The plight of Italian banks and their fragile capital positions - highlighted by recent European stress tests - promises to be one of the factors unsettling investors this year.

One of the financial and economic risks in the European – and wider – economy is the fragile capital position of Italian banks, with recent central bank stress tests highlighting deep worries about the country’s financial sector. 

According to Swiss private bank REYL, a move by Italy to contain the problem by recently forming Atlante, a private fund to hold non-performing loans, is, at most, a “baby step”, albeit one in the right direction. In a note, Nicolas Roth, co-head of alternative investments at REYL, said Italy needs to create a functioning market for non-performing loans (NPLs) by accelerating reform of the judicial process and creating incentives for banks to write down balance sheets and sell NPLs to private investors.

“A few bold investors have already set foot in the country to buy NPL from willing sellers; however the market remains far behind Spain from a liquidity perspective,” he said.

The comments came after the European Banking Authority last week announced results of new stress tests on 51 European lenders, giving most of them a clean bill of health but also showing serious problems in Italy. Italy’s largest lender, UniCredit, suffered a fall in its shares earlier this week. UniCredit recorded a capital ratio of more than 7 per cent after the stress test simulated the effect of a shock to growth, currencies and markets; the test showed that Unicredit was among the five weakest banks out of the 51 financial institutions. Meanwhile, last Friday, Banca Monte dei Paschi di Sienan (MPS), Italy’s oldest bank, announced a sale of NPLs and a rescue package to raise at least €5 billion ($5.6 billion) of capital. It performed the worst of any bank in the stress test.

Roth said a letter sent by the European Central Bank in July to MPS was a blow to Italy's hopes of settling troubles in its own way. The ECB said the lender must cut its bad loan exposure by around €10 billion over the next three years, which Roth said will put more strain on the sector.

Another headache for Italy is that EU state aid rules stipulate that before any public money can be used to help a stricken bank, the lender must use 8 per cent of total liabilities as a preliminary "bail-in". (A bail-in is a term applied when a financial institution that is about to fail is rescued by making its creditors and depositors take a loss on their holdings.)

“In Italy, approximately 30 per cent of bank bonds are being held by retail investors due to preferential tax treatment of fixed income instruments,” Roth said. If there is such a bail-in, this could destroy the current Italian government and give power to populists – the opposite of what German chancellor Angela Merkel wants to see. 

Roth said the “best-case” outcome for Italy would be the EU allowing state aid for Italian banks without triggering bail-ins.

Italy's financial problems, while to some extent obscured by media commentary about Brexit recently, have been causing alarm for some time. In a note in April, for example, Berenberg, the Germany-headquartered bank, said it was worried about Italian banks and European banks’ capital positions more broadly. 

“Simply put, European banks have too much debt on their balance sheets at the wrong margin. The solution remains the same - write down the debt or reprice it. However, banks remain short of capital, which rules out the first route and borrowers are unable to absorb a repricing as they have too much debt. Central bank intervention merely perpetuates the problem as it suppresses risk pricing and the ECB now provides zero cost financing to allow banks to forbear. Balance sheet certainty is needed to give confidence to valuation,” it said.