Reports indicating that Italy is close to establishing a bad bank prompted one wag to ask if  Italy does not already have enough. The country may be better served by setting up a good bank. 

The sharp sell-of in shares of Italian banks this year is an important driver of G7-leading 12.4% slide in the local bourse this year.  

The Renzi government has been trying to establish a “bad bank” to warehouse the non-performing loans (NPLs) that are hardening the arteries of Italy’s financial system, and contributing to the economy’s sclerosis. However, he has found it difficult to secure the EC’s approval.  

First, the EC wants to minimize state support for banks, and especially in Italy, which has the highest debt in EMU after Greece. Second new rules went into effect at the start of the year (Bank Recovery and Resolution Directive), ostensibly protects taxpayers by bailing in more stakeholders, including senior creditors. Also, the new rules require that 8% of the bank’s liabilities need to be wiped out before public money is used. 

Few observers seem to grasp the implication of the Bank Recovery and Resolution Directive (BRRD). Many were surprised when Portugal forced a haircut on some senior creditors at the end of last year, but the new directive makes bonds less appealing by making them less safe. The BRRD is particularly important for Italian banks because they are more reliant on debt securities than other banks in EMU. The share of debt securities, including certificates of deposit, accounts for 16% of Italian bank liabilities compared with about 7% for the EMU as a whole. The bond-to-deposit ratio is near 40%, the second highest behind Germany. 

The EU pushed back against Renzi’s initial bad bank plans because it appeared to include a subtle form of state assistance. He has responded with a new version that offers a lighter touch.  Rather than bundle up the NPLs in a common pool, the new version, would allow investors who buy NPLs could also to buy a guarantee for some protection.  More details of the guarantees are expected in the coming days.