In Italy, where two decades of economic stagnation have created a long line of barely breathing companies, Feltrinelli, one of the country's largest booksellers, stands out. Since 2012, the company has chalked up three consecutive years of losses totalling nearly €11 million. Even so, late last year, Feltrinelli was able to secure a fresh €50 million line of credit from a syndicate that included two of Italy's largest banks, UniCredit and Intesa Sanpaolo, at an interest rate below what top-rated companies in Europe were paying.

As Italy and Europe more broadly struggle to come to grips with an escalating problem with bad loans, a new paper by economists connected to the Centre for Economic Policy Research, a European policy shop, highlights the extent to which Italy’s main banks – known to be the weakest in the euro zone in terms of cash reserves – have stepped up their lending to the country’s most troubled companies.

In recent weeks, Italian bank stocks, down 70 per cent for the year, have rallied, buoyed by recent stress-test results and, for some, earnings that were better than expected. But with the International Monetary Fund estimating the size of Italy's bad loan pile to be €360 billion – or about a third of the total amount in the euro zone – economists contend that any improvement in the debt situation will be short-lived.

Zombie lending

At the heart of the problem, the research paper concludes, is a nexus of inert banks lending to inert companies that has kept a lid on the recovery of Italy’s economy, the third largest among countries that use the euro. The bank-driven slowdown recalls the zombie lending cycle Japan entered in the 1990s, leading to its own lost economic decade.

Then, instead of biting the bullet and taking losses, large Japanese banks kept credit lines open to borrowers even when they had slight chance of making good on the loans. "Europe has not learned anything from Japan – it has just repeated the same mistakes," said Tim Eisert, a German economist at Erasmus University in the Netherlands who participated in the study.

"Mario Draghi may have saved the euro, but we still have undercapitalised banks in Europe."

In their report, the economists calculate that if European banks were subjected to a scrubbing similar to what US banks experienced, they would need to raise €125 billion in new capital. At a time when investors across Europe have become deeply sceptical of investing in banks, and governments are loath to offer bailouts, achieving such a number borders on the impossible.

Moreover, since the onset of the debt crisis, Europe's leaders have been slow to address their banking problems. In the regulators' latest stress test, despite poor performances from a number of banks, including AIB, only one European institution, Monte dei Paschi di Siena of Italy, came out as needing more capital.

Feltrinelli is just one example of a number of highly indebted Italian companies receiving loans at below-market interest rates over the last three years, a period when aggressive policies by the European Central Bank freed extra cash for European banks to dole out credit.

Benetton

Other companies cited in the paper include the clothing retailer Benetton, which has lost €240 million since 2012, yet also received a below-market-rate loan in that year, according to data collected by the economists.

Massimiliano Tarantino, a public relations executive at Feltrinelli, said the company had suffered during the recent crisis and was now shifting its strategy, making new investments in television, electronic publishing and book sales over the internet.

In their paper, the researchers found that of the €540 billion in syndicated European Union loans that they tracked, 8 per cent went to companies they classified as zombie institutions. In Italy, however, the proportion of new loans that have gone to struggling companies such as Feltrinelli over the past three years is 17 per cent.

According to a paper on troubled Italian loans put out by the IMF last month, three-quarters of the €360 billion bad-loan figure are owed by Italian companies – most of which are small or medium-sized.

While such an amount, about 18 per cent of total Italian loans outstanding, is certainly arresting, Italian government officials argue that sufficient steps have been taken to address the problem. They say banks have set aside cash to cover nearly half of the loans and that all of the exposures are backed by sufficient collateral.

They also point to the recent formation of a €4 billion fund that will buy some of the bad loans from the banks. Still, €4 billion does not rise to the level of a bazooka that would give the markets confidence. And as the IMF report lays out, Italian banks are among the least profitable in Europe, which gives them little incentive to write off their loans, especially when there are tax incentives for bankers to not take such a step.

Banks also have little incentive to pursue debtors in Italy’s courts. The IMF study says liquidations of troubled Italian companies last, on average, eight years, with preferred creditors likely to claw back just 29 per cent of their claim.

So, instead of taking a hit, many Italian banks have decided to keep the liquidity flowing in the hope that a company might turn its fortunes around. But with growth averaging about 0.3 per cent for the past two decades and now threatening to dip back into negative territory, a spate of corporate recoveries seems unlikely.

Global regulators

And the lesson for global regulators is a powerful one, the economists involved in the study argue. Before using unconventional measures to inject cash into lending markets, central bankers must ensure that their large banks are sufficiently capitalised – as was the case in the US, when one of the first steps regulators took was to force banks to increase their capital cushions. Without this extra layer of security, banks have little incentive to write down bad loans and focus on healthier companies.

“These zombie loans are just bad for the economy,” said Viral V Acharya, one of the report’s authors and a specialist in European debt at New York University’s Stern School of Business.

"The problem is that Europe never injected capital into its banks like . . . in the US." – (New York Times Service)