Italy reached a deal with the European Commission late on Tuesday for a mechanism to manage over 200 billion euros in bad loans that are weighing on the balance sheets of Italian banks.
The non-performing loans, which built up during the country's recession between 2012 and 2014, are a burden for Italian banks and the economy as they limit banks' ability to provide new credit that could help boost a recovery.
Here's how the loan management scheme agreed by Italy and the EU works: Everything revolves around a system of securitisation, which involves taking an illiquid asset such as a mortgage and transforming it into a security that can be negotiated on the market. Banks give the non-performing loans, currently on their balance sheets, to a separate financial vehicle which is off their books. This vehicle will sell debt backed by the loans as underlying assets. The bonds it issues will be bought on the market and likely also from the European Central Bank through its asset purchase programme.
However, a large part of the loans were given to debtors who have become insolvent so they are not fully recoverable. The Italian Economy Ministry will therefore facilitate the mechanism by providing guarantees to help narrow the difference between prices offered by buyers and sellers.
Here is where the problems lie. The deal struck with Brussels says the Italian state should only guarantee senior tranches of the securitisation, that is the safest ones. It will also only offer the guarantee if the bonds have received an investment grade rating. Some banks will find themselves with very few senior tranches and so will only be able to offload some non-performing loans. They will therefore likely have to proceed to further capital increases that Barclays estimates will reach up to 28 billion euros.
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