[monte paschi]REUTERS/Stefano Rellandini As a new year begins, we look at a key forecast that will bridge 2016 and 2017: the Italian banking crisis. In Geopolitical Futures’ 2016 forecast, we said that the focal point of Europe’s financial crisis would shift from Greece to the Italian banking system. For 2017, we forecast that the evolution of this crisis will eventually force a confrontation between Italy, Germany, and the European Union. Here, we establish a starting point for the looming Italian banking crisis in 2017, which will unfold over many months and have a range of consequences. THE KEY BANK TO WATCH Italy’s banking crisis currently pivots around the fate of Banca Monte dei Paschi di Siena (MPS). The bank spent 2016 trying to shed 28 billion euros ($29.6 billion) in non-performing loans (NPLs), which account for 36 percent of the bank’s loan portfolio. That is the highest proportion of NPLs of any Italian bank. As a result, investors and depositors began taking out their money. This added to the bank’s financial crisis by creating a liquidity problem. In December, MPS said that its remaining 11 billion euros in liquidity would only last until April. The bank’s efforts to privately solve its financial woes failed, leaving the Italian government as the bank’s last recourse. MPS spent the fourth quarter of 2016 seeking 5 billion euros of capital and a fund to underwrite it. The bank failed to meet its December 22 deadline, after the deal’s largest backer pulled out at the last minute. With the private sector and outside financial institutions reluctant to help, MPS asked the Italian government for aid. On December 23, the Italian Cabinet said that the bank would be rescued with a 20 billion euro fund approved by Parliament. The next obvious question is will 20 billion euros be enough to save MPS? While the sum would meet MPS’ immediate needs, estimated at about 8.8 billion euros, many independent researchers believe it will not save the bank in the long run. Goldman Sachs estimates that successful recapitalization would require 38 billion euros. A senior market analyst at London Capital Group suggests the number might be closer to 52 billion euros. THE BROADER CONSEQUENCES As a member of the eurozone, Italy’s banking crisis is not just an Italian problem. Uncertainty in the Italian market could lead risk-averse investors to stay away from Italian assets and thus the euro, impacting its value. Also, should MPS or other large Italian financial institutions fail, Italy would sink into an economic crisis that would have severe effects on other EU members and the value of the euro. Italy, in theory, also needs to comply with EU regulations. The divergence between Italy’s needs and the EU’s needs has made finding a solution acceptable to both parties very difficult. Italy wants to protect taxpayers while the EU wants depositors, not the European Central Bank (ECB), to assume the burden of debt. The solution thus far has been to promote a plan in which Italy appears to be following EU regulations, but which provides enough wiggle room to protect the bank’s domestic investors. Article 32 of the EU’s Banking Recovery and Resolution Directive, which took effect at the beginning of 2016, states that banks must go through a “precautionary recapitalization,” also known as a bail-in, before they can get state funds. This is meant to protect taxpayers from bearing the entire burden of a bailout. [Pier Carlo Padoan Italy]REUTERS/Stefano RellandiniIn MPS’ case, this would mean that bondholders must take an 8 percent loss in assets before the government can inject capital into the bank. However, the ECB is negotiating a plan with the Italian government in which the bank could protect these retail investors by swapping their riskier junior bonds for more stable senior ones. Germany, as de facto leader of the EU, is the main force behind the ECB’s opposition to bailouts. Germany has elections in 2017 and is also facing a looming crisis due to falling export demand. Politically and economically, it cannot keep propping up the eurozone. The EU must walk a fine line of being flexible enough to avoid financial collapse, but stringent enough to preserve the union’s institutional integrity—at least what remains of it. But Italy’s December 4 constitutional referendum gave the Italian government more leverage. Italian voters rejected former Prime Minister Matteo Renzi and his negotiator approach with the EU. This reflects the public’s growing desire for Italy to do what is best for Italy, even at the expense of the EU. DOMESTIC POLITICAL IMPLICATIONS These economic problems naturally affect the lives of average Italians. Problems like inflation, stagnating growth, and unemployment affect their pocketbooks. A 4 billion euro bail-in for four smaller Italian banks in 2015 led to protests, after 130,000 bank shareholders and bondholders lost their investments. Renzi was fiercely criticized, and residual anger drove many voters into the arms of anti-establishment parties. Paolo Gentiloni, Italy’s new prime minister, has asked the EU to let Italy protect retail investors to avoid a repeat of Renzi’s experience. An estimated 40,000 households in Italy hold 2 billion euros of MPS’ subordinated bonds. The loss of life savings for 40,000 families in Italy could spark unrest and lead to a flare-up in anti-EU sentiment. All parties understand that if the EU does not allow the Italian government to protect its retail investors, nationalist parties like the Five Star Movement and the Northern League will become more popular. Both parties have promised a Brexit-style referendum if they come to power in Italy’s 2018 elections. It would also cause public pressure that the future prime minister, to be selected early this year, could not ignore. This would not only jeopardize the frail political and economic landscape in Italy, but also the entire eurozone. While MPS is just one bank, the ripple effects of its failure would be numerous and deep. This would severely escalate the crises already underway. The bank’s salvation would allow Italy and the EU to fight another day, but it’s a far cry from solving the underlying structural causes of Italy’s problem. 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