Italian non-performing loans post welcome fall in February, healthiest financial institutions will fund new "bad bank"

The Bank of Italy reported that the banking sector's bad loans fell back slightly in February, but still signified continued pressure on the quality of banks' assets and their profitability. Specifically, the volume of bad bank loans shrank by 3.0% month on month (m/m) to stand at an eight-month low of EUR196.1 billion (USD213.5 billion or 12.0% of GDP), compared to a record-high EUR202.053 billion by end-January 2016. It had stood at just below EUR40.0 billion during late 2008. Additionally, the central bank puts the estimated realisable value of bad bank debts in February 2016 at just EUR83.079 billion. Therefore, the non-performing loans ratio (for non-financial institution and households) stood at 13.7% in February 2016, compared to 13.2% in the corresponding month a year earlier. Interestingly, according to the Bank of Spain, the bad bank loan ratio for Spanish banks stood at 10.1% during January 2016.

A breakdown by economic sector reveals the volume of troubled debts held by Italian households (consumer households, producer households and non-profit institutions) increased 5.2% y/y to EUR53.6 billion in February 2016, implying a bad bank loan ratio of 8.7% (up from 8.5% in February 2015). More encouragingly, loans to households rose for an 11th straight month on y/y basis, up by 3.4% to stand at EUR617.782 billion.

Meanwhile, loans to non-financial firms continued to retreat by 1.8% y/y to EUR791.512 billion, and have fallen in almost every month since mid-2012. In addition, doubtful loans continued to climb, and stood at EUR138.9 billion (up 4.1% y/y, the lowest increase since early 2009). This translates to a bad-debt ratio of 17.6% in February 2016, up from 16.5% a year earlier.

The situation appears to be more daunting, with the International Monetary Fund (IMF) estimating Italian banks have around EUR330 billion of credit likely to be repaid late or not at all, of which EUR180 billion is in or close to default in early 2015. Again, lengthy bankruptcy procedures and tax laws are making it difficult for banks to monetise their bad bank loans, creating a nervous lending environment. 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.

The challenging environment for the sector is highlighted by Italy's major banks enduring volatile share prices during 2016. Investors are wary that Italian banks face a twin threat of a substantial stock of non-performing loans and low interest rates (placing additional pressure on already squeezed revenues). Still, the government has pushed through a reform to transition Italy's top 10 co-operative banks into joint-stock companies by end-2016. But investors continue to note slow progress on two fronts, namely cleansing the Italian banking sector of its toxic loans and the much-needed consolidation in the sector. In addition, Italy compares unfavourably with the Spanish experience; numerous mergers in the sector and a stream of major reforms have helped the sector recover from a property market meltdown and significant consumer deleveraging.

Not surprisingly, the Italian government has announced a new bad bank initiative, and will be financed by the major domestic financial institutions. Quaestio Capital Management will run the fund named Atlante, and has gathered the support of institutional investors, major banks, insurance firms and the state lender Cassa Depositi e Prestiti. No information is available with regards to size of the fund, but banking sources suggest it will hold up to EUR5 billion. Quaestio hopes the fund can buy shares in upcoming stock issues at distressed lenders and purchase non-performing loans, focusing on less attractive junior debt. Economy Minister Pier Carlo Padoan hopes the European Commission will not block the new bank fund. He said, "The state plays no role in the initiative... so I do not see any risk." In addition, the Bank of Italy Director General Salvatore Rossi said the vehicle "did not increase systemic risk for Italian banks".

Outlook and implications

A wide array of government initiatives have been rolled out to address the substantial mountain of bad bank loans both in volume and as a proportion of overall lending terms. Clearly, the sector is still suffering the fallout from Italy's recent prolonged and deep recession, not helped by fragile recovery since early 2105. 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. Not surprisingly, the central bank has instructed Italian banks to raise their loan loss provisions in an effort to cleanse their balance sheets, and have addressed their capital shortfalls by forgoing 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. Economy Minister Pier Carlo Padoan hopes Italian banks will grow by seeking mergers. He points out that the government passed a law in March 2015 to 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.

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. However, given the size of troubled loans (likely to be repaid late or not at all), more dramatic measures have been rolled out, with the sector-funded "bad bank" being the latest initiative.

First, the government has launched a new system to undertake a EUR3.6-billion (USD3.83-billion) rescue of four small saving banks: Banca delle Marche, Banca Popolare dell'Etruria,Cassa di Risparmio di Ferrara and Cassa di Risparmio di Chieti in 2015. The four banks were placed under special administration recently when audits exposed holes in their balance sheets. The Bank of Italy is organising the rescue, and the cost will be shared among the country's healthy banks, which will pay into a newly formed National Resolution Fund. The troubled savings banks appear to be too small to pose a systematic risk to the sector as a whole, but the government wanted to avoid any losses being incurred by retail clients should the rescue take place after the introduction of the new EU rules. Importantly, the authorities want to avoid the risk of triggering panic among small savers concerned about future losses on their holdings, resulting in withdrawals while threatening a traditional source of funding for Italian retail lenders. Therefore, the government passed an emergency decree to allow the immediate implementation of the rescue plan, already approved by the EU. The Bank of Italy will also create a "bad bank" containing the impaired assets of all four failing lenders, and seek buyers for what will then be sound banks. Worryingly, with a highly fragmented financial sector, and a number of small lenders affected by Italy's two recessions from 2012, we can envisage further rescues. In addition, the bank resolution fund is entirely financed by Italy's major financial institutions, adding a further layer of pressure to the sector already dealing with strangled flows of credit, rising bad loans and damaged profitability.

Second, the government has launched a bad loan guarantee scheme, known as GACS, to provide banks with a better platform to sell off their non-performing loans (NPLs). The initiative is 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 pedestrian economic recovery. Indeed, the scale of task is revealed by data compiled by KPMG, which reveal that sold Italian non-performing loans totalling just EUR18.8 billion in 2015. Therefore, the scheme aims to bridge the considerable gap between the book and market value of the NPLs, and help to evolve a private market for bank loans that at present is virtually non-existent. The Italian government would provide a guarantee for the bad loans, thus capping the losses of potential buyers, which are most likely to be hedge funds and other alternative asset managers. According to Moody's, the gap between the book and market value of NPLs is significant, with banks valuing at around 40% of par, but could be worth just 20–25% in the market. Therefore, the scheme allows Italian banks to package their bad loans into tranches and purchase a government guarantee to lessen the risk for potential investors. After a dispute between the Italian government and the European Commission about the price of guarantee, an agreement was reached to set it using the price of credit default swaps of similar loans, or a market rate. The price of the guarantee will initially be low, and rise over time, in an attempt to make the scheme more attractive to banks. The less advantageous state price guarantee for banks is a result of the new EU state aid laws blocking governments from providing cheaper financial assistance to its banks than currently available in the market. Furthermore, the scheme has certain limitations, namely embracing the senior tranche of the loan packages, and restricted to just investment-grade securities, implying riskier, lower-rated loans will be excluded.

Banking analysts argue that the state guarantee scheme and the new bad bank will do little to help Italy's small lenders to remove their bad loans from their balance sheets, arguing the cost of state guarantee could wipe out any potential gains on the valuation of the portfolios arising from the scheme. Given we assume the scheme will only provide Italy's largest banks a better platform to sell off their non-performing loans (NPLs), the country's smaller and regional banks will need seek out mergers to lessen the impact of their non-performing loans on their balance sheets. This will be critical to revive confidence in Italian financial institutions and improve credit channels to elevate a rather pedestrian economic recovery.

Without a radical and prompt overhaul of the Italian banking sector, the country could still be forced to seek external financial assistance like Spain and Ireland. Indeed, we suggested that an Italian approach to the ESM for assistance to recapitalise its banking sector could not be ruled out if it were to be accompanied by soft conditionality and limited supervision, matching the Spanish experience. We argue that the state guarantee scheme of NPLs and the proposed "bad bank" appears to be insufficient to tackle the still growing mountain of bad bank loans, which continues to place pressure on the quality of banks' assets and profitability.