Why Italy’s banks could ignite a eurozone crisis

It wouldn’t be summer without Europe threatening to upend global financial markets. The looming threat this year comes from Italy and its long-suffering banking sector.

“As we trend into the second half of the year, the situation in Italy, and its spill over for the rest of Europe, will continue to be one of the biggest macro-political risks we are concerned about,” said Federico Santi.

The focus on Italy comes after the U.K. voted in late June to exit the European Union. In a worst-case scenario, analysts fear Italy’s bank problems could threaten the country’s membership in the eurozone.
In coming weeks, the situation has the potential to create at least near-term global market turmoil as financial and political risks collide.

What’s the problem?
Italy’s banks are neck-deep in nonperforming loans. Official data puts the total amount of nonperforming loans, or NPLs, at around 200 billion euros. But some analysts argue that another €160 billion worth of loans could soon be pushed into NPL status.

Results of a stress tests by the European Banking Authority due on July 29 are expected to shed more light on the capital needs of the Italian banking sector, potentially serving as a spark to renewed financial turmoil.

Weren’t the banks fixed after the financial crisis? In a word, no. While Italy was widely praised for reforms in the wake of the crisis, most of the measures were relatively modest, said Ben May, lead eurozone economist at Oxford Economics

Can’t Italy just bail out the banks?
Under new European Union rules, bondholders must take a hit in the event of a public bank bailout.
The problem is that around a third of bank bonds in Italy are held by household retail investors.
The situation presents a difficult dilemma. A taxpayer bailout will irritate voters, while failing to protect bondholders also would risk a backlash.

That would empower the so-called euroskeptic 5 Star Movement, founded by comedian Beppe Grillo, ahead of an October constitutional referendum. If the referendum on Renzi’s reform agenda fails, he has vowed to step down.

Are Italian banks a global systemic risk?

Foreign exposure to Italian banks is relatively contained (see chart above).
The bigger worry, analysts say, is that a backlash over a bailout leads voters to revolt, empowering the 5 Star Movement, which has called for a referendum on eurozone membership.

The prospect of a 5-Star led government likely would lead to a surge in bond yields, credit-rating downgrades, further economic slowing and added troubles for banks—a scenario that would likely require Italy to seek assistance from the Eurozone, May said.

The bottom line, May said, is that “Italy could be a ticking time bomb.”