Italy referendum result: What is going to happen to the country's fragile banks?

Is Italy facing a new financial crisis? Are traders now assuming Italy will leave the single currency?

Italian banks have lost half their market value in 2016

The Italian electorate has rejected a major constitutional reform in a national referendum, precipitating the resignation of the Prime Minister Matteo Renzi.

Many eyes have turned to the weak Italian banking sector for market reaction.

The share price of Italy’s third largest bank Banca Monte dei Paschi di Siena (BMPS) fell sharply when the stock market opened.

The other major listed Italian banks – Unicredit, UBI, Banco Popolare, Mediobanca and Intesa Sanpaolo – are also now trading considerably lower.

Going down

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Is Italy facing a new financial crisis? Are traders now assuming Italy will leave the single currency?

We answer the big questions below.

What is wrong with Italy’s banks?

The fundamental problem is that the sector was never properly restructured and recapitalised in the wake of the global financial meltdown and the subsequent eurozone crisis.

The result is that these banks are now weighed down by a heap of “non-performing loans” with a nominal value of around €360bn – around 16 per cent of the total of all their assets.

Low interest rates from the European Central Bank and the extreme weakness of the Italian economy in recent years have also damaged the banks’ profitability.

They upshot is that they urgently need to be recapitalised – either with private or public funds. Monte dei Paschi had planned to begin a €5bn capital raising process this week.

The size of the total capital hole in the Italian banking sector is estimated by Citi at between €20bn and €40bn, or between 1.2 and 2.4 per cent of Italian GDP.

Why does the Italian referendum result matter to any of this?

Because the government is a central actor in the bank recapitalisation drama.

The Renzi government had been walking a political and economic tightrope in recent years. It needs to help recapitalise the banks for the good of the wider economy, but eurozone rules mean all banks can only be bailed out with public money if private bondholders are first “bailed in”, meaning these debt investors have to take losses.

This is to ensure private lenders to banks do not get a backdoor public bailout when banks fail, as happened in many Western countries in 2008/09, prompting great public anger.

The problem in Italy is that several banks flogged around €30bn of their subordinated bonds to ordinary Italian households, rather than just sophisticated institutional investors such as pension funds and insurance companies. Subordinated, or junior, bonds are first in line for losses in the event of a bail-in.

And according to the IMF retail investors also hold a third of the total €600bn of bank bonds.

These vulnerable households – though relatively small in number – stand to take disastrous and politically-explosive losses in the event of a bondholder bail-in.

The government has been working to avoid this outcome, while also putting the banks on a stronger financial footing.

The Renzi strategy has been to encourage the banks to raise new funds privately first, but if this fails, to prepare to undertake a bail-in recapitalisation with special protection for small investors.

On top of this, the Renzi government has been the sponsor of a scheme to package up and sell off the questionable debt on Italian banks’ balance sheets at a major discount to other private investors.

So the government can’t help now?

The fall of the Renzi government means this whole delicate bank support strategy is now up in the air.

Without a political backstop some analysts think stricken banks like Monte Dei Paschi could struggle to raise new private capital.

“The No result in the referendum has undoubtedly made it harder to attract private sector capital to fill Monte dei Paschi’s gaping capital hole,” said Kathleen Brooks of City Index.

“The risk is that investors lose faith that it will be able to do this, which triggers a run on the bank and a full-blown financial crisis.”

So why have the share prices not totally collapsed?

Largely because the referendum result and the fall of the Renzi government was “priced in” by the financial markets already.

Opinion polls two weeks ago had pointed to the likely rejection of the reforms.

And the share prices of Italian banks had already been falling sharply.

The sector as a whole has lost nearly half its stock market capitalisation this year.

Already punished

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So what will happen now?

Many analysts predict a caretaker government will be appointed by the Italian President and that this government will still be led by Renzi’s Democratic Party, possibly by the current finance minister Pier Carlo Padoan.

This administration could carry on with the previous bank recapitalisation strategy – although there can be no certainty about this.

Economists at Citi point out that Italian banks hold €400bn of Italian government bonds.

They warn that if traders mark down the value of these bonds in the coming weeks due to renewed political and economic uncertainty, it could prompt further falls in Italian banks' stock prices, creating a "vicious spiral" of lower bank lending and weaker GDP growth.

“Italy's financial markets, its underfunded banks and its overall economy could suffer unless Italy resolves its political crisis fast,” said Holger Schmieding of Berenberg.

What if the new government falls?

The most dangerous scenario for Italian bank investors is if there are early elections and the populist Five Star movement manages to form a government.

Five Star, which is currently the second most popular party and which campaigned strongly for the "no" vote in the referendum, wants to hold a referendum on Italy’s membership of the eurozone.

There are big instutitional obstacles to any of this happening – but if Italy voted to leave the single currency the ramifications would not only be disastrous for Italian banks but the entire eurozone.