10 July 2013

Bank of Italy/Visco: Overview of Italy's economy and banking system

The timing and strength of the recovery are subject to the risk of a slowdown in the global economy, in particular in the emerging economies, together with the risks inherent in financial market developments. Italy’s large public debt and weak growth prospects, as well as the uncertainties over European governance, make risk premiums on government securities highly sensitive to swings in market confidence, as has been shown recently by the wide fluctuations in interest rate spreads relative to German Bunds. A deterioration would further narrow the scope for fiscal policy measures and would have repercussions on banks’ funding and hence on the availability and cost of credit to firms and households.

We cannot risk losing investors’ confidence, which is fragile and exposed to the changeable evaluations of analysts. Budgetary policies must continue to be responsible; the reforms already decided and those still to be implemented should be set within a comprehensive design and the aims clearly defined.

Monetary policy will sustain the recovery. On 4 July, the ECB Governing Council announced that monetary conditions would continue to be accommodative for as long as necessary. It adopted innovative communication procedures, specifying that it expects official rates to be kept at or below their current levels for an extended period of time given the subdued Outlook for inflation, the weakness of economic activity and modest monetary growth in the euro area.

The Italian banking system has been under severe strain from the financial crisis, the double dip recession and sovereign debt tensions. The banks’ income-producing capacity has been  reduced; in the absence of an adequate response it would be further undermined by the persistence of the crisis or the occurrence of new adverse shocks.

The work to create a single supervisor in the euro area, consisting of the ECB and the national authorities, is proceeding expeditiously. Starting out from the national authorities’ store of technical knowledge, the new institution will have to ensure a supranational vision based on best practices in supervisory methodologies, modelling and assessment of banking risks. The transition to the single supervisory mechanism will give stability to the euro area, helping to counter the trend towards the segmentation of the financial markets along national lines, which we have seen during the crisis. It will facilitate comparisons between the banks and systems of the different countries.

On 20 June, the Eurogroup reached an agreement on the possibility of using the resources of the European Stability Mechanism (ESM) to recapitalise banks directly under certain stringent conditions for a maximum of up to €60 billion. This will be conditional on the launch of the single supervisory mechanism, which in turn will have to be preceded by a balance sheet assessment of the banks subject to centralised supervision at European level and, in particular, by an asset quality review.

In the following days the ECOFIN Council reached a general agreement on the rules for the recovery and resolution of banks in crisis. The procedures whereby creditors are to share the costs of a banking crisis were decided, with entry into force scheduled for 2018. These so-called bail-in mechanisms are consistent with the recommendations of the Financial Stability Board aimed at curbing opportunistic behaviour and limiting the costs of bank crises for taxpayers.

The agreement specified the bank liabilities covered by a creditor bail-in and the order in which they will be called on to participate. At national level, a minimum share of liabilities able to ensure sufficient loss-absorbing capacity will be established for each bank. In addition, it was decided to set up national resolution funds financed by the banks themselves; within 10 years these funds must have an endowment equal to 0.8 per cent of the deposits covered by the respective deposit guarantee schemes. Only if a number of conditions are met and if there are severe risks for the system’s financial stability may public funds also be used.

Recourse to the resolution fund − allowed when the bail-in process makes available resources equal to at least 8 per cent of the bank’s liabilities − enables account to be taken of national specificities, such as the widespread use of retail bond funding in Italy. The work to establish the fund must proceed rapidly, with appropriate negotiations with national and Community authorities. The transition phase must be completed well before the time limit of 10 years indicated in the agreement, while assessing the scope for synergies with the entities already in place. When the fund is fully operational, the availability of adequate resources will allow the cost of crises to be divided between the bank’s creditors and the banking system as a whole, with advantages for the cost of banks’ funding.

A European resolution mechanism must be created as soon as possible, based on a single resolution authority and pooled resources, able to cope with systemic crises and prevent contagion. The possibility of using ESM funds to recapitalise banks directly has in practice been postponed for many months, since it depends on the entry into operation of the single European supervisor. There remains the possibility of using such funds indirectly, by means of ESM loans to Member States, but recapitalising banks in this way bears on the public debt of the countries concerned.

Any capital shortfall that emerges for some European intermediaries will be met in the first place with private-sector resources. Prompted by supervisory authorities, banks will have to take appropriate action to meet their needs, such as restricting the distribution of dividends or disposing of non-strategic assets. The definition of an adequate financial back-stop, to be established ex ante, will be necessary to prevent deleveraging.

The asset quality review will be followed, in 2014, by stress tests conducted by the European Banking Authority and the ECB to assess banks’ ability to withstand low-probability extreme shocks. The similar exercises performed by the IMF under its Financial Sector Assessment Programme (FSAP) show that, all told, the capital of the Italian banking system is well above the regulatory minimum and meets the capital requirements established for the Basel III phase-in period. However, given the low level of profits, in extreme circumstances capital buffers could be rapidly depleted. These results confirm the need to carry on the process of capital strengthening.

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