Bad debts may force Italy's banks to tap investors, state for capital
* Bank of Italy extends scrutiny before ECB takes on role
* Bad debts expected to climb for at least another year
* Banks' stocks of Italian sovereign debt highest on record
* Mid-sized lenders seen most in need of bolstering capital
By Silvia Aloisi
MILAN, Aug 8 (Reuters) - With bad debts set to climb for at least another year and the central bank intensifying its scrutiny of the sector, Italy's banks may be forced to tap investors or even the state for a capital fix.
Italian lenders have raised more than 26 billion euros ($35 billion) since the 2008 financial crisis, cut 20,000 jobs, sold assets and closed branches to strengthen their balance sheets.
But that is unlikely to be enough as an entrenched recession depresses profits and their large stock of Italian government bonds exposes them to the risk of a resurgent euro zone crisis.
Under pressure from the Bank of Italy, banks are cleaning up their balance sheets before a health check-up on asset quality by the European Central Bank (ECB) expected in early 2014, before it takes over supervision of euro zone lenders mid-year.
That may force them to turn to the market or the state for cash.
"If done properly, the asset quality review should result in loan losses spiking in the second half, dividend cuts and potential capital increases," analysts at Berenberg said in a note to clients.
Monte dei Paschi, the country's scandal-hit No. 3 lender, and a string of mid-sized banks look particularly vulnerable.
"Italian mid-tier lenders are among the weakest in Europe," Royal Bank of Scotland chief credit strategist Alberto Gallo said.
He estimates that Monte dei Paschi, which posted its fifth straight quarterly loss on Wednesday, may need up to 5 billion euros over the next three years, on top of a 4.1-billion-euro state bailout it received in February.
The bank will find it difficult to lure private investors for such a sizeable amount - more than twice its market capitalisation, potentially requiring more support from Italy's cash-strapped government, Gallo said.
Assuming a worst-case scenario of a 50 percent increase in non-performing loans in the next three years and a one percent widening in sovereign bond yields, Gallo sees another six Italian banks on top of Monte dei Paschi falling short of European capital requirements.
Among them is Genoa-based Carige, which like Monte dei Paschi is controlled by a charitable foundation with close ties to local politicians and is desperately trying to avoid a cash call to plug a capital shortfall of 800 million euros.
Other banks that may need more capital are Banca Popolare di Milano, Banca Popolare di Vicenza, Banco Popolare, UBI and Banca Marche.
Popolare Milano is expected to launch a 500 million euro cash call in the autumn, while Banca Marche has approved going to market for 300 million this year, with the possibility of raising another 100 million next year.
With Italy stuck in its longest recession since World War Two, souring loans on Italian banks' balance sheets have nearly tripled since 2007 to 249 billion euros in March, or about 14 percent of total loans, according to Bank of Italy data.
Bad loans are set to keep rising throughout 2014, with Italy expected to return to only modest economic growth next year, as they tend to lag economic activity by 12 to 18 months.
Banks have responded by scaling back lending, which in turn is delaying economic recovery. The latest data from the central bank shows loans to businesses fell four percent in June, the 14th consecutive monthly decline.
Instead, lenders have increased their stock of Italian sovereign debt by nearly 7 billion euros to 402 billion euros, the highest level since 1998, central bank data shows.
Banks load up on Italian bonds because yields are high and they can be used as collateral for ECB refinancing operations. They are also encouraged to do so by the Italian treasury, which sees them as longer-term investors than non-Italians.
But that risks futher tightening the "doom loop" between the Italian state and its banks.
"It's a pernicious circle in which persistent economic weakness, growing bankruptcies among small and mid-sized firms and cumbersome foreclosure laws that make it difficult for banks to write off their bad loans are all feeding on each other," said Nicholas Spiro of Spiro Sovereign Strategy, a consultancy firm focusing on sovereign credit risk.
Defending its own oversight of the industry, the Bank of Italy says it has strict criteria on non-performing loans, and that if it adopted the same definition used by leading European banks, excluding loans fully guaranteed by collateral, Italian lenders would look in much better shape.
Still, it is worried enough to have forced some 20 Italian lenders to increase their loan loss charges by some 3.4 billion euros in 2012, and last month it extended its inspection to the entire loan book of eight banks.
A source close to the matter said none of Italy's top five banks - Intesa Sanpaolo, UniCredit, Monte dei Paschi, Banco Popolare and UBI - were among those being more closely scrutinised, but the central bank will keep up "strong pressure" on the sector throughout 2013. ($1 = 0.7471 euros) (Editing by Louise Ireland)
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