(Adds source on JP Morgan’s involvement)
By Paola Arosio and John O’Donnell
MILAN, July 21 (Reuters) - The European Central Bank examined on Thursday a plan by Monte dei Paschi to sell bad loans, three sources close to the matter said, as Italy’s third-largest bank works to comply with a regulatory demand to strengthen its balance sheet.
ECB supervisors have told the Tuscan bank to cut its net non-performing loans by 9.6 billion euros ($10.6 billion) over the next two and a half years, a much faster pace of reduction than envisaged in the bank’s current strategic plan.
Monte dei Paschi is rushing to approve the new measures by July 29, when results of European stress tests will be unveiled in which the bank is expected to fare poorly.
A source familiar with the matter said the plan submitted to the ECB envisaged quickly selling the entire portfolio of loans to borrowers deemed insolvent — currently valued in the bank’s books at 37 percent of their face value, or 10 billion euros.
The source said they could be sold at between 33 and 27 percent of their nominal value — translating into a loss of between 1 billion and 2.7 billion euros.
The ECB and Monte dei Paschi declined to comment.
To fill the capital shortfall, a cash call will be launched that could be underwritten either by a consortium of banks that is still in the making or by the Italian state if this was allowed by European authorities, the source said.
Italy is in talks with Brussels over ways to support its lenders without breaching EU rules that aim to limit state aid to banks. The rules would require inflicting losses on investors in the banks as a precondition of any state support.
Monte dei Paschi, whose balance sheet has been wrecked by a costly acquisition and risky derivatives deals, has long been seen as the weak link in Italy’s troubled banking system.
A harsh recession has saddled Italian banks with 360 billion euros in non-performing loans, compounding the challenge posed by negative interest rates that erode margins.
In an effort to help its banks, Italy has sponsored the creation of a privately financed rescue fund, Atlante, and set up a state guarantee scheme for banks looking to sell bad loans repackaged as bonds.
Atlante is in talks with Monte dei Paschi to buy its bad debts, sources have said.
Monte dei Paschi plans to sell its bad loans to a vehicle that would fund the purchase with debt, sources said. Atlante would buy the riskier notes issued by the vehicle while a state guarantee would be applied to the remaining notes, making them no riskier than a government bond and drastically widening the range of potential buyers.
A fourth source familiar with the matter said JP Morgan was arranging a bridge loan to fund the vehicle’s purchase of the bad loans for the part not covered by Atlante. This is necessary because the state guarantee scheme requires months to be set up.
JP Morgan declined to comment.
Atlante has been left with just 1.75 billion euros, less than half its initial endowment, as it was forced to rescue two regional banks in recent weeks. Rome’s efforts to find new contributors to the fund have failed so far. ($1 = 0.9082 euros) (Additional reporting by Pamela Barbaglia and Stefano Bernabei; Editing by Mark Bendeich and Alexandra Hudson)