A wide array of government initiatives appears to have slowed the climb in bad bank loans both in volume and as a proportion of overall lending terms during the first seven months of 2016. But with the Italian economy under increasing pressure, and ultra-low interest rates expected to prevail, Italian banks need to find a broader solution to their poor profitability and bad loan problems are mounting.
Implications | The Bank of Italy reported that the banking sector's bad loans rose slightly in July, but they have flattened out during 2016. Nonetheless, they still signify continued pressure on the quality of banks' assets and their profitability. |
Outlook | The banking sector is suffering the fallout from Italy's recent prolonged and deep recession, not helped by fragile recovery since early 2015. This implies banks are likely to face significant write-downs in the coming quarters. |
The Bank of Italy reported that the banking sector's bad loans rose slightly in July, but they levelled off during seven months of 2016. Nonetheless, they still signify continued pressure on the quality of banks' assets and their profitability. Specifically, the volume of bad bank loans grew by 0.2% month on month (m/m) to stand EUR198.6 billion (USD220.3 billion or 11.9% of GDP), compared to EUR197.2 billion in June and a record-high EUR202.053 billion by end-January 2016. It had stood at just below EUR40.0 billion during late 2008. Therefore, the non-performing loans ratio (for non-financial institution and households) stood at 13.8% in July 2016, compared to 13.6% in the corresponding month a year earlier.
A breakdown by economic sector reveals the volume of troubled debts held by Italian households (consumer households, producer households and non-profit institutions) increased 1.4% y/y to EUR53.4 billion in July 2016, implying an unchanged bad bank loan ratio of 8.6% when compared to a year earlier. More encouragingly, loans to households rose for a 16th straight month on a y/y basis, up by 2.1% to stand at EUR622.193 billion.
Meanwhile, loans to non-financial firms continued to retreat by 2.8% y/y to EUR787.9837 billion in July, and have fallen in almost every month since mid-2012. In addition, doubtful loans continued to climb, albeit marginally, and stood at EUR141.2 billion (up 0.2% y/y, the best performance since early 2009). This translates to a bad-debt ratio of 17.9% in July 2016, up from 17.4% a year earlier. The protracted downturn took a heavy toll on Italian firms, with the largest hit being endured by the country's large number small and medium-sized enterprises (SME), which dominate the Italian industrial landscape. In addition, the accumulation of non-performing loans to non-financial firms is a result of banks being reluctant to write off bad loans due in part to the inflexible bankruptcy laws and long legal processes to monetise collateral. Specifically, a report by Citi estimates that Italy's average foreclosure time is around five years, compared to 1.5 years in Europe as a whole.
Entrenched corporate credit risk continues to trigger cautious banking lending, resulting in limited external financing to non-financial firms. The credit flows to SMEs appear to be insufficient, with their financial situation already suffering in light of inadequate internal financing as a result of weak pricing power and profitability and lower capital provisions. Overall, the lack of external financing to SMEs is a notable headwind to a stronger industrial investment cycle, with firms already cautious when enduring weak pricing powers and significant past income and profit losses.
Finally, the overall situation appears to be more daunting, with the International Monetary Fund (IMF) and others estimating Italian banks have in excess of EUR350 billion of credit likely to be repaid late or not at all, around 22% of nominal GDP.
Outlook and implications
A wide array of government initiatives appears to have slowed the climb in bad bank loans both in volume and as a proportion of overall lending terms during the first seven months of 2016. However, the sector is still suffering the fallout from Italy's recent prolonged and deep recession, not helped by fragile recovery since early 2015, and implies banks are likely to face significant write-downs in the coming quarters. Indeed, we expect the stock of non-performing loans (NPLs) to remain troublesome in the next few years, implying that banks' increased perception of notably high credit risk will continue to weigh down on normal credit channels.
Economy Minister Pier Carlo Padoan hopes Italian banks will seek mergers, noting a law in March 2015 should make it easier for large co-operative lenders to be taken over, hoping to overcome the fragmented nature of Italy's banking system, where most banks are small and local. In addition, Italy has pushed through a set of emergency measures to reduce lengthy bankruptcy proceedings and help banks to recover collateral more rapidly on bad loans. The new measures have been welcomed by banks, noting that faster bankruptcy procedures and the full fiscal deductibility of loan losses will provide a welcome impetus to the still small Italian market for bad loans. And, the government has promised new measures.
The UK's EU exit vote has added another layer of uncertainty to the Italian banking sector, adding to the already wide spectrum of risks. Italian banks face the twin threat of a substantial stock of non-performing loans and ultra-low interest rates likely to be prolonged in light of the Brexit shock (placing additional pressure on already squeezed revenues). Clearly, the banking sector continues to creak under the duress of still soft economy activity, which is set to be even more challenging with the fragile recovery in Italy being partly derailed by the financial volatility and uncertainty triggered by the UK vote. In addition, a major spillover of the UK referendum outcome is likely to be sharper focus on the next potential crisis spot in the region, and the continued travails of the Italian banking sector is attracting greater attention. Not surprisingly, investors are wary that the prospect of even weaker growth in Italy in the wake of Brexit vote could elevate already dangerous levels of non-performing loans, ratcheting up the pressure on the quality of banks' assets and both their profitability and capital levels. Banks are already under intense pressure to forgo dividend payouts, selling assets and cutting costs even considering some consolidation across the sector, while putting in place strategies to offload accumulating NPLs to private investors. In addition, Italian banks have raised their loan loss provisions, which continues eat into their operating profits, which are considered to be the worst in Europe.
To summarise, with the Italian economy under increasing pressure, and ultra-low interest rates expected to prevail, the pressure on Italian banks to find a broader and deeper remedies to their poor profitability and bad loan problems are mounting. Despite the flurry of options to generate some recapitalisation of the banking sector (Atlas funds, third-party private equity investors and the government guarantee scheme to provide banks with a better platform to sell off their non-performing loans), we continue to argue some state assistance will be required, either to take equity stake in troubled banks or launch a taxpayer-funded "bad bank" to speed up the removal of non-performing loans from banks' balance sheets in order to revive confidence in Italian financial institutions and improve credit channels to elevate a rather strangled economic recovery.