Lockdown Puts Italian Banks Under a lot of Pressure

Hotel beds are made, restaurant tables set, white wine is in the chiller.

After nearly three months of travel bans, Italian hotels, restaurants and cafés are more than ready to receive their first foreign tourists tomorrow. But the economists of Nyhedsbrevet Finans warn that the country’s banks can only look forward to a sharp increase in the number of defaulted loans from businesses unable to survive the consequences of lockdown.

"The number of defaulted loans will rocket skywards now", says Lorenzo Codogno, former Senior Economist at the Italian Finance Ministry, now associated with the London School of Economics and owner of his own consultancy.

"One of the things I most fear over the next six months is a bank crisis, especially in Italy", says Saxobank’s Senior Economist, Christopher Dembik.

"I’m not saying that there will be no problems. We will see an increase in defaults, but if the economic effects of the crisis remain so concentrated over a short period, it can be dealt with", is the more reassuring opinion of Francesco Masala, Senior Economist at the Italian Banking Association.

Worst in Southern Europe

In principle, the situation is the same throughout Europe. Despite large-scale rescue packages and bank guarantees, small and medium-sized businesses have found it hard to get through the lockdown, and pay what they owe. That applies in particular to the hotel and restaurant business.

"I expect a wave of defaulted loans over the next two to three quarters", said José Manuel Campa, the Spanish head of the European Banking Authority (EBA), to Reuters last week.

Even though it may be too early to determine the final cost of lockdown according to economists, there are indications that the situation in Southern Europe is much worse than most other places on the continent. One of the reasons is because the economies of countries such as Italy, Spain, Portugal, Greece and to some degree France, are so dependent on tourism, that they have naturally been hard-hit by travel restrictions.

Another cause is the extremely tough lockdown measures, compared with Northern Europe for example, and that their governments had fewer resources to offer rescue packages. Out of the approx. DKK 15 billion state aid paid out by the EU, Germany alone accounts for half, or about three times as much as France and Italy.

Stronger Italian banking sector

This cocktail is going to hit Italian banking particularly hard, according to the economists.

Even though the situation is serious for our colleagues in Spain for example, "the Spanish banking sector is extremely strong. The main difference between Spain and Italy is that Italy’s banking sector is weak", says Dembik.

But not everything is so gloomy, claims the Italian Banking Association.

Italian banks have been struggling for over a decade with the gigantic backlog of defaulted loans from the finance crisis. As late as in 2015, the banks were unable to determine the real value of as much as 10% of their lending. Finally, they decided to sell off most of those loans in bundles to fund managers willing to take a risk, naturally at a loss, but at least they had a clean slate.

"The new crisis situation came at a time when the banks were ready in terms of capitalisation and the quality of their assets, thanks to a strong increase in equity and a fall in the number of defaulted loans", says Masala.

Codogno and Dembik agree that banks were much better prepared at the start of lockdown then during the finance crisis, and the subsequent government debt crisis

"Households and non-financial businesses are much stronger than before. Non-financial businesses are, on average, secure, and their financial and solvency positions are in line with or better than their Euro colleagues. All-in-all, Italian businesses and households are well-prepared for a short-term crisis, and I stress short-term, which is the most likely scenario at this time. How long the pandemic lasts is the key factor. Infection figures indicate that the crisis will be short-term, and its economic effects will mainly be concentrated in the first two quarters of this year".

Risk of 'junk’ rating

But if we are to believe Codogno, Dembik and many other economists, a much more serious danger awaits.

The risk of the world’s three dominant credit rating bureaux downgrading Italian government bonds when the cost of lockdown is determined. Once the year is over, the EU Commission expects Italian government debt to have risen to 159% of gross domestic product (GDP) in the best-case scenario. Codogno’s own estimate is 170%.

Moody's, Standard & Poor's and Fitch could then move Italy from the ‘Investment’ grade, to ‘Junk’.

"By the end of the year or early next year, they will probably push them under the investment grade for securities", believes Codogno. "In no more than a year, Italy’s bonds will be downgraded to 'junk'. This is an unavoidable situation", in Dembik’s opinion.

An opinion that Masala rejects, as "extremely unlikely, especially if the effects of the pandemic are concentrated in the first half of the year". He points out that the Italian government can continue to borrow at low interest rates thanks to the European Central Bank’s (ECB) massive emergency buying of its bonds.

Downgrading will hit banks

The question is whether the official creditworthiness of Italian government bonds is not just a headache for the country’s finance minister, but for the private sector as well, as banks and other businesses by definition cannot have a higher rating than the state.

And all things being equal, lower creditworthiness means that investors will be more reluctant to lend money to (or invest in) a business.

"That will be bad news for the country. Every borrower in the private sector would have to pay higher interest", says Codogno. "The level of debt in businesses is very high, and the banks will have to sit down and find solutions. Debt will unavoidably be a problem for a number of businesses". Dembik also believes that the banks are going to hit problems. "They will be downgraded, and are facing a higher level of defaulted loans".

By contrast, Masala believes that most Italian businesses will make it, because government backed loans, which are currently distributed by the banks, have extremely favourable terms:

"Given that interest rates are very low, I expect that most businesses will be able to pay off some of their debt at least within the first two years. These government backed loans allow interest-only payments for the first two years. I therefore expect no significant increase in defaulted loans".

Read “Mafia exploits Coronavirus situation to replace banks”

Read the article “Southern Europe in debt respirator”

Read the article “From coronavirus to the Japanese disease” in Magasinet Finans no 3. 2020.