14 February 2013

Bank of Italy/Visco: Effective reforms needed for balanced and rapid growth of the Italian economy

Visco said that Italy had not yet left behind the effects of the financial crisis and the double-dip recession that accompanied it. "The renewed decline in economic activity that began in mid-2011 has wiped out the partial recovery that took place after 2009."

In the past we have argued that our banking system has withstood the global financial crisis thanks to its fundamentally sound business model and limited exposure to structured financial products, within a regulatory and supervisory framework oriented to prudence. The exceptionally long and deep recession, however, has inevitably affected the quality of bank loans, while the deterioration in the creditworthiness of the sovereign issuer has increased the cost of funding and made it especially difficult for Italian banks to procure resources in the international market.

The grave developments of recent weeks at Monte dei Paschi di Siena (MPS) do not alter our assessment of the overall state of the Italian banking system. The MPS group’s problems originated in an ambitious acquisition carried out on the eve of the crisis, by procedures which are now being subjected to intense and obligatory scrutiny, as well as in poor management of financial risks, whose repercussions were aggravated by the sovereign debt  crisis.  Even counting the additional interventions already decided for MPS, the public support provided to banks in Italy remains very limited by comparison with other countries. Public recapitalisations in Italy have amounted to 0.3 per cent of GDP. According to the latest study of the European Commission, as of June 2012 such aid came to 1.8 per cent of GDP in Germany, 2.0 per cent in Spain, 4.3 per cent in Belgium, 5.2 per cent in the Netherlands, and  over 40 per cent in Ireland. For the Spanish banks, a programme of recapitalisation using European funds of up to €100 billion was authorised in July, of which €41 billion (3.9 per cent of GDP) has already been disbursed.

Unlike many of the foreign interventions, the support extended to MPS, like that given to other, smaller Italian banks in recent years, is not the bail-out of a troubled bank. It is in the form of a loan that is eligible as regulatory capital, granted by the government at an interest rate that is particularly high and rising over time. The intervention was decided last summer in order to enable MPS to comply with the European Banking Authority’s recommendation to constitute an exceptional and temporary capital buffer, well beyond the minimum capital requirement, against its large holdings of government securities. This support, provided by the government in complete compliance with the European rules on state aid, was authorised by the European Commission. The Bank of Italy’s assessment of the current and prospective capital adequacy of MPS, in the opinion submitted under the law to the Ministry for the Economy and Finance, is positive.

With the crisis, the need for strict regulation of the derivatives market has come to the fore. The initiatives promoted by the Financial Stability Board at the behest of the G20 go in the right direction, increasing the market’s transparency through contract standardisation, the requirement to trade on regulated markets, settlement through central counterparties, and the reporting of the terms and conditions of transactions to trade repositories. The aim is  ambitious. Progress has been made, but it is necessary to pick up the pace, overcoming the  difficulties of implementation, particularly for cross-border transactions, and the industry’s  resistance.

Liquidity and credit to the economy

The measures adopted by the ECB from late 2011 onwards – the two three-year refinancing  operations (LTROs), the expansion of the range of assets eligible as collateral for refinancing  with the central bank and, most recently, the announcement of Outright Monetary Transactions (OMTs) – kept the banks’ fund-raising difficulties in the markets from triggering  a disorderly contraction of balance sheets and jeopardising the functioning of the monetary policy transmission mechanism in the euro area. For Italian banks, whose ratio of lending to the more stable forms of funding approaches 120 per cent, these measures provided the means to cope with the decline in international interbank funding that began in mid-2011 and to redeem their maturing bonds.

Credit quality, supervision and capital

A growing number of firms are having difficulty repaying their loans: in the third quarter of 2012 the ratio of new bad debts to the stock of outstanding loans was 2.2 per cent for bank customers as a whole, while for firms it was 3.3 per cent. In November the share of loans to  firms in temporary difficulty (sub-standard and restructured loans) again increased. By contrast, the deterioration in loans to households has been small, thanks to the limited amount of household debt and the low level of short-term interest rates.

Banks’ profitability

Given the persistently unfavourable economic and financial situation, it has been contended that banks’ profits are high, especially compared with those of firms. So the banks, the argument runs, should be called on to expand the supply and lower the cost of credit, to reduce their fees, and to offer an array of services free of charge. Actually, two recessions in the span of three years, undermining the quality of banks’ assets, have generated loan losses that seriously erode profitability. The sovereign debt crisis has made funding in the wholesale markets harder and more costly, further reducing the  profitability of traditional credit activity. The profitability of the major banking groups is low. In the first nine months of 2012 their return on equity, annualised and net of extraordinary goodwill impairments, was just above 3 per cent.

The modest growth in the volume of business and the incidence of loan losses will continue to compress banks’ earnings until the economic recovery takes hold. The uncertainty over economic and financial market developments will continue to weigh on the speed and the extent of the rebuilding of profit margins, which are in any event bound to remain below their unsustainable pre-crisis levels.

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