The banking lobby and the ECB will have a cow.

By Don Quijones, Spain, UK, & Mexico, editor at WOLF STREET .

On Friday, Italy’s coalition government unveiled new banking regulations that it hopes to pass in the coming months, including a rule that would separate banks’ commercial and investment arms. It would be the Italian equivalent of the Glass-Steagall Act, the 1933 U.S. law that separated commercial banks that took deposits, made loans, and processed transaction, from riskier investment banking activities. The law was designed to protect deposits. Its repeal in 1999 led to the consolidation of the U.S. banking sector, unfettered risk-taking by deposit-taking banks, and arguably the Financial Crisis just eight years later.

In Italy investment and commercial banks have been able to operate in unison since 1993, but that could all change if this new law is passed. Breaking up the banks would remove a lot of the risk, such as derivatives and other speculative instruments, from Italy’s deposit-taking banks. Without these hedge-fund and investment-banking activities, large banks such as Unicredit and Intesa Saopaolo would become smaller, less interconnected and less systemically risky.

In an economy as large, chronically weak and systemically risky as Italy’s, that would be no bad thing. The country has already experienced a string of bank collapses in the last couple of years.

Less than a month ago, Italy’s populist government, in its eighth month in power, held its nose, ate its words, and agreed to bail out mid-sized Banca Carige with public funds, adopting virtually the exact same playbook it had criticized its predecessor for using in the previous three bank resolutions.

If the government needs to pour capital into Carige it will take full control of the lender, Deputy Prime Minister Di Maio told parliament’s lower house on Friday. Di Maio, who is also industry and labor minister, said that after its precautionary capitalization, Carige, with the State’s help, “will become a bank for citizens”. In other words, it will be a full-blown bank nationalization, which both the European Commission and the ECB are likely to oppose.

The Italian government is already the majority owner of the perennially troubled Tuscan bank Monte dei Paschi di Siena (MPS) following the Gentiloni administration’s controversial bailout of the lender in 2017. Despite having billions of euros of public funds poured onto its balance sheet, and many of its worst assets taken off its books, the 547-year-old bank is still not nearly out of the woods.

A couple of weeks ago, its shares, which have lost almost three-quarters of their value since being relaunched in October 2017, were halted after plunging on news that the ECB had cautioned the lender about potential funding and profitability risks it faced as well as its weakened capital position. The central bank also told MPS to boost provisions against bad loans in the coming years. Even following a record €24 billion sale of bad loans, MPS’ soured loans are still equivalent to almost a fifth of its total lending.

Italy’s banking sector as a whole holds the largest stock of non-performing loans (NPLs) in the EU. The total gross stock of NPLs decreased by approximately €50 billion during the first six months of €238 billion thanks to a combination of direct sales and securitizations backed by the GACS (Garanzia Cartolarizzazione Sofferenze) Government Guarantee Scheme, according to the credit ratings agency DRBS. Italy’s gross NPL ratio is now down to 12.5% from a mind-boggling peak of 18.2% in 2015. But it’s still three times the EU average, which itself is verging on the high side.

Italy’s NPL problem could be exacerbated by the economy’s recent slowdown. Economic output as measured by GDP shrank by 0.2% in the fourth quarter, following a 0.1% drop in the third quarter, statistics agency Istat reported on Thursday, putting Italy once again in a “technical recession.” The declines are small for now, but if they pick up momentum, triggering a fresh cascade of bankruptcies, job losses, and mortgage defaults, the banks’ NPL problems would swell with renewed vigor.

This is all happening at a time that monetary conditions in the Eurozone are beginning to tighten. While the ECB’s Main Refinancing Operations Announcement Rate remains anchored at 0%, the central bank has finally ended its four-year QE program, one of the largest expansionary monetary experiments of recorded history. Since QE funds were instrumental in keeping a lid on Italian sovereign bond yields, this is bad news for both the Italian government and the Italian banks that are among the biggest holders of Italian government debt.

The ECB’s multiyear virtually-free-loans-for-banks (LTRO or TLTRO) program has also, for now, apparently run its course. ECB Chairman Mario Draghi recently said there are no plans to launch a new round of LTRO loans unless there were guarantees that such funds would translate into lower lending rates for bank customers. This is bad news for Italian banks since they were the biggest recipients of the funds, accounting for one-third of the total money issued.

It is against this backdrop that Italy’s populist government now seeks to launch its own version of the Glass Steagall act. But getting it passed and implemented is likely to be a gargantuan feat given the already parlous state of Italy’s rickety banking system — and it’s going to do nothing to alleviate the NPL problem.

The bill will face stiff opposition from the domestic banking sector as well as the European Commission, which in 2017, under pressure from Europe’s banking lobbies,abandoned its own pledge to break-up too-big-to-fail lenders.

Since the global financial crisis, big banks on both sides of the Atlantic have been fighting tooth and nail all regulatory attempts to split their deposit-taking commercial units from their riskier investment banking units. Such legislation would would make each entity smaller. And that is not in the interests of the big banks, nor the ECB, which hopes to breathe life into a new generation of trans-European super-banks by serving as matchmaker to Europe’s largest domestic lenders. By Don Quijones.

Desperate measures for desperate times? Read… Lloyds Bank Resurrects 0%-Down Adjustable-Rate Mortgages for First-Time Buyers to Prop Up UK’s Housing Market

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