Italian Banks Brace For Bailout

Luigi Motti -

Italian banks face increasing market turbulence amid investors’ concerns about their creditworthiness. S&P Global Ratings does not expect recent events to affect its ratings on Italian banks

Following a rocky start to the year, Italian banks are facing increasing market turbulence amid investors’ concerns about their creditworthiness. Bad loans in the country have grown significantly in past years, recently reaching about 20% of total outstanding loans in the system. Market participants are also worried about the outcome of the European stress test that will be disclosed at the end of July. More recently, the European Central Bank’s request for Banca Monte dei Paschi di Siena (MPS, not rated)–one of Italy’s largest banks–to reduce its holdings of nonperforming loans, has exacerbated this volatility.

S&P Global Ratings does not expect recent events to affect its ratings on Italian banks. This is because we already incorporate the risks we currently see, including those related to asset quality and capital, in our assessment of their business and financial profiles. We consider that Italian banks face higher risks than global peers, and therefore assess economic risk for Italy at ‘7’ (on a scale of 1 to 10, 1 being the lowest risk) in our Banking Industry Country Risk Assessment framework.

The Italian government has launched several initiatives in the past 18 months in a bid to resolve some of the financial system’s problems. Although in our view this is a move in the right direction, we don’t expect these initiatives to alleviate the issues in the short term. We understand that the government is negotiating with European authorities to set up a wider support package and, potentially, a bailout of troubled banks. We note that European state aid rules, which explicitly require private sector involvement to reduce or avoid the use of public funds, significantly constrain the government’s capacity to provide unconditional support to stressed banks. Nevertheless, we believe that rising Euroscepticism in several countries, and uncertainty regarding the economic and financial consequences of the “leave” result in the U.K.’s June referendum on EU membership, could provide the Italian government with some bargaining power in these ongoing discussions. We will continue to monitor this situation, as well as the potential additional support measures that the government is considering. If eventually launched, we believe that such measures could help alleviate some of the current stress that Italian banks are facing.

Three Key Weaknesses Constrain Banks’ Creditworthiness
S&P Global Ratings sees three main weaknesses for Italian banks. First, the accumulation of a large stock of nonperforming loans. Second, relatively high cost bases owing to structural rigidities. And third, a reduced ability to achieve economies of scale owing to the highly fragmented system.

A combination of structural and cyclical factors has been a significant constraint to Italian banks’ credit profiles over the past few years. In particular, the protracted recession in Italy triggered a significant deterioration of banks’ asset quality. As a result, banks have accumulated a large stock of nonperforming loans (NPLs) on their balance sheets, reaching about 20% of total loans. Most Italian banks have already booked large credit provisions in recent years–some of them up to levels that would be sufficient to cover potential losses that we estimate are embedded in their portfolios. Provisioning coverage, however, has generally declined in the system. For some banks, it is well below levels reported by the strongest domestic and international peers, and significantly lower than the current market value of these problematic assets. What’s more, over the same period, extraordinarily low interest rates have constrained banks’ loss-absorption capacity. In addition, low efficiency and difficulties in adjusting their cost bases—mainly due to the system’s high fragmentation–have also continued to hinder banks’ capacity to sustain operating profitability. Increasing credit losses have thus impaired the capital position of some of the weakest and more fragile entities, prompting requests by regulators for additional actions to enhance banks’ solvency. Moreover, the balance sheet clean-up from the sizable amount of impaired assets accumulated through the cycle is likely to take a long time, in our view.

The elements that we consider relevant that both constrain and boost banks’ credit profiles are reflected in our ratings on Italian banks. The wide distribution in the ratings on Italian banks–from ‘BBB-‘ to ‘B’–reflects the dispersion of performance and resilience within the system and, consequently, our varying assessments of entities’ creditworthiness.

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We maintain a positive trend for economic risk in Italy. We believe that the ongoing economic recovery supports a gradual strengthening of overall private sector creditworthiness, particularly that of domestic corporations. It also benefits Italian banks’ asset quality. In addition, the stock of nonperforming assets has stabilized in the first few months of 2016. However, these improvements are likely to remain fairly gradual; therefore, we expect the benefits to banks’ credit profiles will be slow to emerge.

If our view of expected economic growth were to falter, we would assess this in relation to our view of economic risk for the Italian banking system.

Tackling The Problem
Since last year, the Italian authorities have launched several initiatives to tackle the main weaknesses affecting domestic banks in a bid to restore their credit standing. These include: a government guarantee on securitizations of NPLs, the creation of the Atlante fund, changes to the bankruptcy and judiciary law, and the reform of the Popolari banks and Cooperative system.

Earlier in 2016, the Government reached an agreement with the European Commission on the “GACS” mechanism, which is intended to allow banks to securitize their NPLs, with the Italian government guaranteeing the senior-most tranches. However, in our view, the guarantee was limited in scope and, being based on “market terms”, was relatively expensive for the banks. For this reason, the government supported the creation of the Atlante fund, aimed at helping Italian banks in their ongoing efforts to enhance capital and clean up their credit portfolios. More specifically, this privately owned investment fund was set up as a backstop to the potential shortfall in the underwriting of banks’ right issues and to potentially acquire the most junior tranches of the securitizations of NPLs under GACS. We expect to see further write-downs and subsequent divestment of NPLs as a result of these two initiatives. The above instruments have no immediate or direct fiscal cost for the otherwise highly indebted Italian government.

The government has also changed the law on the foreclosure of collateral. The decree creates new mechanisms for the banks to realize pledged collateral much faster than in the past. For example, for mortgages, banks can now seize the real estate after 18 months instead of seven years. This should help speed up the NPL recovery process and enhance their value on the secondary market.

The Italian government also approved two different decrees. First, the reform of the “popolari” banks in 2015. And second, that of the cooperative banking (BCC) system in 2016. As a result of the first decree, popolari banks (mutuals) were required to transform into joint stock companies by the end of 2016. In addition, the second decree created a common structure for the BCC network that provides stronger support to its mutual bank members via a “joint and several guarantee” to share risks among member banks–in effect, creating an integrated banking group. The move aimed to improve corporate governance in the sector and foster greater and more rapid consolidation within Italy’s highly fragmented banking system. The consolidation would help correct overcapacity in the sector, generally enhance management practices, and generate larger entities with stronger franchises, while boosting banks’ pricing power and creating greater economies of scale. We believe that all these factors could help improve banks’ operating efficiency while economic growth remains low.

Unlike the broad support packages that were implemented in Ireland and Spain in previous years, we expect the initiatives outlined above to have a milder, more gradual impact on Italian banks and no simultaneous impact on the government’s balance sheet. We expect the combination of GACS and Atlante to accelerate the disposal of NPLs, but we believe that the size of the scheme remains limited. We therefore don’t believe that it would be sufficient to repair the problems of the entire system. For this reason, we believe that banks investing in the Atlante fund may be required to increase their participation in the future and, thus, their exposure toward weaker financial institutions. A progressive mutualization of problems within the financial system could impair the financial profiles of more creditworthy Italian banks. In addition, each measure that aims to accelerate NPL recovery clashes with the large backlog of cases currently pending in several Italian courts. The reform of the bankruptcy law is therefore likely to benefit the collateral foreclosure process of future defaulted loans rather than existing ones.

Government Support Is Now Less Predictable
Current regulatory constraints have prevented the Italian government from creating a wider support package, such as those in other European countries. This includes the creation of a proper “bad bank”, which has the capacity to acquire assets below market value. The Bank Recovery and Resolution Directive (BRRD) limits the government’s ability to provide state aid without the write-down of capital instruments. Political considerations compound this restriction. Furthermore, if a bank enters resolution, the BRRD would likely require loss absorption by the full 8% of liabilities, which could include obligations placed with retail customers at some banks.

That said, the BRRD includes some exceptions to the general rules that prevent state aid. Under certain conditions, this could be the case when “in order to remedy a serious disturbance in the economy of a Member State and preserve financial stability, the extraordinary public financial support takes any of the following forms: a State guarantee to back liquidity facilities provided by central banks; a State guarantee of newly issued liabilities; or an injection of own funds or purchase of capital instruments at prices and on terms that do not confer an advantage upon the institution.” In all these cases, however, the measures must be intended to benefit demonstrably solvent institutions, must be precautionary and temporary, proportionate to remedy the consequences of the serious disturbance, and not used to offset losses that the institution has incurred or is likely to incur in the near future. They also require European Commission approval.

Within the boundaries of this regulatory framework, the Italian authorities have already approved a guarantee scheme that backs up to €150 billion of Italian banks’ bond issues in case of a liquidity crisis in the market. We view this positively as we believe it could help cover banks’ funding needs in a potential liquidity crisis–a scenario that we don’t envisage at present–while also taking into account the ECB’s monetary policy and its enhanced targeted longer-term refinancing operations (TLTRO).

We will continue to monitor the evolution of the Italian economy, as well as the potential implementation of additional initiatives by Italian authorities. If the government were to launch a new, broader scheme to backstop banks’ capital position, we would assess its impact on banks that benefit from such support and, based on our existing criteria, we could incorporate notches for potential short-term extraordinary support in the ratings on those banks. However, even if combined with previously mentioned liquidity support, the implementation of such a package is unlikely to change our view that potential extraordinary government support in Italy–like in most of the rest of Europe–remains uncertain. This is based on our perception that support for senior unsecured creditors is less predictable under the new legislative framework. And the apparent difficulties that the Italian government is facing in obtaining approval on its proposals by the European authorities further support our view.

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Luigi Motti – Credit Analyst – S&P Global Ratings