A proposed lowering of Italy’s budget deficit to 2.04% led to a rally in Italian bank paper, but the knock-on effects of heightened sovereign risk caused by political uncertainty on the banks’ underlying businesses had already started to emerge.
Prolonged negative sentiment towards the Italian sovereign has gone way beyond higher debt issuance costs for Italian banks; it has to all intents and purposes deprived them of reasonable cost access to public wholesale bond markets. Because Italian banks make relatively little use of wholesale funding, the impacts are manageable. But short of a sustained asset-price rally amid a shift in buyside sentiment and full clarity on the outcome of budget negotiations, Italian banks are not yet out of the woods.
The extent of market access issues became apparent in late November when UniCredit paid a reported 7.83% coupon on a USD 3bn five-year private placement of senior non-preferred (SNP) debt negotiated directly with Pimco to bolster its bail-in-able debt buffers. By comparison, the bank’s oversubscribed debut SNP offering in mid-January – a EUR 1.5bn five-year – came with a coupon of just 1%.
Even accounting for the currency differentials, the bigger size, the fact that the whole market had moved wider over the year and that UniCredit’s euro SNP notes had traded off, the bank still paid a significant premium to get the issue away. In a situation where management needed certainty of funding and size, it had little option but to pay up.
Scope had foreshadowed such an outcome in its 30 October note (Scope affirms ‘A’ Issuer Ratings of large Italian banks but changes Outlook to Negative from Stable). Referencing Intesa and UniCredit, Scope had said a prolonged period of poor market sentiment related to Italy “may negatively impact the two banks’ debt issuance capacity at economically affordable costs … especially so as the two large Italian banks, like other EU banks, will eventually have to issue more MREL-eligible non-preferred senior debt in the markets.”
The material widening of sovereign and other Italy-related spreads on the back of political uncertainty came at a highly inopportune moment for the country’s banks. “It is unfortunate that just as the banks were finally getting to grips with their legacy asset quality problems and were regaining the trust of the investment community, the crystallisation of political risk made them more vulnerable again,” said Marco Troiano, executive director in the banks team of Scope Ratings.
The situation prompted Scope to change its Outlook on the Italian banks it publicly rates (A for Intesa and UniCredit; BBB for IBL) to Negative from Stable on October 30.
Higher bank funding costs have had the effect of reducing Italian banks’ room for manoeuvre on the business front, because they have little option but to pass those higher costs on to customers. In fact, the evidence is that the cost of household and business borrowing is already starting to rise, including rates on new fixed-rate residential mortgages. “Banks are economic concepts and they have to deliver value for their shareholders over the long term. You cannot expect an entire banking system to do business on a loss-making basis for a long period of time,” said Troiano.
Italian sovereign risk, as measured by the 10-year Bund-BTP spread, has increased precipitously since the elections. In recent days, however, BTPs have rallied and are off their recent lows. But the market is susceptible to bouts of volatility, direction uncertain.
From around +120bp around the time of the elections, the spread to Bunds had been on a one-way track, trading at highs above 325bp in the latter half of November. This had tightened to the low-260s area in December 13 trading, spurred by reports of the lower deficit proposal and in recent days on the back of cover provided by President Macron’s fiscal boost in France.
The effects of higher sovereign spreads on the Italian banks are manageable at this stage. The mark-to-market on the Italian banks’ huge holdings of government debt directly hits their capital levels, but at this stage Troiano is not overly concerned. Only a portion of the direct sovereign exposure is marked to market, and the capital positions of the banks rated by Scope remain reassuring, so they are able to withstand some erosion from losses in the securities portfolios.
“Short of a full-blown crisis, the direct impacts on capital are very manageable,” Troiano said. “For the large banks, we are talking about tens of basis points so far. In the short term, banks can hold out and absorb any impacts by managing their liquidity and perhaps foregoing a bit of profitability. But if the adverse markets conditions persist, sooner or later the spread will be transposed into loan prices and availability,”