Italian Prime Minister Matteo Renzi is resigning after Italian voters rejected a constitutional reform proposal Renzi had avidly supported. His resignation could have big implications not only for Italian politics but also for the health of Italy’s banks and ultimately the future of Europe’s common currency.
Renzi’s resignation will lead to a period of uncertainty as Italy tries to form a new government. And that’s significant because some Italian banks are teetering on the edge of insolvency. One of Italy’s leading banks, Monte dei Paschi di Siena, is planning to sell new shares days after the vote to shore up its balance sheet.
But the “no” vote, and Renzi’s resignation, is likely to scare away investors worried that political turmoil could undermine the already shaky balance sheets of Italian banks. And that, in turn, could have big implications for the future of the Italian economy.
Italy and the EU disagree about who should pay to fix Italy’s banks
Italian banks are facing a problem that’s broadly similar to the problem some American banks faced in 2008. They made a lot of loans — around $400 billion worth, by some estimates — to people who aren’t paying them back, a situation that’s been made worse by years of weak economic growth in Italy.
Over the past year, Renzi has worried that this would lead to a collapse of several major Italian banks, which could trigger a broader financial crisis. So he has sought to organize a government bailout, injecting $45 billion into the banks to provide the cushion they need to ride out a wave of loan defaults.
This is the kind of bailout that the United States and many other countries orchestrated in the recent past, but Renzi had a problem doing it for Italy: Post-crisis European Union rules prohibit governments from doing this kind of no-strings-attached bailout. Under European law, a bank’s own creditors — investors in the banks’ bonds — must take losses before the government can spend taxpayer money shoring up the bank's finances.
That’s exactly what critics of America’s TARP bailouts wanted to happen in 2008. They said it wasn’t fair to make taxpayers pay billions of dollars to bail out a bank while people who made loans to risky banks get 100 cents on the dollar.
They also argued that making creditors pay before taxpayers would create an incentive to do due diligence on a bank’s finances before lending it money. They thought making creditors pay would make them more wary of lending to banks making reckless investments. That, in turn, would force banks to be more prudent, making future crises less likely.
This argument assumes that a bank’s creditors are wealthy, sophisticated financial institutions that understand the risks they’re taking on. But in Italy, that assumption doesn’t necessarily hold. According to Bloomberg, 45 percent of Italian bank debt is held by ordinary Italians. That means complying with the EU rules could mean some Italians lose a big chunk of their life savings.
Renzi got a taste of the potential backlash a year ago, when the Italian government rescued four banks in accordance with EU rules. Creditors took losses in the process, and one of them was an Italian man who lost $110,000 he had invested in bonds issued by one of the bailed-out banks. The man killed himself, leaving a suicide note criticizing his bank.
Renzi was understandably reluctant to repeat this experiment on a broader scale. So he spent a lot of time earlier this year lobbying EU leaders for an exemption from the EU’s anti-bailout rules that would allow him to inject cash directly into Italian banks. But European leaders were unconvinced. German Chancellor Angela Merkel, the most powerful EU leader, refused to budge, insisting that it would set a bad precedent to relax the EU’s anti-bailout rules just two years after they were overhauled in 2014.
So Italian banks have been trying to shore up their balance sheets without much help from the Italian government. Banca Monte dei Paschi di Siena has made plans to sell €5 billion ($5.3 billion) worth of new shares shortly after Sunday’s vote. That’s a figure that’s several times as large as the bank’s current market capitalization. With more cash on hand, the bank will be able to unload €28 billion ($30 billion) worth of bad loans — likely at a discount to reflect their uncertain repayment prospects — to give investors more confidence about its balance sheet.
But investors could get spooked by Sunday’s “no” vote, making it difficult for the bank to raise the funds it needs. Greater political turmoil could hamper the growth of the Italian economy, and a weak economy makes it less likely that those bad loans will be repaid. And the resulting political turmoil would make it less likely that the Italian government would be able to organize a bailout of Italian banks in the event of a crisis.
Italian bank failures could create problems across the Italian economy
If this were just a debate about the solvency of a few random Italian banks, there’d be no reason the rest of us should care. The concern is that an Italian banking crisis could have broader effects in the Italian economy — and potentially the rest of Europe. And, of course, a financial crisis in Europe would have global repercussions.
The reason is that banks play a central role in modern economies. Making and receiving payments is an essential function for any business. If these payment functions were disrupted by a wave of Italian bank failures, it could have an outsize impact on the Italian economy.
And while the goal of discouraging banks from making too many risky investments seems sensible, it’s important to remember that a financial crisis can transform otherwise sound investments into money losers.
In a crisis, financial institutions tend to sell assets in order to shore up their cash reserves. But that can make things worse by pushing down asset values. Suddenly, banks that were perfectly sound prior to the crisis find their assets are worth less than their liabilities. They might be forced to start selling assets themselves to make sure they have enough cash on hand if the crisis gets worse. The result can be a downward spiral that takes down responsible banks along with irresponsible ones.
So if authorities are too fastidious about refusing to bail out banks that have been irresponsible, it can wind up taking down banks that never did anything wrong.
This is why Renzi wanted to rescue banks earlier this year — before panic starts to set in, and without worrying too much about making banks’ creditors pay. But European leaders said no, leaving Italy’s banks in a precarious position.
So Sunday’s “no” vote could be the first of a series of dominoes that could trigger a full-blown banking crisis.
Why a “no” vote makes a banking crisis more likely
A big issue here is that the mere possibility of an Italian exit from the eurozone sometime in the future can cause problems in the present. If investors think there’s a 20, 10, or even 5 percent chance that Italy will exit the eurozone within the next 5 years, and that an exit will be bad for Italian banks, they’re going to be that much more reluctant to put their money into Italian banks today. Depositors will also be more reluctant to keep their money in Italian banks, fearing that those deposits will eventually be converted into depreciated liras.
And while a “no” vote won’t lead directly to Italy exiting from the eurozone, it does make it more likely to happen.
Renzi took a calculated risk earlier this year by vowing to resign if the referendum fails. The idea was to raise the stakes of the vote and encourage wavering voters — especially Renzi supporters — to vote “yes.” Now that gamble appears to have backfired. His resignation will leave Italy without a government for the next few months, making it harder for Italian authorities to respond in case Italian banks run into more trouble.
An even bigger worry is the possibility that Sunday’s “no” vote is a sign that Italians are souring on the entire European project. In the last Italian elections, held in 2013, the euroskeptical Five Star Movement, which holds an eclectic mix of right-wing and left-wing positions, got 25 percent of the vote. This was a respectable showing in a highly fractured political system.
Polls in recent weeks have shown the party doing even better: almost tied with Italy’s governing Democrats. The next election isn’t scheduled until 2018, but with Renzi stepping down, it’s possible fresh elections will be called in 2017 instead.
And even a small probability of Italy exiting the EU is going to spook investors. Right now a euro in an Italian bank is worth exactly the same as a euro in a German bank. But if Italy were to leave the eurozone, Italian euros would likely be converted to Italian liras, and the value of this new, separate currency would quickly fall in value against the euro. Fearing this outcome, people would likely start pulling euros out of Italian banks in the weeks before any referendum on European membership — exactly what happened during last year’s Grexit crisis in Greece.
To be clear, none of this looks very likely at this point. Italian voters might say “yes” to Sunday’s referendum. They might decide not to put the Five Star Movement into power at the next election. A Five Star government might decide not to hold a referendum on European membership, or Italian voters might choose to vote “yes” in an EU membership referendum.
Italy’s exit would create a crisis across the eurozone
The larger issue here is that Europe’s common currency likely can’t survive the departure of a member as large and influential as Italy.
Britain’s vote to leave the EU earlier this year sent shock waves across the continent, since Britain is one of Europe’s biggest and wealthiest nations. But at least Britain had never joined Europe’s common currency, so Brexit didn’t do anything to undermine public confidence in the euro.
Italy is a member of the eurozone. And if it were to start on the road to leaving the common currency, that could fatally undermine confidence in the entire euro project.
Remember, the basic idea of the euro is that a euro in a German bank is worth the same as a euro in an Irish or Italian bank. That confidence depends on the belief that the common currency regime is permanent. That belief allows people to make long-term, cross-border investments denominated in euros, secure in the belief that an Irish or Italian euro will be worth as much as a German euro five, 10, or 20 years in the future.
But if people start to doubt the euro’s long-term viability, it’s going to introduce a lot of frictions into the European system. People will be reluctant to lend euros to people in peripheral countries like Italy, Portugal, or Ireland for fear that they’ll eventually be paid back in depreciated Italian liras, Portuguese escudos, or Irish pounds.
And that, in turn, will hamper the growth of peripheral economies, hindering economic growth in these countries even further and increasing public dissatisfaction with the euro regime. That could increase pressure for peripheral countries to exit, making discussion of the possibility of a self-fulfilling prophecy.
To be clear, none of this is all that likely to happen. Europe’s leaders have repeatedly vowed to maintain the euro at all costs, and right now investors seem to believe them.
But the eurozone’s awkward institutional structure — it’s something in between a single sovereign entity and a confederation of 19 independent nations — creates uncertainty about its future. Any one of the 19 members can create chaos for the other 18 by threatening to leave the currency block.