What will Draghi do? 

By Don Quijones, Spain & Mexico, editor at WOLF STREET.

After two controversial bank rescue operations that stretched Europe’s bank resolution laws beyond recognition, things are beginning to look a little less desperate for Italy’s banking sector. The initial market reaction to the interventions has been overwhelmingly positive. For the first time in years Italian banks are leading Europe’s Stoxx 600 bank Index — upwards, not downwards.

Even the recent announcement of a capital raising and bad-loan sale plan by troubled bank Banca Carige was met with enthusiasm, sending its shares up 30%.

One of the Italian banking sector’s biggest problems — its sky-high bad loan ratio — will soon be under control, claimed Bank of Italy Governor Ignazio Visco in a recent speech to the Italian banking association. The interventions in Monte dei Paschi di Siena and the two Veneto-based banks, Popolare di Vicenza and Veneto Banca, will take almost €50 billion of bad loans off their balance sheets, leaving about €275 billion in the system. Within a year Italy’s non-performing loan ratio will be down to an almost respectable 8% of total loans, Visco said.

To that end the government will create a new semi-publicly owned national asset management company (NAMC) that will help “develop the market for bad loans.” To lend the scheme legitimacy, European finance ministers rushed through approval of NAMCs for all Eurozone economies last week.

These NAMCs will vacuum up some of the nonperforming loans from bank balance sheets and sell them at a discount on the secondary market. According to Visco, the only way such a scheme would be “useful” is if it is applied on a purely voluntary basis and the assets are transferred at a price “not too far from their real economic value” — i.e. the value assigned to them by the banks. Untold billions of euros of taxpayer funds will be used to make up the difference between what market participants are willing to pay for the banks’ impaired assets and the price the banks want for them. This is the more covert part of Italy’s publicly funded bank rescue program.

Yet even if this scheme, together with the recent bail-out of MPS and bail-in of the two Veneto-based banks, helps to steady Italy’s banking sector, the banks are still not out of the woods. Indeed, a whole new problem is already brewing.

A pending Basel III reform package could eliminate the equity capital privilege for EU government bonds. This equity capital privilege essentially means that banks are currently exempted from documenting their equity capital for government bonds, as they are required to do for loans, corporate bonds, and other receivables.

Until now, financial regulations have assigned a value of zero to the risk of EU government bonds regardless of the actual level of risk attached to the respective government debt. This equity capital privilege has enabled banks to finance the purchase of EU government bonds using third-party capital only, by issuing their own bonds or using customer deposits. It’s an easy way of making money that, together with the ECB’s QE program, has helped to keep the yields on government debt artificially low. But it could be about to come to an end.

The prospective new rules stipulate that the lower the EU member state’s rating, the higher the proportion of equity capital required when investing in government bonds. As a study by the German Institute for Economic Research shows, Italian banks would be particularly hard hit by the rules. Due to the comparatively weak rating of Italian government bonds (on the collection date they had a Fitch Rating of BBB+), the Italian banking sector would have to substantially increase its equity base.

For each euro invested in the purchase of an Italian government bond, the banks would have to finance four cents out of their own funds. To put that in perspective, for Italian government bonds worth 100 million euros, a bank would need four million euros in additional equity capital. The total bill for the entire sector could reach €9 billion, compared to €3 billion for French banks and €2 billion for German banks.

This would leave the Italian banks with two far from attractive get-out clauses: either they raise new funds from investors, something most of them have struggled to do in recent years, or they cull some of the Italian government bonds from their portfolios. Given Italian banks are the biggest owners of Italian government debt (after the ECB) this could have serious consequences, not only for the banks but also for the government.

The interest rates on Italian bonds would rise, first due to diminished demand, and second, because the risk premium on equity capital would also raise the cost of government bond purchases. Of course, the ECB could step in and take up the slack, but it has already tapered its asset purchases by €20 billion a month and purportedly plans to further taper them.

If the banks can’t raise new funds or sell off their government bonds at a survivable price, the government may be tempted to step in, again. The problem here is that Rome has already earmarked €20 billion of public funds to save the banks — and the powder on that is almost dry. As the German Institute for Economic Research points out, expanding the rescue program would force up Italy’s already vertiginous level of public debt, which grew to a fresh record in May of €2.28 trillion, from €2.27 trillion in April.

The main goal of the new legislation is to disentangle the default risks between sovereigns and banks in the Eurozone — the infamous “doom loop.” The problem for Italy is that, aside from the ECB, its domestic banks are just about the only big-time market players left that are still willing to buy Italian debt at its current QE-inflated price. If the new legislation is passed and they become net sellers at the same time as the ECB begins to scale back its stimulus, the price of Italian debt could return to reality with a very harsh bump. Thus the change in bank capital rules designed to reduce the risks of the doom-loop could be triggering, in doom-loop fashion, a renewed sovereign debt crisis in Italy. By Don Quijones.

Only two things keep these European banks alive. Read…  Many EU Banks Would Collapse Without Regulators’ Help: Fitch

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