Avoiding Europe's Next Banking Crisis

(Bloomberg View) -- Italy's slow-motion banking crisis is getting worse, and if it isn't stopped, it could cause system-wide damage across the euro area and beyond. To contain this danger, the European Union must be willing to bend some rules.

Shares in Italy's third-largest lender, Banca Monte dei Paschi di Siena, are down about 75 percent this year and trading at one-tenth of book value. A ban on short-selling the bank's stock was imposed on Wednesday. Monte dei Paschi is only one of a group of Italian banks beset with 360 billion euros ($398 billion) of nonperforming loans; that's some 20 percent of Italy's gross domestic product.

Banking crises in Spain and Ireland were rooted in real-estate bubbles, but Italy's stems from a culture of cronyism, poor governance and shoddy lending. The banks' sickness has hurt the broader economy, too: As borrowers defaulted, banks withheld credit, dragging down growth.

Reforming Italy's banking culture is the job of years, but short-term action is needed right now to halt the panic. The simplest approach would be to sequester impaired loans in a state-supported “bad bank” -- along the lines of the ones used by Spain and Ireland. A stabilized banking industry could then resume its vital economic function of supporting investment.

After Greece's financial debacle, though, the European Union adopted rules requiring a failing bank's shareholders and creditors to shoulder much of the cost of any rescue -- to be “bailed in,” as it's called. That's a good idea in principle. In Italy, it's close to impossible politically, because a third of bank bonds are held by households.

The result has been a characteristic EU muddle of half-baked answers and hoping for the best. A scheme to attract private capital and securitize bad loans has been tried but hasn't worked. Confidence kept on deteriorating.

Italian Prime Minister Matteo Renzi is doubtless looking to save his political skin, but he's right that Italy needs more freedom of action than EU rules allow. Renzi has staked his job on an October referendum on constitutional reform, one that polls show he could lose. If that happens, the euroskeptic, populist Five Star Movement might take the country in a new direction not to Europe's liking -- least of all now, coming on the heels of Brexit.

A cleansing of the banks that spreads the cost more widely would lessen that danger. Europe should let this go forward, seeing it as a wise investment. At the same time, it should insist that rescue and recapitalization are only a first step. Once the system is stabilized, Italy must undertake a comprehensive bank restructuring, requiring consolidation of branch networks and job losses.

Italy's economy is strong enough to withstand its banking crisis if the issue is properly managed. That's a big if. Renzi has given more reason than many of his recent predecessors to hope that the country can rise to such a test, but he'll need Europe's help to prove it.

--Editors: Therese Raphael, Clive Crook

To contact the senior editor responsible for Bloomberg View's editorials: David Shipley at davidshipley@bloomberg.net.

For more columns from Bloomberg View, visit http://www.bloomberg.com/view.