Italian banks brace for an uncertain future after a bumper year

One of Europe’s most anxiously watched financial centers is about to find out that what goes up must come down.

Italy’s banks have had a bumper run, returning to rude health a decade after nearly collapsing under a mountain of debt and almost bringing the eurozone down with them.

But bank officials in the bloc’s third-biggest economy now worry that the high interest rates that fattened their profits over the past two years will cripple the borrowers that sustain their business, while political instability, economic stagnation and war on Europe’s frontiers could rip open old wounds. 

As European Central Bank Chief Economist Philip Lane highlighted in a panel last week, it’s a challenge that applies to all eurozone banks. But Italy is an especially sensitive case because of the size of its banking system, and because its banks shoulder a large part of Italy’s €2.8 trillion sovereign debt. 

“Things cannot go well indefinitely,” Fabio Panetta, the new governor of the Bank of Italy, told the Italian Banking Association (ABI) earlier this year. “I don’t want to play the prophet of gloom, but it’s when things go well that we need to pay attention.”

To an outside observer, Panetta’s comments might jar with the stellar annual reports — and surprisingly upbeat outlooks for 2024 — that Italy’s biggest banks have just put out. Those reports boasted strong levels of capital, high liquidity and far lower levels of bad debt than in the past. Even the hapless Monti dei Paschi di Siena posted bumper profits and offered its first dividend in 13 years.  The stocks of sector leaders Unicredit and Intesa Sanpaolo are trading at their highest in eight and six years, respectively.

What’s more, unlike during the eurozone crisis, banks in Italy and across the bloc are generally more alert and not sleepwalking into catastrophe, as the ECB’s Lane said in a response to a question from POLITICO.

Good times, bad times

But as Panetta warned, the good times were born of “exceptional factors” — and the cycle is about to turn.  

Banks make the most money at the start of a rate-hiking cycle by charging higher interest on loans without raising the rate paid on deposits. Profit margins expand, often drawing unfavorable political comment, as happened last year, calling it an attempt to seize “windfall” profits. 

But as borrowing becomes too expensive, demand for new loans shrinks and depositors start demanding higher returns — causing a two-way squeeze on profitability. 

The reversal in fortunes is already looming. Banks will soon begin “a competition for liquidity that will increase the cost of funding,” said Andrea Clamer, co-founder of digital bank Illimity. “Potentially in the next two to three years, we’ll see a higher cost of money and a higher cost of liquidity — and banks’ balance sheets will not be good.”

At the heart of this is the fact that the European Central Bank is deliberately making money scarcer. At the start of last year, Italian banks had over €300 billion in cheap ‘TLTRO’ loans from the ECB outstanding. By September, that will nearly all be gone. 

Banks will soon begin “a competition for liquidity that will increase the cost of funding,” said Andrea Clamer | Andre Pain/AFP via Getty Images

More generally, when families and businesses borrow less, the overall amount of cash they deposit at their banks shrinks, said Brunella Bruno, a researcher at Bocconi University. In the last year, loans to companies and households fell over 3 percent.

“This is not a moment where the pie can be enlarged,” agreed Clamer. “The pie will probably shrink a bit — that is something that is going to start in the next two months.” 

There are also more competitors for what money is left over. Over the past year, the Italian government itself has competed away over €30 billion of bank deposits with bonds targeting retail investors. New technology allowing rapid withdrawals has added to the usual problems that accompany the turn in the cycle, said ABI general manager Giovanni Sabatini. Such competition especially hurts smaller banks that are more reliant on deposits. 

Bad debt pile 

Historically, as interest rates peak, debtors begin to turn delinquent. This pivot, too, is underway. Ever so slightly, Italian borrowers are beginning to falter on debt repayments. The ABI forecasts that the share of non-performing loans (NPLs) will rise from 2.8 percent to 4.1 percent of total loans this year, although that’s still far from the peak of 16.5 percent seen in 2015, when a wave of defaults followed the eurozone crisis.

Meanwhile, around 70 percent of mortgages in Italy are due to reset this year, ensuring Italians across the board feel the full, if belated, effects of monetary policy. 

“Credit risk remains one of the major focuses of supervisors of Italian banks,” Sabatini said, citing the combination of high rates, weak growth and the possibly inflationary effects of geopolitics, especially the ongoing attacks on commercial shipping in the Red Sea. But he added that while credit problems are gently picking up, companies and households have — so far  — proved resilient. 

Back to square one 

As such, the non-performing loans problem is still largely in abeyance. That’s due mainly to the success of reforms introduced in 2016 that offered a state guarantee (known as GACS) for sales of lower-risk debt to investors. The government safety net gave private investors the reassurance to take bad loans off the banks’ books and spread the burden across a broader and, all things told, stronger part of the financial system.

But that initiative was wound down in June 2022, and the financial world is now spooked by an increasingly activist government which twice last year threatened to hurt banks’ business models with new legislation. 

The first was the infamous (if ultimately diluted) windfall tax, but lawmakers in the ruling Brothers of Italy party also targeted the NPL secondary market directly, with a proposal that would have let Italian companies and households buy back loans up to €25 million that were listed as non-performing between 2015 and 2021 at the original transfer price, plus a 20 percent premium. 

That would have allowed certain borrowers to restore their tarnished credit ratings cheaply, but would have hurt the profits that NPL buyers could make on their trades and reduced the incentive to take on such risks. 

The proposal was ultimately shelved under pressure from the banks and the ECB, but it left the financial sector nervously on guard for more surprise announcements.  

As one Italian banking executive told POLITICO, “The concern [is that] in times of crisis the banks could be targeted with particularly heavy measures.” 

Some investors who played a crucial role in redistributing NPL risk have already seen enough. Sweden’s Intrum shifted nearly all of its €11 billion NPL portfolio to a vehicle controlled by alternative investing giant Cerberus earlier this year. 

The Financial Stability Board, in a recent report, warned that the government can’t afford to let the NPL market languish. After all, with insolvencies having risen steadily throughout last year and now at their highest since 2021, who knows how soon it will be needed again?