the Course of History, by Henry Kissinger
This insightful book identifies how European Islamic, Chinese and American “world orders” have distinct views that have evolved over time, offering a particularly interesting perspective on how recent digital advances are shaping relations between nations.
The Silk Roads: A New History of the World, by Peter Frankopan
Frankopan carefully details the history of the Silk Roads, from Eastern Europe to China and India – a region that is still mysterious to many in the West yet is once again at the centre of the world’s attention.
Clean Disruption of Energy and Transportation: How Silicon Valley Will Make Oil, Nuclear, Natural Gas, Coal, Electric Utilities and Conventional Cars Obsolete by 2030, by Tony Seba
Seba passionately believes that the current industrial age will be over by 2030 as a clean-disruption phenomenon radically alters economies – a convincing argument for investors stress-testing their portfolios for the future.
The Rise of the Robots: Technology and the Threat of a Jobless Future, by Martin Ford
Almost any job can be automated, creating frightening implications for a civilized society. Ford says that with so many kinds of “robots” putting capitalism itself at risk, we need to rethink everything from our economic structures to our politics.
The Bitcoin Big Bang: How Alternative Currencies Are About to Change the World, by Brian Kelly
The transformative blockchain technology that underlies digital currencies has the potential to affect anyone who pays for goods and services; this book helps investors appreciate not just the technology, but its potential for disruption.
Squirrel Inc.: A Fable of Leadership through Storytelling, by Stephen Denning
The business metaphor of "burying nuts for squirrel clients" is under threat as humans cut down trees and landscape their gardens, emphasizing the need for new methods of “storage”. Perhaps it’s time for a new model for business and corporate leadership?
Essentialism: The Disciplined Pursuit of Less, by Greg McKeown
Facing a world filled with too much information, McKeown champions what he calls the “disciplined pursuit of less”. Instead of trying to have it all, Essentialists pursue “the right thing, in the right way, at the right time”.
Team of Teams : New Rules of Engagement for a Complex World, by General Stanley McChrystal
As the leader of America’s special forces, McChrystal transformed an organization that was once mechanically efficient into one focused on adaptability. Could more organizations meet today’s challenges by providing the freedom to experiment and share information?
Superforecasting: The Art and Science of Prediction, by Philip E. Tetlock and Dan Gardner
The authors explain how “superforecasters" use special methods and tools – not computing power – to accurately assess what the future holds. Investors and analysts alike can benefit from these insights to improve their investment processes and risk-assessment strategies.
Black Box Thinking: The Surprising Truth About Success, by Matthew Syed
Syed says “black box thinking” is a new approach to high performance that provides an edge in a complex and fast-changing world. His exploration of how success really happens has powerful implications for business, politics, families – in other words, all of us.
GDP: A Brief but Affectionate History, by Diane Coyle
In this entertaining book, Coyle shows why the idea of “gross domestic product” – a widely used term that hardly anyone truly understands – was a helpful metric for simpler times, but it is woefully inadequate for today’s more complex global economy.
Books I’ll be reading this holiday
While I’m away from the office, I’ll continue to explore books about topics that fascinate me – politics, finance, leadership, self-improvement and more. Here are just a few:
- Conspiracies of the Ruling Class: How to Break Their Grip Forever, by Lawrence B. Lindsay
- Throwing Rocks at the Google Bus: How Growth Became the Enemy of Prosperity, by Douglas Rushkoff
- Pebbles of Perception: How a Few Good Choices Make All the Difference, by Laurence Enderson
- The Power and Independence of the Federal Reserve, by Peter Conti-Brown
- Duty: Memoirs of a Secretary at War, by Robert M. Gates
- The Most Wanted Man in China: My Journey from Scientist to Enemy of the State, by Fang Lizhi
- The Master Algorithm: How the Quest for the Ultimate Learning Machine Will Remake Our World, by Pedro Domingos
- Players: The Story of Sports and Money, and the Visionaries Who Fought to Create a Revolution, by Matthew Futtermann