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The Italian-German Banking Disease

Economically, Italy and Germany seem worlds apart. Why then are the two countries’ banks both facing a deep crisis?

November 4, 2016

Economically, Italy and Germany seem worlds apart. Why then are the two countries’ banks both facing a deep crisis?

Italy and Germany seem worlds apart. The Italian economy has not grown since the year 2000 and the country’s unemployment rate is near record highs, while government indebtedness is an open sore.

Compared to this, the German economy has quickly bounced back from recession in the wake of the financial crisis. German employment is at a record high and German government finances are the most solid among industrial countries.

Different symptoms, same root cause

Yet, the two countries share a common problem: a weak banking sector. And although symptoms are different, the source of the illness is the same in both countries: the single European currency.

The weakness of the Italian banking sector reflects the weakness of the economy and the habitual meddling of Italian politicians in the banking business.

The share of non-performing loans in total loans of Italian banks stands at a record 16%. The respective figure for Germany is only 2%.

Monte dei Paschi di Siena (in short: MPS), the world’s and Italy’s oldest bank, is also Italy’ most troubled financial institution. MPS has over years not only been emasculated by a weak national economy, but also by local politicians abusing it to fund politically opportune projects.

That is telltale evidence that neither Italy’s politicians nor the Italian economy per se have managed to adjust to Italy’s membership in EMU.

Italy just can’t live in a hard currency regime

Before that, regular devaluations of the Italian lira created breathing room for an economy hobbled by an anachronistic structure and continuous intrusions into the economy by inept politicians.

Thus, the value of the lira, expressed in D-Mark, fell by 73% between 1975, when exchange rates began to float freely, and 1998, the last year before the lira was merged into the euro.

Since the beginning of EMU, nominal devaluations of the currency are no longer available to compensate for rigid economic structures and bad policies.

The practical result of this relief valve for the economy being shut henceforth is that the Italian economy has ceased to grow.

MPS with tax payer money?

Earlier this year, Prime Minister Matteo Renzi wanted to stabilize Monte dei Pasci by a tax payer funded capital injection. The German government was the loudest to protest.

What would be the message, the Germans asked, if — less than a year after the introduction of a euro area wide bank restructuring and resolution regime that intends to charge bank owners and creditors instead of tax payers for stabilizing distressed banks — the Italian government would rush to bail-out

The new agreement on bank restructuring and resolution would be in shambles and with it the so-called Banking Union that was supposed to put the euro on a firmer footing, the Germans argued.

The Italian government grudgingly retreated and mandated a consortium of international investment banks to draw up a plan for the private recapitalization of MPS.

Conveniently, the plan will not be ready before the end of the year, safely after a popular referendum on constitutional reform in early December, to which Prime Minister Renzi has tied his political future.

Since few people believe that shareholders can be found to invest money in a bank with the habit of destroying shareholder value, all that has really happened is that the day of reckoning has been postponed to a politically much more convenient date.

A bail-in of bank shareholders and creditors after the failure to raise new private capital for MPS before the crucial referendum would have been the death knell to Matteo Renzi’s political ambitions.

German warning backfires

So much for German principledness. If only, in early October 2016, Deutsche Bank, Germany’s biggest private bank and a symbol of German economic prowess in the past, had not been rocked by a leak to the press of the intention of the U.S. Department of Justice to fine the bank with $14 billion for mis-selling American Collateralized Mortgage Obligations to U.S. customers.

Given that the market capitalization of Deutsche Bank is only some $18 billion, market participants feared that the fine would wipe out Deutsche Bank. The bank is among the 30 global “SIFIs” (=Systemically Important Financial Institutions).

To make matters worse, it was only recently dubbed the world’s most dangerous bank by the International Monetary Fund, largely because of its huge holdings of derivatives.

Understandably enough, the Italian government did not lose time to crow that it was actually German — and not Italian banks — which posed a risk to the euro and the global financial system.

German banks’ problems? Also due to the euro

The difficulties of Deutsche Bank and other German banks are the other side of the coin of the malfunctioning of European Monetary Union. Just as Italy could no longer devalue its currency after joining EMU, Germany could no longer let its currency appreciate.

For Italy, that has meant that it struggled with an overvalued currency — which impeded GDP growth and weakened banks’ balance sheets.

For Germany, that has meant that it has had to operate with an undervalued currency – which, in turn, has created huge external surpluses. This effectively forced German banks to finance the surplus by moving German savings abroad, both within and outside the euro area.

German savings fund and U.S. mortgages

In the course of exporting capital, German banks acquired for their customers (and themselves) large amounts of U.S. mortgage obligations. When these obligations began to turn sour in 2007-08, several
German public and private banks had to be rescued by the German tax payer.

During the 2000s, Deutsche Bank became a significant player in the U.S. mortgage market. In 2007, a matter of truly terrible timing, it acquired MortgageIT, a U.S. mortgage bank with licenses in all 50 U.S. states.

At the time of the global financial crisis, Deutsche Bank did not need a bail-out by the German government (though it profited from U.S. government support for the U.S. insurance company AIG, where it had insured some of its mortgage obligations).

However, its operations in the United States — the MortgageIT acquisition and the related activities– have haunted it ever since.

So far, Deutsche Bank has paid some 13 billion euros in fines and legal expenses mostly for its investment banking activities, with the bulk of this money going to U.S. authorities.

German savings fund and other euro area countries’ deficits

German banks also did their “intermediation” business by exporting the surplus in Germany’s national savings, largely stemming from the huge export surplus, to other euro area countries.

In the process, they acquired euro area government bonds for their customers (and themselves), and they lent to other euro area banks.

The problems with that “strategy” emerged as soon as the financial crisis arrived in the euro area, when the German and other solvent governments had to support over-indebted euro area governments and banks.

The European Central Bank also came to the rescue — by buying euro area government bonds in large amounts and supporting ailing national banking systems through the generous provision of liquidity.

In the course of this operation the German Bundesbank at the peak held some 750 billion euros in claims on the Eurosystem under the Target 2 interbank payment system. Today, these claims still stand at EUR 660 billion and are rising again.

The Bundesbank’s lending reflects the borrowing of euro area central banks in weak countries in support of their countries’ ailing banks.

The hope was – and is—that this lending prevents their collapse. Much more realistically, all it might achieve is the postponement of that collapse of EMU, which seems inevitable.

ECB policy weakens German banks

All that action undertaken by the ECB to preserve the euro has also created yet another problem for German banks.

They suffer at present from extremely low credit rates as the ECB’s rescue operation of the euro has driven the average yield of German government bonds into negative territory.

Since they feel unable to introduce negative deposit rates, their net interest income will soon be insufficient to cover their costs.

Italy and Germany: Connected at the hip

The difficulties of both the Italian and the German banking sectors may look different (and are due to some different specifics). However, they have been created by the same factor: the one-size-fits-all monetary policy and exchange rate in EMU.

Although the economic costs of the euro keep growing, politicians are doing everything to preserve it. Eventually, however, political will – no matter how determined – will have to succumb to the prevailing economic conditions.

After all, the basic imbalance will last forever – unless the Eurozone unwinds itself, at least into more manageable entities.


Italy and Germany seem worlds apart. Yet, they share a common problem: a weak banking sector.

There is a shocking nexus between eurozone imbalances and U.S. mortgages.

The difficulties of both the Italian and the German banking sectors have been created by the same one-size-fits-all monetary policy.