A radical cure for Italy�s banking problems: A combination of good banks and soft bail-in

Italian banks are in a precarious situation, burdened by non-performing loans (NPLs) that are almost of the same magnitude as their capital and provisions. The gradual approach of dealing with NPLs via more provisioning and some sales has yielded little results. The political crisis now gives an opening to the authorities to take radical steps to put the Italian banking system on a sound footing. Policy Recommendations The balance sheets of Italian banks should be cleaned-up. The quickest way to achieve this would be to transfer non-performing exposures to an asset-management vehicle. The losses resulting from the transfer could be covered by capital, obtained via soft (conversion of debt instruments into equity) or hard bail-in (loss absorption). The hard bail-in of creditors would amount approximately to only �5 billion. The Italian government should clearly explain to its citizens the difference between �hard� and �soft� bail-in, in order to facilitate the acceptance of the inevitable. Only a hard bail-in leads to a total loss. In a soft bail-in, investors participate in the upside from a cleaned-up banking system. Government intervention is needed only to extent that one wants to protect some investors from losses for political reasons. The Italian banking sector does not have many foreign creditors. It is not necessary to enlist the involvement of the pan-euro-area institutions, such as the Single Resolution Fund and the European Stability Mechanism, which could in any event only cover part of the losses.