Tuesday 05 July 2016 by Opinion

Bad Italian Banks: Implications for bond investors

The Italian banking system is once again under pressure from non performing loans

According to various press reports, the ECB has told the Italian regulatory authorities that its banking sector needs to reduce its bad loans (net of provisions for losses) by a further EUR9bn to EUR15bn in 2018 from EUR24bn now.

The world’s oldest bank and Italy’s third largest bank, Banca Monte dei Paschi di Siena founded in 1472, has been asked by the ECB to sell about 30% or EUR14bn of gross non performing loans.  Italy’s largest bank – UniCredit – and Monte dei Paschi shares are trading at record lows.  Monte dei Paschi’s shares are down 60% on a year to date basis.  Furthermore UniCredit and Monte dei Paschi are valued at a discount to book value of 80% and 90% respectively. 

The broader Italian banking sector has EUR198bn of gross non performing loans and a further EUR162bn of doubtful loans.  As such, it is no surprise that the Italian government is pushing a EUR40bn recapitalisation of the sector.  The problem is that it wants to use taxpayer funds.

Putting aside these facts about the state of the Italian government’s finances:

  • It has EUR2.2trn of debt outstanding
  • After the US and Japan, Italy is the third largest government debtor in the world
  • Its debt:GDP ratio is at 130%
  • Italian banks hold about EUR420bn of Italian government debt

The bigger problem is that using public funds to bailout the banking sector is no longer allowed under EU rules.  If banks are to be bailed in then creditors must bear most of the pain.  In severe cases, as we saw in Cyprus, depositors may even receive a haircut.

As it is unlikely that private sector funds can be found for these bail outs, it is unclear and uncertain as to which path the Italian banking regulatory and government will take.

Once again investors in banks’ capital structure not only have to understand the fundamental performance of each bank, but also the ever changing regulatory landscape.  Given the changes with Basel III, banks have had to increase their capital levels but it is still undecided by regulators what specific forms of capital will be counted.

Australian banks

In this regard, APRA in its recent Insight publicationExternal link - opens in a new window examined the major banks capital levels compared to international comparisons. A Financial System Inquiry (FSI) recommendation was that banks should only be regarded as unquestionably strong if they have capital ratios that place them in the top quarter of international banks.

APRA stated:

“…since the 2015 study the relative position of the major banks’ other weighted average comparison capital ratios have improved […] the major banks’ comparison Tier 1 ratio of 14.8 per cent is positioned in the top quartile as compared to the third quartile as at June 2014; and comparison Total capital ratio of 16 per cent is positioned at the bottom of the top quartile as compared to the median of the distribution as at June 2014 […] As noted above the major banks have undertaken significant capital raisings since the 2015 study, which has significantly improved their capital adequacy positon relative to international peers.”

This is good news for senior and subordinated bondholders; the domestic majors have now issued more capital that sits below bondholders and will help to protect them in the event of a default.  However, there is more for the majors to do and APRA noted:

“That said, the trend of international peer banks strengthening their capital ratios continues. Forthcoming international policy developments will also likely mean that Australian banks need to continue to improve their capital ratios in order to at least maintain, if not improve, their relative positioning.”

That suggests and reaffirms the view that banks will have to continue issuing additional qualifying capital instruments to maintain their position in the top 25% of global banks.  The key question for bank investors is: what form will these instruments take?  And more specifically, will they rank senior or subordinated to their existing bonds?

Unfortunately this is not yet clear, with APRA equally vague:

“The final design and calibration of these reforms will not be decided until around the end of 2016, and it would be prudent for Australian ADIs to continue to plan for the likelihood of strengthened capital requirements in some areas.”

Implications for bank bond investors

I would counsel that investors in financial bonds need to fully comprehend that both the global and domestic regulatory frameworks continue to evolve – and will likely be tested again in Italy soon – as there has been speculation that a new so called Tier 3 bond may be allowed in Australia, similar to what has been proposed in France. This is potentially a senior bond that is TLAC (Total Loss Absorbing Capacity) compliant and would be explicitly eligible to be bailed in if the bank got into trouble.

In addition, the prospect of a hung parliament and a weak Australian government makes the prospect of a Royal Commission into the banking sector more likely. This may have a greater impact on the domestic major banks rather than the regionals, as there may be an attempt to level the playing field.

As can be seen there are plenty of moving parts and investors are encouraged to understand which tranche of the current and potentially future banks’ capital structure they are buying.  Partly due to some of these uncertainties, there appear to be some attractive yields on offer.

Issuer Call date Maturity date Bond type Trading margin Yield to maturity Running yield Capital price Face value Capital value
Australia and New Zealand Banking Group 25/06/2019 25/06/2024 Floating 1.70%  3.47% 3.85%  100.641 $100,000  $100,641
Australia and New Zealand Banking Group (USD denominated) 19/03/2024 19/03/2024 Fixed  2.43% 3.61%  4.25% 105.905   USD200,000  USD211,809
Auswide Bank 12/06/2019 12/06/2024 Floating 3.45% 5.22% 6.14% 102.174 $100,000 $102,174
Bank of Queensland 10/05/2021 10/05/2026 Floating 2.55% 4.52% 5.20% 103.686 $100,000 $103,686
ME Bank 29/08/2019 29/08/2024  Floating 2.78% 4.58% 4.70% 99.773 $100,000 $99,973
Rabobank Netherlands AU 02/07/2020   02/07/2025 Floating 2.25% 4.19% 4.41% 100.910  $200,000 $201,820
Royal Bank of Canada (USD denominated) 27/01/2026 27/01/2026 Fixed 1.89% 3.20%  4.16% 111.855 USD100,000 USD111,855
Westpac Banking Corporation 14/06/2023 14/06/2028  Fixed 2.26% 4.31% 4.67% 102.879 $200,000 $205,758
Bonds listed are in AUD unless otherwise specified
All bonds available to wholesale investors only
​Note: Prices accurate as of 5 July 2016 but subject to change