With €220B NPL problem, Italy’s banks face glare of stress test spotlight

There are big differences in asset quality in these three countries. In both Spain and Ireland, the government, under EU supervision, intervened to help the struggling financial sector, creating bad banks to manage NPLs and taking measures to recapitalize and restructure lenders. The result is that the ratio of NPLs to tangible common equity and reserves — often known as the Texas ratio — is significantly lower, and coverage ratios significantly higher, in these countries than it is in Italy. There, the state is struggling to clean up bank balance sheets amid fears that private investors in subordinated debt could be bailed in under the new European Bank Recovery and Resolution Directive.

The five Italian banks being stress tested have, in aggregate, tens of billions more in NPLs than the six Spanish companies — a total of more than €220 billion. The Italian lenders would need €68.88 billion in additional capital to reach a coverage ratio of 80%, compared to €39.64 billion for the Spanish banks and €21.85 billion for the two Irish banks.

Italy is now striving to address its systemic weakness without breaching the EU moratorium on state aid. There is a distinct danger that private investors could face losses under European bail-in rules, threatening the government of Prime Minister Matteo Renzi.

Ireland’s banks are noticeably benefiting from a recovery. Allied Irish Banks Plc achieved provision writebacks in 2015, boosting profits. Bank of Ireland booked low credit costs, equivalent to just a fifth of operating profits. Both banks achieved double-digit returns; none of the 11 Spanish and Italian banks in the stress test sample managed this.

Banks in Spain and Italy, apart from Valencia-based Bankia SA, were impeded by significantly higher credit costs in 2015, typically paying out more than half of their pre-impairment operating profits to cover loan losses. Returns were not impressive either in Spain or Italy, but were generally higher for the Spanish banks — a trend that continued into the first quarter of 2016.

Spanish banks’ figures are somewhat flattered by the exclusion of foreclosed and restructured loans and other noncore assets from the strict NPL ratio.

In terms of the Texas ratio, Italian banks are significantly worse off than their Spanish or Irish peers, with Unione di Banche Italiane SpA, Banco Popolare Società Cooperativa and Banca Monte dei Paschi di Siena SpA all registering higher NPLs than tangible common equity and reserves at the end of 2015. This is also true of Banco Popular Español SA which has since launched a rights issue and announced a plan to aggressively reduce its nonperforming assets during the next three years.

Given that the impending EBA stress test underlined the need for Popular to act, these three Italian banks look exposed and might be required to raise capital.