The world’s oldest bank is collapsing and it could level the entire global financial system

Before Columbus set sail for America…

Before Italy became a country…

And way before the formation of the European Union…

There was Italy’s Banca Monte dei Paschi di Siena.

Founded in 1472, the majestic Italian bank stands as the world’s oldest.

It has survived genocides, world wars, and economic depressions…

Through fire, a great flooding, and World Wars I and II… La Rocca—or “the fortress,” as the Italians like to call it—has persevered.

That is, until now…

How Leverage Toppled a 500-Year-Old Institution

Today, Banca Monte dei Paschi is on life support. This past December, the Italian government was forced to bail out the bank for the fifth time.

You see, there’s one thing it couldn’t overcome: too much leverage.

Here’s what I mean…

Banks can lend out more money than they have in assets. The Basel Accords (a set of global banking regulations) recommends that banks be levered no more than 33-to-1. For instance, a bank with $1 billion in assets should lend no more than $33 billion.

Having additional leverage increases profitability when things go well… But it magnifies losses when things don’t go as planned.

If a bank is levered at the recommended 33:1 ratio, it would only take 3% of its loans to go bad before equity holders in the bank are completely wiped out.

Some Italian banks are seeing default rates of more than 10 times that.

Italy’s Banks Are Tanking

According to PricewaterhouseCoopers, 22% of Italian loans are classified as non-performing. Not all of them have defaulted yet, but the likelihood of them defaulting is high.

It’s even worse at Banca Monte dei Paschi. The bank’s non-performing loan rate is a staggering 35%.

To keep the bank afloat, Italian regulators threw it a lifeline…

In December, the Italian government agreed to give the bank a 5-billion-euro ($5.4 billion) taxpayer-funded bailout. But even that wasn’t enough to keep the bank solvent. Less than a week later, the bailout was raised to 8.8 billion euros ($9.6 billion).

Here’s the thing: Banca Monte dei Paschi isn’t alone. Other Italian banks will need bailouts as well.

In the chart below, you can see how poorly they’ve performed over the past 10 years.

Italian banks are down 81% from their peak in 2007. They would be down even more if the Italian government didn’t just bail out Banca Monte dei Paschi. Expect more bailouts to come.

A Global Contagion

The Italian banking system is on the verge of collapse. And if it does, the fallout could be widespread.

U.S. financial institutions have exposure to more than $2 trillion in European Union debt and credit default swaps (CDS).

CDSs are like insurance contracts that pay off when a company defaults on its bond payments. These are the same types of contracts that nearly collapsed the U.S. financial sector in 2008.

If these Italian banks default and can’t make good on their contracts, the contagion will spread across Europe. And from there, the contagion could sail across the Atlantic… where it could blow away 70% of the entire market cap of the S&P 500 financial sector.

As long as the Italian government continues to bail out its banks, most investors should be fine.

But the Italian economy is on the edge of a cliff. If the bailouts stop, that could be enough to send the global financial system tumbling down the hill.

We’ll continue to watch this story.

Regards,


Nick Rokke, CFA
Analyst, The Palm Beach Daily

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—Nick Rokke

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