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Monte dei Paschi and the Doom Loop - April 3, 2018

Monte dei Paschi’s Woes Continue:

In past TFTDs, we’ve been drawn to Italy (see here and here) and it’s not simply because we enjoy a nice Barolo every now and again. In truth, it’s because Italy has taken over for Greece as the bête noire of the Eurozone banking system. This fact came to the forefront last year, when Banca Monte dei Paschi di Siena, the world’s oldest bank, having been unable to right itself after failing a stress test in July of 2016, was forced to seek a bailout (see New York Times article). Related to past TFTDs, the article noted:

“Leaders in Rome are worried that forcing small-time investors to take a hit would make them susceptible to appeals by the populist Five Star Movement or the right wing Northern League. The Five Star Movement has organized noisy demonstrations in front of Monte dei Paschi’s headquarters.”

At the time, in addition to potential political ramifications, there were concerns that Monte dei Pacshi’s troubles could spread beyond its own walls to infect other Italian banks. More than 6 months and 8 billion euros of bailout money later, Monte dei Paschi still doesn’t have a clean bill of health, according to a recent article, again from the New York Times.

Doom Loop:

However, Monte dei Paschi’s woes are just the tip of the iceberg. While the bank may have issues stemming from bad loans and mismanagement, it also has massive exposure to Italian sovereign bonds and, in that, the bank is not alone. As a recent article from Wolf Street reports, despite the ECB buying boat loads of BTPs, Italian banks are still massive owners of sovereign Italian debt. Perhaps even more remarkably the exposure isn’t limited to the Italians. This is illustrated by the table compiled by Eric Dor of the IESEG that lists the banks with the largest exposure, the top 6  of which are shown below.

Why is this dangerous? As outlined in a Bloomberg editorial from the end of 2017:

“Banks that hold large, concentrated portfolios of their own governments' bonds can be a threat to financial stability.“

This is a well known phenomenon that inspired a review by the Basel Committee on Banking Supervision back in 2015. The report generated by the review highlighted that:

“[T]he existing treatment of sovereign exposures is more favourable than other asset classes. Most notably, the risk-weighted framework includes a national discretion that allows jurisdictions to apply a 0% risk weight for sovereign exposures denominated and funded in domestic currency, regardless of their inherent risk.”

Meaning banks can take ever larger positions without raising additional capital. It is hardly surprising that banks took advantage of the regulations to ramp up their exposure. However, given the current developments in Italian politics and the threatened tapering of ECB