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Italy's Bank Reform that wasn't

The history of the modern bank goes back to Italy during the Renaissance period. In an age when lending was prohibited by the Catholic Church, a charity institution run by Franciscan monks started offering loans at moderate rates. It was a social and political organization, not an economic one.

Today, Italian banks have modernized, but many remain close to their original mandate, acting as social and political institutions and centers of power instead of drivers of the economy. Of the nearly 700 banks in the country, few are publicly listed. The majority remain as cooperatives or popolari, mutual lenders with foundations controlling nearly 20% of their capital.

It’s a fragmented system, with the top three banks holding only 25% of the market share. Today Italy has more bank branches than any other developed country, a per capita number that exceeds those of its pharmacies or restaurants. Fixed costs are high, eroding around 30% of loan revenue on average. As a result, Italy’s banks, like Germany’s state-owned landesbanken, generate some of the lowest returns on assets in the eurozone.

Without a housing bubble like in Ireland or Spain, the Italian banks escaped the initial part of the 2008 global financial crisis relatively unscathed. But resilience soon turned into complacency. According to data from the European Central Bank, Italy’s banks accumulated €337 billion ($365.07 billion) of bad loans, or more than 30% of the eurozone’s total. The credit crunch was hard on Italian firms too, as banks cut €114 billion of loans since 2008, out of an initial total loan book of €864 billion.

Despite the European Central Bank’s quantitative-easing program, which was initiated in January 2015, lending volumes have continued to fall. The situation calls for an urgent response, especially since 95% of Italy’s firms are small businesses relying exclusively on banks for funding.

Little has been done to improve the system. After a record number of lenders failed the European Banking Authority’s stress test in 2014, the government of Prime Minister Matteo Renzi implemented a reform to first convert the popolari banks into public companies, and then eventually to merge them. Yet so far only one such bank has been listed, while no mergers have taken place.

Other lenders were able to raise capital and sell assets, but made few structural changes to their business model. According to Bloomberg, the nation’s top five lenders after national champions UniCredit and Intesa raised €19.8 billion of additional capital since 2008. Their total market capitalization is now €16 billion.

Investors are getting anxious. A last-minute rescue of four small lenders at the end of last year, with losses on equity and subordinated bondholders, sparked a broader sell-off on other banks. Today, Italian banks’ equities trade near the heaviest discount to book value in the eurozone, suggesting external capital may be either expensive or unavailable in the future.

The rules of the game have changed. EU rules in effect since Jan. 1 introduced a mandatory bail-in for banks receiving state aid. This means holders of stocks, subordinated and senior bonds, as well as depositors above €100,000 in the banks applying for state aid, will take a cut of the losses. The new rules improve transparency and protect taxpayers, but also limit the room for the government for band-aid solutions.

After a long negotiation, last week Italy reached a deal with the EU for a private “bad bank” that would include a state guarantee to those who bought bad loans at market prices. While the new guarantee may unblock some sales, it is by far not enough. Unlike the public bad banks created in Ireland and Spain, Italy’s deal excludes any sort of restructuring of participating lenders. Without structural consolidation, Italy’s banks will remain weak, vulnerable to an economic slowdown and unable to support the economy.

As the global economic outlook worsens, Italian authorities must act without hesitation. Asking for an exception to the new EU rules on bail-in requirements, as the Bank of Italy is considering, is politically tempting but ineffective.

Instead, national regulators must improve transparency, implementing public stress tests and a regular assessment of bad loans, rather than bilateral inspections. They have the power to push consolidation and should use it, even if it means losing political allies.

The government must also expand the alternatives to bank lending. Bonds and securitizations can help firms refinance while banks are healing. Finally, Italy’s legal system must be overhauled, especially with respect to the bankruptcy proceedings that can help banks clear nonperforming loans from their portfolios. With an average of eight years to complete a civil trial, Italy’s late justice is no justice: it increases the risk and cost of lending and discourages investment.

“Everything must change, so that everything can stay the same,” writes Tomasi di Lampedusa in “The Leopard,” a novel that 50 years ago portrayed the Sicilian aristocracy’s resistance to the advent of modernization and democracy in 1860. The image remains relevant to Italy’s elites and its banks today. It’s now time for real change.

This article as published on The Wall Street Journal on February 1, 2016.

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