08 January 2019

Banca Carige: an inauspicious start to 2019?

On the first working day of the New Year, the ECB announced that it has appointed temporary administrators to the troubled Banca Carige – Italy’s tenth largest bank – to safeguard the bank’s financial stability. This was the first time the ECB used these powers so is Carige a foretaste of a new dimension of the slow-burning EU banking crisis? Is this the first bank where, paradoxically, the final nail in the coffin may be IFRS 9 – the accounting standard designed to be the solution to lax accounting before the Great Financial Crash (GFC)? Is the cure worse than the disease? Or is Carige’s new round of problems just an uncomfortable part of the transition to the new world where no bank is too-big-to-fail?

Carige’s lack of profitability puts it at the extreme end of the spectrum in the EU. However, the EBA Transparency Exercise continues to report for the whole banking EU system that “Profitability remains low on average and has not yet reached sustainable levels.”  Shareholders may look nervously at the way that Carige is treated and wonder whether they should throw good money after bad at other banks. According to Reuters, the 27.6% owners – the Malacalz family - has invested more than €400 million since 2015. That is now worth little and the family has baulked for the moment at contributing to a further €400 million – the specific trigger for the ECB’s decision.

Carige is well known to have long-standing problems principally stemming from massive loan losses. The magnitude of the problems is set out in gory detail in the EBA’s 2018 EU-wide Transparency Exercise[1]. Key highlights, as at mid-2018, include (versus the 130-bank average): fully-loaded CET1 ratio 10.04% (14.27%); NPL ratio 22.75% (3.58%); NPL coverage ratio 50.01% (45.97%); net interest income v total operating expenses 38.12% (56.84%); and cost/income ratio 96.42% (63.75%)

Putting the NPLs in perspective, the EBA data shows the bank’s Tier 1 capital at €1,780 million versus loan exposures in default (after provisions) of €2,794 million. Its total operating income barely covers its administrative expenses so a gradual write-off of the bad loans from profits does not seem plausible. 

So the key question is how much, and how quickly, will the NPLs have to be written off. IFRS9 arrived just a year ago – forcing expected (instead of incurred) credit losses to be recognised. It may be a game-changer for weak banks like Carige – and Carige is ranked number 8 in the EBA listing of NPLs.

As IASB Chair Hans Hoogervoorst remarked recently “there is no denying that the quick loss crystallisation in an expected loss model will lead to a faster hit of bank capital, so it is essential that banks are adequately capitalised when the next crisis hits.” This is precisely why the ECB has spent 2018 pushing banks such as Carige to make additional loan write-offs – said to be €219 in the first nine months of the year (pushing the bank into a €189 million loss). EBA data showed only a €40 million write-off in the first six months.

The post–GFC regulatory framework may yet produce further paradoxes.  In aggregate, the effects of IFRS 9 should be quite modest – as reported in the EBA’s 2018 stress test. The negative impact would be a 20 b.p cut from the average CET1 ratio of 14.4%. However for banks with major NPLs, the picture may be rather different. As at mid-year, Carige reported an “IFRS transitional adjustment” of €333 million – equivalent to nearly 20% of its Tier 1 capital. 

How is such a significant item calculated? According to a recent ICAEW report[2], it will rely on models rather similar to those “now being progressively limited by Basel” but this time in the P&L account rather than capital. Such uncertainty may not matter much to the “average” bank but it may be critical to a bank with a mountain of NPLs. 

The Carige example may turn out to be the beginning of a new trend for poorly capitalised banks with weak profitability and large NPLs. Shareholders may be quite nervous about supplying fresh equity when future prospects may hinge on regulatory forbearance about uncertain calculations of IFRS9 expected losses. The post-GFC framework to prevent banks being “too big to fail” may yet be to be a very painful cure for the disease, especially for depositors of banks with only modest bail-in-able bond finance.

© Graham Bishop