Mattia Corritore, BSc Financial Management, year 3
The fallout from the Great Recession left European banks severely exposed. Most have improved the fundamentals of their balance sheets, such as reducing their leverage or their amount of non-performing loans, but Italian banks are still, according to Steve Eisman, looking vulnerable to potential new shocks. I am going to use Bloomberg to construct one commonly used metric, the Texas Ratio, to evidence the criticality of the current situation. I am also going to investigate the underlying reasons why economic and financial stagnation in Italy is still enduring compared to elsewhere in Europe.
Southern European countries were particularly hard hit by the 2008 financial crisis. The precise way each country was affected depends on the structure of its banking sector. In the case of Italy, the crisis acted to expose the contradictions within the regulatory framework of the Italian banking system. This was reflected in the abnormal increase of non-performing loans on the banks’ balance sheets, increasing from 94 to 360 billion Euros in the space of 8 years.
Numerous Italian banks tailor their business plans according to regional logics, as their stated mission focuses on the support of local entrepreneurial projects through lending activities. On top of that, several banking institutions are owned by public foundations, whose board members are elected by local public authorities. The resulting conflicts of interest are, according to many exponents, a major cause for the structural problems of non-performing loans affecting Italian banks. It is undeniable, in fact, that the exertion of political influence pursued through unconventional methods such as the concession of easy credit, has been heavily burdensome for the sustainability of many Italian banks. As Professor Casella of Bocconi university argues, there is a clear correlation between the presence of board directors with political bonds and the amount of non-performing loans.
Famous is the case of Monte dei Paschi di Siena, the world oldest bank founded in 1472. Initially conceived to provide economic support to the lower classes of Siena, the narrative and mission of this Italian bank have shifted with the tightening of close ties between its board members and influential Italian entrepreneurs. From 2007, the bank has been involved in many political scandals and criticized for its inaccuracy in estimating the real value of each loan’s collateral. The list of the major insolvent debtors is somehow comic, such is the loan provided to Siena football club’s owner, whose degree of risk was incredibly distant to the type of lending activities a bank like Monte dei Paschi should pursue. Striking is also Monte dei Paschi’s incautious acquisition of Antonveneta bank in 2007 for 9 billion euros, which only 6 months earlier was acquired for 6 billion euros by Santander. Someone is perhaps wondering why the bank was paid an additional 3 billion, but the absurdity does not end here. The complete absence of due diligence among Monte dei Paschi’s board members also resulted in a miscalculation of the acquisition, not “noticing” the debt restructuring plan of 8 billion euros previously imposed by Santander. The disbursement of 17 billion euros for a bank barely worth 6 billion, represents the starting point of Monte dei Paschi’s decline.
Unfortunately, Monte dei Paschi di Siena is not an isolated case. The so called Banche Popolari, small local banks, reproduce similar dynamics resulting in major losses due to non-performing loans or reckless acquisitions. Such suboptimal allocation of credit is hence liable to offset the monetary stimulus in the form of “Quantitative Easing” promoted by the European Central Bank governor, Mario Draghi. Quantitative Easing is thought to benefit the real economy through the injection of liquidity into banks’ balance sheets, hoping these latter will lend this money to enterprises. Unfortunately, to date the cumbersome persistence of non-performing loans has not enabled them to benefit from this monetary policy, leaving Italian enterprises without their primary source of financing.
The impact of a vulnerable banking sector with excessive NPLs has been particularly harmful to the Italian economy because of the reliance on the large number of small and medium enterprises (SMEs) which are reliant on the banking sector for financing. The economic slowdown suffered from Italy in the past decade has been rendered harsher by a profound lack of alternative lending channels for the Italian SMEs. Only lately have innovative lending strategies, such as private debt funds, taken place in the Italian capital markets, but the path to counterbalance the destabilizing effects of NPLs still presents many challenges ahead.
Analysts are showing many signs of concern for Italian banks, warning investors of the relatively high probability of default due to non-performing loans. As recently highlighted by Steve Eisman, a commonly used metric to assess their stability and resilience in this regard is the Texas Ratio. To compute this metric, the total amount of non-performing loans, including owned real estate, are divided by the tangible common equity plus the reserves for loan losses. In a nutshell, the numerator deploys all the bad loans whereas the denominator provides an estimate of the capital available to banks to cover their potential losses from lending activities, or as Mr Eisman has famously described it, “all the bad stuff divided by the money you have to pay for all the bad stuff”.
When the Texas Ratio is above 100%, a bank is generally considered at serious risk, since the shortage of its available capital leaves it with little flexibility when facing the downward trend of an economic cycle. Below, I have computed the Texas Ratio of the biggest Italian banks in term of capitalization and I compared it with some important German, French and English banking institutions. The data provided are taken from the fiscal year 2010 and 2016 in order to demonstrate the persistent vulnerable state of Italian banks compared to European ones.
The table is a good indicator to grasp the state of the Italian banking system, especially when compared with other important European banking institutions. Most of the Italian banks have a Texas Ratio above 100% and are deemed extremely vulnerable to shocks, as the quantity of NPLs in their balance sheets exceeds the capital at their disposal. Intesa Sanpaolo and Unicredit, the two biggest banking groups in Italy, look healthier than their Italian peers, but two facts must be pointed out. Firstly, these two banks were created as a result of maxi fusions, and since then, their governance assumed a more institutional approach than the other Italian banks. Secondly, whether compared with Deutsche Bank, Commerzbank, BNP Paribas, Credite Agricole, Societe Generale or HSBC, their capital structure, analyzed through the lens of the Texas Ratio, still does not provide signals of strong stability. In fact, none of the European banks present a Texas Ratio above 50%, meaning that their lending practices are way more meticulous than those of healthy Italian banks.
The Texas Ratio is a meaningful metric to assess the exposure of a bank, but it must be kept in mind that banks can remain solvent even though their Texas Ratio is above 100%. The financial evaluation of banks is a thorough procedure and one single ratio cannot provide a comprehensive overview. For example, the table shows that Deutsche Bank Texas Ratio is only 13% but obviously such a ratio alone cannot encapsulate it as a good bank. Whilst this bank did not appear to have NPL issues, their efforts to render their assets profitable have failed in the past decade. Deutsche Bank’s return per dollar employed, also defined as Return On Asset (ROA), is currently negative, -0.09, while a positive ratio indicating the effectiveness of a business model should be around 1%. Furthermore, several of Deutsche Bank’s assets are derivative securities categorized as “Level 3 Asset”, whose fair value is not estimable using classic parameters due to their illiquid nature. This data does not necessarily imply a negative outlook for Deutsche Bank but it suggests the need of a more subtle analysis to understand the true quality of its assets. Investors should therefore interpret a range of different ratios to assess the fundamentals of a bank.
All being said, Italian banks have challenging times ahead. The persistence of non-performing loans has slowed down the engine of the Italian economy, the banking system, impeding SMEs from being able to borrow capital necessary to finance their entrepreneurial objectives. It is extremely urgent for banks to hasten restructuring plans which involve the sell-off of non-performing loans to private securitization vehicles. The sale of a large quantity of NPLs as packages could quickly improve Italian banks’ balance sheets. Until then, investors must hold on.
To obtain the Texas Ratio: Type and click on the name of the security you are interested in; On the main menu of the security, click on 7) Financial Analysis; on the horizontal bar, click on 7) ADDL; on the light gray horizontal bar select the option Banking; in Banking page, pay attention to the following estimates: Non-Performing Loans; Tangible Common Equity; Reserves for Loan Losses. Finally, compute the Texas Ratio: NPLs / (Tangible common equity + reserves for loan losses)*100
Return on assets: Financial Analysis – Addl – Banking – Return on Asset ]
Level 3 assets: Financial Analysis – Addl – Banking – Fair Value Analysis – Level 3 Assets/Total Assets]