Tuesday 12 July 2016 by Opinion

Italian bank hybrids plunge - a few warnings to Australian investors

The risks are becoming more real as Italy's banks have bad debts at around 18% of total loans



  • Bad debts in Italy’s banking sector are now 18% of total loans, nearly four times the level in US banks in 2008
  • The Italian government is pressuring the EU to allow taxpayer funded bailouts, avoiding the EU’s new bail in rules
  • The EU, led by the Germans, are refusing to bend the rules, leading to a stand off
  • Many of the Italian bank bail in securities are held by household investors, which means a political stand off between Italy and the EU could play into the hands of the anti EU political party in Italy, the Five Star Movement
  • In addition to the heightened risk of more volatility surrounding the EU, one of the biggest losers from an Italian banking crisis is the French banking sector, with around A$400bn in loans outstanding
  • For bond investors, while a full blown banking crisis in Europe is still reasonably unlikely, there is no point taking unnecessary risks by holding any exposure to the European banking sector or Euro positions 
  • If you want to profit from Europe pulling through this crisis, use equities for the upside potential.  If you want income, for the time being, avoid all things Europe unless you are being paid very handsomely for it

In FIIG’s “5 biggest risks for Australian investors” seminars in 2015 we named Italy as the biggest risk to longevity of the EU, and that it was the Italian banks that would be the particularly weak point.  That risk now seems to be becoming more real.

Italy’s banks have bad debts at around 18% of total loans.  As shown in Figure 1, this places Italy around three times the level of the Euro area as a whole.  In fact, even at the peak of the GFC, the US and UK remained below 5% of gross loans. 

Like with the Greek debt crisis, the problem once again is a lack of consensus across the EU about how to deal with the problem.  The European Central Bank began supervision of Europe’s banks in 2014 and in that same year introduced “anti bailout” rules to prevent governments bailing out bank bondholders.  Italy wants to inject €40bn into its banks to stabilise the system, but once again Germany has stepped in to block this.  That leaves Italy exposed to the potential for a banking crisis they are constrained from preventing.

The problem for the EU is exacerbated by the contagion risk with other countries’ banking sectors.  French banks have EUR250bn (~A$370bn) in outstanding loans to Italian banks, and while this is a fraction of the total assets of French banks, banking crises are created by confidence issues first, with actual failures typically being isolated to a relatively small number of banks. 

A crisis of confidence is what hurts the economy as depositors withdraw funds and banks stop lending to businesses, leading to the real economy being hurt.  This is how the US and UK banking crises of 2007 2009 played out, and the chances of the same happening in Europe are rising.

Bank bail in precedent

The Italian situation might provide the world with some insight into how the post GFC bailout rules actually get applied once public and political pressure is applied.  The rules used around the world say “no government bailouts until investors wear losses” but already the Italian government is asking for an exception to be applied. 

So far, financial markets seem to expect that the rules will be upheld.  Share prices for Italian banks are down an average of 57% in 2016, and the hybrids have fallen around half as much.  One of the biggest concerns in Italy is its third largest bank, Banca Monte Dei Paschi Siena; its share price is down 79% this year and its hybrids are trading at 64c in the dollar, dropping 13c last week alone.  Monte Paschi has around 33% of its gross total loans as non performing loans. 

In an interesting parallel with Australia, much of the bank hybrid issuance has gone to household investors.  This creates one of the big challenges with the new bail in rules, namely that when it comes time to force bail ins, these investors can take action against their government such as protests or voting.  In November last year, four small Italian banks had bail in conditions forced upon 10,000 retail investors, resulting in riots and even one suicide. 

Italian household investors hold around €50bn, or 2.7% of Italy’s GDP in hybrid securities.  In Australia, retail investors hold around A$40bn in hybrids or around 2.5% of Australia’s GDP.  While Australian banks have a much higher credit rating than Italy’s, the issues in Italy will be watched very closely by Australia’s regulators.  Italy, like Australia, allows the sale of hybrids to retail investors, but if Italy is successful in circumventing the new bail in rules using the retail investors as an excuse, other banking regulators are highly likely to ban their sale going forward.

Anti EU social unrest and implications for the EU

The Italian government has been pressing the EU on this topic since Brexit two weeks ago.  A collapse of a major Italian bank will likely result in losses to the public through their share and hybrid holdings. Coupled with community fear of deposits also being used in a bail in would likely increase the public vote to exit the EU.   

The real concern with this early but rapidly escalating story is that if there are factions that wish to use this situation to fuel a larger public movement against the EU establishment, this would be bad news for the Italian banks and economy and for the European economy as a whole.  These anti establishment movements are divisive and highly contagious, particularly for the other countries already facing rising anti EU pressure such as France, Spain, Austria, Sweden and The Netherlands.


Few Australians will have direct exposure to Italian banks, but this is not just about Italy, this is about the EU’s stability.  EU instability is a global financial market risk due to the economic impact of social unrest and the fall in business confidence that, as we’ve already seen in the UK, leads to lower investment and hiring intentions, fuelling the whole movement further.

There is also a strong warning in the EU banking sector’s decline for hybrid investors in Australia.  This isn’t limited to Italian banks, which could be dismissed as being poorly governed: Deutsche Bank, one of the world’s largest banks, has Tier 1, 6% CoCo (hybrid) securities with similar bail in terms to many of the ASX listed bank hybrids, that have fallen to 75c in the Euro in the past 12 months, including a 21% plunge in just seven days.