Italy rejects bad bank

After the Irish experience with a bad bank, I expected the Spanish government to reject setting up a bad bank as a bad bank doesn't restore confidence in the banking system and only consumes the government's access to credit (the Irish experience).

Clearly, the Spanish government did not reject setting up the bad bank and by doing so has committed itself to continue to place the burden of the excess debt in the Spanish financial system on a real economy that cannot afford this burden.  The result will be further shrinkage of the real Spanish economy.

Bloomberg reports that Italy is getting ahead of the curve and is rejecting setting up a bad bank.  The reason Italy is rejecting the bad bank is it produces only negative consequences for Italy.

Italian Treasury officials rejected proposals to create a so-called bad bank to take non-performing loans off the books of the nation’s lenders amid concern the plan would strengthen the link between sovereign and bank debt, said people with knowledge of the matter. 

At least three restructuring advisers held talks with government officials about a bad bank that Italy could fund without seeking external aid, said the people, who declined to be identified because the discussions were private. The bad bank could hold 30 billion euros ($39 billion) to 100 billion euros of assets and lenders would receive government bonds in return for their bad loans, according to one person....

I am shocked! Shocked I tell you to see that bankers are out there pushing for a solution that benefits them and nobody else.

Regular readers know that a bad bank does not work because of the issue of how to value the assets taken off of the bank balance sheets and the question of how does anyone know that all the bad exposures were transferred.  [These problems undermined the US Treasury's plan to buy opaque, toxic assets from the banks.]

To address these problems requires the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  With this information, market participants can independently value the exposures.

As a result, the market knows if the exposures are transferred at their market value or the bad bank pays too much (a boost to the banks at taxpayer expense).

If the exposures are transferred at market value, why bother with the bad bank in the first place as the banks have already written the loans down?

A bad bank is a tool the government could use to spur a turnaround in the country’s economy by easing funding needs among smaller banks that would allow them to boost lending, said the people.

This assumption is false.

It bears repeating that bank lending is independent of the bad debt on the bank balance sheet.  For proof, just look at how much lending the US Saving and Loans did during their crisis in the 1980s.

Bank lending is separate from how the loan is financed because the bank can sell the loan to other financial market participants like an insurer, pension fund, hedge fund...

Still, it could strengthen the link between government and bank debt, going against reforms including plans for a European banking union that seek to weaken that nexus that has exacerbated the region’s debt crisis. 

“The last thing Italy needs right now is a further strengthening of the links between the sovereign and the country’s banks,” said Nicholas Spiro, managing director of London-based Spiro Sovereign Strategy. “While Italian sovereign debt is a much safer asset class than a year ago, Italy is by no means out the woods and is seeking to differentiate itself favourably from Spain as much as possible.”

Please re-read the highlighted text as Mr. Spiro's comment about not setting up a bad bank as a positive point of differentiation between Italy and Spain is telling.

If having a bad bank makes your sovereign debt a riskier asset class, then a government should simply not set up a bad bank.

It is worth repeating, given the design of a modern banking system, there is no need for setting up a government funded bad bank.  Between deposit guarantees and access to central bank funding, banks are capable of absorbing the losses on their bad debt and continue supporting the real economy even if they have low or negative book capital levels.

The reason banks can continue to support the real economy is the deposit guarantee effectively makes the taxpayers the banks' silent equity partner when they have low or negative book capital levels.