How to fix Italian banks

Yakov Amihud, Carlo Favero 19 July 2016



Fixing the Italian banking problem is crucial to restore growth, and growth is not out of reach for Italy. Over the last eight years, the country has been going at two speeds. Industrial firms have been performing well. In particular, the small firms included in the STAR segment of the market have been rising and until last year the segment was performing as well as the DAX index; since 2008, the STAR index has risen by about 50%. On the other hand, the Italian Stock Market Index (FTSEMIB) – where bank stocks have great weight – has underperformed, declining by 50% since 2008. The performance of Italian small firms is remarkable given the financial problems in the market. Solving the banking problem will create the conditions for the industrial sector to perform even better and to reach its growth potential, which is stronger than the general current consensus.

Figure 1 Stock market performance

The public debate on how to resolve the problem of Italian banks is over whether there should be a government bailout, or whether the banks’ bondholders will bear the burden.  Absent from the discussion is what will happen to the banks’ stockholders.  Bailing out the banks usually amounts to giving stockholders a gift. And demanding that bondholders undergo a haircut – i.e. give up part of their claim – also benefits stockholders.  Theoretically, stockholders should be wiped out before bondholders are asked to undergo a haircut. 

But there is a problem: who will manage the banks if stockholders quit?

There is a solution

The Italian government should require banks to issue deep discount rights, which is a coercive way to raise equity and thus strengthen the banks’ balance sheet and their solvency. In rights issues, existing shareholders are offered the opportunity to buy additional shares at a discounted price (e.g. a 50% discount), as opposed to new shares being sold to the general public. A stockholder who does not wish to exercise the right can sell it in the market. At the end, the right issue will raise the desired amount of equity.

We illustrate this with a simple numerical example. Suppose that the bank has 100 shares selling at €1 each, so its value is €100. Each shareholder receives a right to buy one more share at a 50% discount. After the rights are exercised, the bank’s equity will grow by €50. If we assume that nothing else happens, the stock price will fall to €0.75. The stockholder will have two shares that are worth together €1.5. Before, he had one share worth €1 and €0.50 in cash, which he used to exercise the right. His wealth did not change. The stockholder can also sell the right for €0.25, and this gain will offset the price decline from €1 to €0.75.

When the bank is in financial distress, such a move may cause the total wealth of the stockholder end up being less than the €1.50 in our example, because the bank’s bondholders will be partial beneficiaries of the injection of equity. But, on the other hand, it will enable the bank to come out of the current doldrums and resume normal activity, which will enhance value.

Banks indeed issued coercive rights in the past, which helped them survive.  Here are two examples from the 2008 financial crisis. Bank Santander announced in November of 2008 a right issue that would raise €7.2 billion from its shareholders in order to boost its capital. Stockholders received one right for every four shares they owned and the exercise price of the rights was €4.50, a discount of nearly 50% on the previous day’s price. At that time, the bank’s core capital ratio was 6.3% and the equity issue was intended to raise it to 7%. This capital injection surely helped Santander overcome the financial turmoil.

Similarly, Barclays Bank announced on 30 July 2013 a rights issue of £5.8 billion in order to strengthen its resources following a severe capital shortfall. Barclays’ stockholders were offered one right for each four shares they owned with an exercise price which represented a discount of 40% on the closing price on the previous business day.

Why can’t Italian banks do the same?

As to banks that are insolvent and need a government injection of capital, this should be done by the government injecting the capital for the bank to continue to operate normally while completely wiping out the shareholders (see Taylor 2010 for the US crisis case). Bankrupt banks can continue to operate as before under Italian central bank supervision, retaining the same management and employees and the same clientele. In time, management will be replaced or the bank will be sold.

A quicker fix is to arrange an acquisition of an insolvent bank by a solvent one, or by a consortium of banks, with a government aid to offset losses from underperforming loans. Again, stockholders will lose their ownership and the bonds will become liabilities of the acquiring bank. To alleviate the cost to the government, bondholders may be required to consent to a reasonable haircut. The alternative, if bondholders stay with the defaulted bank, may be worse.  To illustrate this solution: the loans of Banca Monte dei Paschi di Siena (MPS) were €102 billion at the end of 2014 (Ufficio Studi Mediobanca 2015). The most recent estimate by the ECB of MPS net non-performing loans is €24.2 billions (MPS 2016). A recovery rate of, say, 1/3 means a loss of €16 billion, which is about three times the bank’s equity as of 2014.  But this is only about 16% of the equity of the largest two banks and slightly over 1% of their total assets (all in 2014 numbers). MPS has non-tangible assets and its merger with another bank will produce synergies that are worth many billions of euros that could be enough to offset a large part of the loss. The government could split MPS between the large banks. If a bank acquires branches of MPS and consolidates them with its own, there will be great cost savings. Naturally, the government will have to make sure that an MPS branch will not be acquired by a bank which is the only competitor in the area; in such a case, the branch will be sold to a third bank. This procedure is followed in bank mergers in the US to overcome antitrust concerns. Cost saving will also be generated when the overhead of MPS is greatly reduced following its consolidation with the other banks. That is, the acquiring banks can reasonably absorb the defaulted bank with little help from the government, if any is needed.

Finally, to avoid run on the banks, the government should raise significantly the amount of deposit insurance. This was done in the US following the 2008 financial crisis. It should be coupled with stronger supervision of the quality of loans that banks make. That is, the banks should be free to make loans of any risk that they choose, but they should pay higher insurance premium for riskier loans. The objective here is not only to cover potential losses of the insurer (the central bank and the Italian government), but also to discipline the banks and reduce moral hazard, i.e. the propensity to take excessive risks with ‘other people’s money’. It will also mitigate the propensity of depositors to move deposits from weaker to stronger banks, which may exacerbate the crisis right now.

It is important that banks continue to operate smoothly because if they do not, there is a ‘dead weight’ cost in the economy – sort of a lose-lose situation.  Banks provide liquidity, without which the economy cannot function. A business ordering merchandise needs to be sure that its bank will provide the credit line needed to carry out this transaction. Otherwise the economy will stall, which may turn into a recession that will exacerbate the economic slowdown.


Banca Monte dei Paschi di Siena (MPS) (2016), Press release

Taylor, J. (2010) “Getting Back on Track: Macroeconomic Policy Lessons from the Financial Crisis”, Federal Reserve Bank of St. Louis.  

Ufficio Studi Mediobanca (2015), “Le Principali Banche Italiane”. 



Topics:  Europe's nations and regions Financial regulation and banking

Tags:  Italian banks, bank resolution, Italy

Ira Rennert Professor of Entrepreneurial Finance, Stern School of Business, New York University

Head of Finance Department and Deutsche Bank Chair in Asset Pricing and Quantitative Finance, Bocconi University; CEPR Research Fellow