They call them le sofferenze – the suffering. The imagery is striking, the thousands of sofferenze across Italy, unwanted and ignored, a problem unsolved.
But despite the emotional name, these are not people. They are loans. Bad debts, draining banks of profits and undermining economic growth.
The name is less clinical than the English term “non-performing loans”, a reflection of the Italian authorities’ emotional rather than business-like approach to the problem.
None the less, the loans are indeed causing real suffering. The €360bn (£300bn) of sofferenze from Italian banks show borrowers are weighed down with debts they cannot afford, while the banks are struggling to offer new credit to the households and firms that need them.
When other countries such as the UK, Ireland and Spain ran into trouble, they bit the bullet and cleaned up their banks quickly. Italy did not.
In a way, Italy’s authorities had good intentions. When loans turn bad and banks lose money, someone has to pay. It should be the banks’ investors, the shareholders and bondholders who take the risk of investing in return for the chance of profits. Unfortunately in Italy, households are keen investors in bank bonds, and would be badly burnt if they had to face up to those losses.
So nothing was done. The bondholders have so far kept sight of their savings, and the banks have been allowed to ignore their bad loans. It saved the country some short-term pain, but the financial problems never went away.
Now they have spread to the wider economy, and are morphing into a political crisis with implications across the EU. It could bring down Italy’s government.
If no compromise is reached between Rome, which wants to protect bondholders, and the EU, which wants to enforce the rules, it could even bring down the eurozone.
“This could be a bigger risk than Brexit,” says a lawyer who is close to the situation.
“The Greeks are desperate to be anchored into Europe, they are willing to suffer and suffer and suffer to stay in – I am not sure that Italy is willing to suffer.” The stakes are that high, and nobody knows whether the EU can muddle through another crisis, or if shock waves from Italy will split the union. Long nights and fraught nerves lie ahead.
This is just the latest phase of the eurozone’s seemingly never-ending crisis, and the International Monetary Fund’s latest assessment of the currency area’s third-largest economy shows why Italy is the latest focal point.
The country faces a slow crawl back to economic health, the IMF warned last week. Productivity growth remains weak, debt is still climbing and the economy can’t prosper while its banking sector is sick.
Under current projections, the economy will not get back to its pre-crisis size until 2025. In other words, Italy faces not one, but two lost decades.
As a result, its banks are sitting on a vast stockpile of bad loans, and the situation will only worsen if the status quo continues.
Few countries have bad debts on this scale – more than 18pc of Italian banks’ loans are non-performing, and the lenders have set aside funds to cope with only half of those.
By contrast, fewer than 5pc of French banks’ loans have run into trouble, and British banks’ bad loans amount to below 1.5pc of their books.
In almost any other economy, these astronomical levels of bad loans would be dealt with quickly.
As Rome has delayed taking action to solve the problem, not only has the scale of dodgy debts grown, but so has the barrier posed by tough new rules and a more hostile political environment.
Such was the expense of taxpayer bail-outs across Europe – and the public anger as voters bore the cost even as bondholders typically escaped unscathed – that European leaders agreed to make sure taxpayers were never on the hook again.
This set-up was expected to restore sanity to bond markets since risk was reintroduced to the equation, and to reduce political problems by removing public money from banks.
Yet in Italy, the new arrangements also risk intense public anger and financial disaster, as household finances are unusually closely intertwined with the banks.
Estimates of the cost of recapitalising the banks typically stand at around €40bn – a large but not insurmountable cost, but one that could have huge repercussions if retail customers have to chip in.
The first impact would be on the banks. They rely heavily on retail deposits and bonds to finance their lending – according to Bank of America Merrill Lynch, households own €235.6bn of bank bonds, amounting to 14.6pc of their wealth – and the banks do not want to frighten them.
“The risk of bailing in retail bondholders is that the domestic bond market, which is important for funding Italian banks, could potentially shut down,” says Roberto Henriques at JP Morgan.
“At the margin, the media coverage of any subsequent losses for retail bondholders might also undermine retail depositor confidence in the same institutions, with the potential for some deposit outflows.”
In this case, the financial crisis could worsen, rather than being resolved.
The second problem is political. The bondholders’ losses risk harming the government’s reputation at a delicate moment.
Prime Minister Matteo Renzi is already facing a close-fought referendum over a planned constitutional reform. If he loses the vote, it could mean the end of his government, and polls indicate that the eurosceptic Five Star party, headed by Beppe Grillo, could perform well in a general election, spreading further political instability through the European Union.
Italian pragmatists argue the cost of a government-backed bailout would be worth paying, to avoid financial instability. Yet the equation is not that simple.
The EU insists bondholders have to bear the cost of the recapitalisation, sparing taxpayers and forcing investors to think about the risks they are taking, to help stop future crises at banks and in governments’ finances.
Officials at the Eurogroup and European Central Bank are digging in their heels – they do not want the past five years of financial reforms undermined immediately by Italy.
Such a result would sap their own authority and open the door to similar state-backed deals in Portugal, which is also suffering from bad bank loans.
Still, even a bailout would bring political risks to Mr Renzi.
Lorenzo Codogno, former director- general of the Treasury Department at the Italian economy ministry, says there is a risk that a bail-in of retail investors could be politically toxic, even if a conversion of debt into equity, could be a “gift” for many bondholders who now have illiquid subordinated debt.
“The risk is clearly that it is not taken well by the electorate, affecting political support for the PM,” says Codogno, the current chief economist of LC Macro Advisors.
Those watching negotiations closely think Italy’s government may end up acting first.
“The EU rules say you can’t do it. But so what?” says a lawyer, who asked not to be named, in criticising the EU’s leadership. “If it is a choice between the collapse of the Italian banking system or being told off by [Eurogroup President] Jeroen Dijsselbloem, I know what I would do in Renzi’s shoes. It is easier to ask for forgiveness than to ask for permission.”
If the Italian government does indeed defy Europe’s rules, the government still has to decide precisely how to recapitalise the banks.
One option to soften the blow to investors could be to take the Greek route, forcing the bondholders to participate, but switching some of their bonds into shares. The shares are worth relatively little at the moment, but if the banks do indeed ultimately recover, the value of the equities should rise in time.
The move could also be used to placate the EU, showing the authorities that investors have at least shared the burden – “a fig leaf”, as one investment banker calls it – while really keeping those household investors sweet.
Either way, something has to be done soon. By the end of this month, the European Banking Authority will have published new figures showing the banks’ weak capital positions.
The stress tests have been ignored in the past, but it is becoming harder to brush aside international comparisons with increasingly strong banks in other countries.
This week, Bank of England Governor Mark Carney said Italy’s banks’ capital positions will only get worse if no action is taken.
“[The Italian banks] have deferred tax assets on their balance sheets. We learnt that lesson with RBS, not to count those assets,” he said.
“By 2019 they won’t be allowed to have those assets on their balance sheets thanks to the European and Basel rules, but for the moment they do. In the case of the Italian banks, it accounts for 2pc to 2.5pc or so of their underlying equity. That is an asset that will go away with time, so quality of capital is a bit of an issue.”
That is to say, even in their current poor positions, the Italian banks are artificially propped up by unreliable assets which will soon be stripped away from them.
The situation is uncomfortably painful, even unbearable for Italy. Expect a political bust-up followed by economic uncertainty and then –if Italians can stomach the other tough economic reforms necessary to free up their labour market and swathes of industry – some form of recovery to put the country back on track to prosperity.
“There is no magic bullet,” says Codogno.