Why Italy’s Banks Are a ‘Doom-Loop’ Risk that Could Bury the Eurozone

July 29th, 2016  |  Source: Knowledge@Wharton

Eight years after the global financial crisis, Italy’s economy remains weak and the country’s banks have a very high rate of shaky – or non-performing — loans at about 18%. That compares with rates of 5% in France and 1.5% in the United Kingdom. Since Italy is the third-largest economy in the eurozone, a breakout of loan defaults or a run on bank deposits could quickly spread eurozone-wide, where many banks have been struggling, in part because of record-low interest rates cutting profit margins. What’s more, companies in Europe depend on bank loans far more than in the U.S., so struggling banks can mean that even successful companies face a credit squeeze.

This has led to fears of a “doom loop” because the potential failure of Italy’s banking system might require a state rescue at a time when the country is already heavily indebted at around 135% of GDP. What’s more, a financially incestuous relationship between the two already exists — Italian banks are heavily invested in Italian government debt. And it is all further complicated because as of January, new regulations require European banks to bail-in shareholders and bondholders – use their holdings to recapitalize a troubled bank — before any taxpayer-funded bailout can occur. Yet in Italy, many bondholders are actually small investors who were duped into buying bank bonds under the impression that they were as safe as insured deposits, explains Franklin Allen, an emeritus finance professor at Wharton and a finance professor at Imperial College in London. If small investors start to take a hit, it could spark a run on bank deposits and kick off a major crisis. In this Knowledge@Wharton interview, he looks at the big picture regarding risky Italian banks, assesses the odds of significant problems breaking out, and considers how officials might avoid a major new financial crisis.

An edited transcript of the conversation appears below: 

http://knowledge.wharton.upenn.edu/article/italys-banks-doom-loop-risk-b...




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