Woes at Italy's Biggest Bank Reverberate in Europe

UniCredit, Italy's largest lender by assets, emerged as one of the weakest big banks in Europe in July's stress tests, showcasing the failure of its attempts to respond to rock-bottom interest rates and a huge pile of bad loans.

Now, as Jean-Pierre Mustier, the bank's new chief executive, readies a big-bang plan to revive UniCredit's fortunes, he faces a series of unpalatable choices: Aggressive action to cut the bank's €80 billion ($89.9 billion) in bad loans--the largest of any European bank--would force the Milanese bank to raise billions in fresh capital, while an asset sale could help bolster its capital position but would hurt already thin profit.

Meanwhile, the travails of Italy's No. 3 lender, Banca Monte dei Paschi di Siena SpA, promise to only complicate Mr. Mustier's job. On Thursday, Monte dei Paschi said its CEO, Fabrizio Viola, had agreed with the bank's board to resign, in a surprise move that came as that bank works on a plan to shed €28 billion in bad loans.

Troubles at UniCredit, which has a vast business in Germany and Eastern Europe, could threaten not only Italy's ailing economy but also the continent's already fragile financial stability.

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Like most of its Italian peers, UniCredit has sustained a double whammy of ultralow interest rates--Italian mortgage rates are as low as 1%--and a decade of economic doldrums in Italy, which have helped drive up bad loans and batter profits... a plan to reach net profit of €5.3 billion in 2018 appears wildly optimistic, with net profit last year at just €1.7 billion. At the same time, the bank has had to write down €24 billion in bad loans in three years.

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Monte dei Paschi presented a plan in July to sell €28 billion of bad loans at 27% of face value. That has effectively set a new benchmark for the pricing of Italian bad loans. Since UniCredit attributes a higher value to its bad loans, a sale of €20 billion of loans would force it to take €2 billion in write-downs--thus increasing the size of a capital increase.

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Any capital increase could also collide with Monte dei Paschi's plans for a €5 billion share sale this winter, amid a market with little appetite for Italian banking shares. Indeed, Monte dei Paschi is considering asking investors to convert riskier bonds into shares to reduce its capital increase.