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New accounting rules to boost Italian bank cleanup, Moody's says

Italy’s banks are set to take advantage of regulatory allowances for a new accounting standard known as IFRS 9 to accelerate the cleanup of their balance sheets, according to rating agency Moody’s.

IFRS 9, which took effect at the beginning of 2018, requires more forward-looking provisioning against bad loans, in a switch from the previous regime that allowed money to be set aside only after a loan went south. EU regulators are allowing banks to "phase in" the capital impact of the early recognition of bad loans until 2023, meaning that Italian banks could write off more of their roughly €300 billion in bad loans with a relatively modest sacrifice of reserve capital, Moody's said in a Feb. 27 report.

The five-year transition, agreed in December 2017, also allows for the cost of any rise in loan loss provisions to be absorbed through equity, rather than through the income statement.

"IFRS 9 therefore gives Italian banks an opportunity to write down their problem loans substantially, facilitating their future sale, without adversely affecting their earnings, and with a phased impact on capital," the analysts said, adding that "some banks will also book a deferred tax benefit on transition."

The overall problem loan ratio in Italian banking was 16.4% as of June 2017, Moody's noted. Those loans that fall into the worst of three categories under IFRS 9 are typically held on the balance sheet at carrying values well in excess of their market values, meaning that selling them crystallizes losses.

Banca Carige SpA and Credito Valtellinese SpA, both of which are restructuring following capital shortages, are set to return to profitability in 2018 thanks to the effect of this measure, according to the report. Carige had nonperforming assets of €4.8 billion at the end of 2017, a 34.6% drop compared to the previous year, and equivalent to a nonperforming exposure ratio of 17.1% net of provisions. Creval, meanwhile, sat on €4 billion of toxic loans as of December 2017, or 21.7% of its book on a gross basis, down from €5.4 billion the year before.

Most Italian banks made significant reductions in bad loan holdings in 2017, mostly through sales and securitization with help from a state guarantee scheme that attracted distressed asset investors from abroad. UniCredit SpA, after raising €13 billion from shareholders, carried out a massive securitization that helped cut its problem loan ratio to 10.2% at the end of 2017 from 16.3% in 2016.

Banca Monte dei Paschi di Siena SpA, which was rescued by the government, brought its dud loans down to 19% from 34% over the same time span.

"Writing down problem loans closer to their market value should result in a healthier balance sheet, with fewer capital constraints, and ease the long-awaited process of selling bad assets," Moody's said. The agency noted, however, that capital levels may also be affected by a rise in risk-weighted assets, the denominator in the crucial common equity Tier 1 ratio, as a result of changes to internal models prompted by the reduction in bad loans.

Banks with higher capital levels are likely to be better placed to take advantage of the IFRS 9 provisions, Moody's said.

"Investors will focus on the capital impact of IFRS 9 beyond the regulatory phase-in period," the agency said. "As a result, only banks with adequate capital, or the capacity to attract fresh capital, will be able to set aside provisions above the minimum prescribed under IFRS 9, or compatible with observance."

It cited Intesa Sanpaolo SpA and BPER Banca SpA as having "substantial capital headroom over requirements."

The impact on capital ratios from IFRS 9 will vary among Italian banks, with the Bank of Italy saying in November 2017 that a survey of 67 lenders projected an average hit of 38 basis points. Moody's noted that the actual impact disclosed by banks with 2017 results varied from 12 basis points to 175 basis points, "partly reflect[ing] the banks' varying loan quality and de-risking strategies."