Italy's Coming Banking Crisis: The rest of Europe is losing patience.

• Author: Codogno, Lorenzo

There are lessons that the European Union has learned about banking crises, but it is still not clear how it can avoid the next one in Italy. Economic and political developments in the European Union and the still-unfinished banking union make any effort all the more complicated, and leave open the issue of how Italian banks can adequately be backstopped.

The end of quantitative easing by the European Central Bank, the spread of populism and Euroskepticism, the fresh fall into recession in the second half of 2018, the deterioration in debt dynamics, and the related renewed pressure on government bond yields may mark the start of a new wave of banking problems. Italy's banking sector may be hit before it adequately addresses remaining vulnerabilities and leftovers of the previous crisis.

What has been the policy and banking response since the previous crisis?

In 2011, Italy experienced a quasi-credit crunch. The debt crisis touched Italy's specific weaknesses, with poor economic performance in the years preceding the crisis and a very high debt-to-GDP ratio. Banking problems were the direct consequence of the government debt crisis and the downturn in the economy. Italian banks suffered from a de facto closure of the eurozone interbank market and the related difficulties in funding their financing gap. The perceived higher lending risk translated into higher spreads versus money market rates and prompted banks to ask for increased guarantees and collaterals to clients. The reduced supply of credit and the higher perceived risk increased the cost for borrowers, especially for small- and medium-sized enterprises. The negative loop, in turn, affected the quality of the credit portfolio of banks. Italy quickly became the focus of financial markets' attention and a threat to the stability of the whole eurozone, given the size of its economy and public debt.

Addressing banking problems in earnest was a plus for the EU countries that did it. Government intervention to support the banking sector in the initial stage of the crisis was indeed massive across Europe, and it appears it reduced the negative economic impact of the crisis and allowed a quicker recovery in credit.

Italy missed that opportunity. Policymakers and banks did not recognize promptly enough the fast deterioration in non-performing loans, and their effect on lending and the broader economy. Moreover, the high debt-to-GDP ratio constrained any possible government intervention. As a...