If you are concerned about the future of the euro and the potential impact of the new Italian Government, try Googling “Italian bank problems”. Two examples give the flavour of the popular discussion that comes up, but are they presenting a complete picture? Is the EU - in the specific form of the ECB’s supervisory arm – the Single Supervisory Mechanism (SSM) – `asleep at the switch’?
· “Euromoney's latest coverage of Europe’s fourth-largest economy as its banking sector stands on the brink.” 7 February 2018
· “Italy's eurozone crisis: no easy fixes for the European Central Bank” 29 May 2018, Guardian
The financial position of the Italian banking system
How does the Italian banking system - in aggregate – compare with the rest of the EU’s banking systems? The European Banking Authority produces a quarterly Risk Dashboard that gives all the key data:
· Tier 1 capital ratio : EU 16%, Italy 14%
· Non-performing loans (NPLs): EU 4%, Italy 11%
· Coverage ratio of specific allowance for loans versus NPLs: EU 44% , Italy 50%
· Return on equity: EU 6%, Italy 8%
· Return on assets: EU 0.4%, Italy 0.6%
· Leverage and liquidity: about the same as the EU average
Overall, Italian banks are substantially more profitable than the EU average but slightly weaker capitalised – though still a long way above minimum levels. The key problem is the level of NPLs – but the Italian bank’s provisions are significantly higher than average. Italy is an €1,800 billion GDP economy so the uncovered NPLs – at €140 billion - are 8% of annual output.
In the event of a problem that posed a risk to the eurozone’s overall financial stability, the European Stability Mechanism (ESM) could provide Italy with loans for “indirect bank recapitalisation”, such as were provided to Spain. Only €41 billion of the €100 billion programme was actually drawn and Spain exited the programme in about a year. So – one way or another - the eurozone has the tools available to deal with Italy’s problems in the last resort. But is the `last resort’ likely to happen?
The EU is not sitting on its hands and simply waiting to see if disaster strikes. It has a multi-pronged strategy that includes pressure to write-off/sell existing NPLs, accounting rules to discourage the build-up of new NPLs, new laws to improve insolvency procedures to recover collateral more quickly and aspects of the Capital Market Union programme to encourage the emergence of an active secondary market in NPLs.
The pressure is also on to follow the ECB’s Guidance especially for Significant Institutions. It published qualitative NPL guidance in March 2017. The Bank of Italy reports that banks are now selling very large amounts of NPLs in the market: €30 billion in 2017 alone, while more than €25 billion are expected to be sold in the first half of 2018. But the constraint is the volume of buyers. If there are insufficient, then the buyers can depress prices so further provisions may have to be made to the written-down economic value of the loans in the books of the banks.
Banks are now under great pressure to provide properly for possible NPLs on current lending. This flows particularly from the introduction of IFRS 9 requiring provisions for expected credit losses rather than the old “incurred loss” model – though banks have been given five years to reflect these expected losses in their regulatory capital. This March, the ECB published an Addendum to its Guidance a year earlier and specified its supervisory expectations for prudent levels of provisions for new NPLs. For Italy, the flow of new NPLs has been decreasing since 2014 and is now about 2 per cent of total loans - below the pre-crisis average.
So NPLs are diminishing quickly and the Bank expects that, by mid-2018, the volume of NPLs net of provisions will amount to less than €140 billion, almost one third below the peak of 2015. Moreover, Italian banks are using about two thirds of their profits to build provisions.
The next constraint is the speed of judicial proceedings to gain control of collateral. In November 2016, the European Commission presented a set of European rules on business insolvency. This initiative is a key deliverable under the Capital Markets Union Action Plan. It included targeted measures for Member States to increase the efficiency of insolvency, restructuring and discharge procedures. For example, the Bank of Italy believes that – on average – the delay is around three years.
This is far from the worst in the EU but it underlines the rationale for the EU’s push to improve insolvency proceedings for businesses. But the Bank also points to the wide heterogeneity in the duration of proceedings across different Italian courts - suggesting that progress is possible also without changing laws at the EU level as it only requires improved efficiency in individual courts.
But the SSM is not waiting for these longer term measure to cut in. The March addendum is non-binding, so it will serve mainly as the basis for the supervisory dialogue between the significant banks and ECB Banking Supervision. However, during the supervisory dialogue, the ECB will discuss with each bank divergences from the prudential provisioning expectations laid out in the addendum.
Thereafter, and taking into account the bank’s specific situation, ECB Banking Supervision will decide, on a case-by-case basis, whether and which supervisory measures are appropriate. The result of this dialogue will be incorporated, for the first time, in the 2021 Supervisory Review and Evaluation Process (SREP). This gives banks time to prepare themselves and also to review their credit underwriting policies and criteria to reduce the production of new NPLs, in particular during the current benign economic conditions.
If these benign conditions continue, then there should be time for Italian banks to deal with their massive – but increasingly manageable – legacy of bad loans.
© Graham Bishop
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