Italy—Background Economic Developments and Issues

This paper reviews developments in the Italian economy during 1994 with some special attention to some specific issues. It describes trends in the real economy, with special annexes focusing on the outlook for inflation and the response of employment to cyclical and structural factors. The paper discusses fiscal developments, and summarizes developments in the monetary sector. It also reviews empirical evidence on money demand in Italy, and the combination of cyclical and structural factors impinging on the banking system.


This paper reviews developments in the Italian economy during 1994 with some special attention to some specific issues. It describes trends in the real economy, with special annexes focusing on the outlook for inflation and the response of employment to cyclical and structural factors. The paper discusses fiscal developments, and summarizes developments in the monetary sector. It also reviews empirical evidence on money demand in Italy, and the combination of cyclical and structural factors impinging on the banking system.

IV. Monetary Developments

During 1994, Italy’s financial markets were influenced by a combination of global financial market trends and domestic economic and political factors. For the second year, monetary policy was formulated in the absence of an exchange rate anchor. In the continued pursuit of disinflation, the Bank of Italy relied on a number of forward-looking indicators of inflationary pressures, among which monetary and credit aggregates were assigned a decreasing emphasis. While embodying some of its elements, this approach differs in important respects from a formal inflation-targeting framework, however. 1/ In the period under review, there were also important structural changes associated with the increasing competition and progressive liberalization of the financial system.

1. Interest rates

In the first part of 1994, the Bank of Italy continued the sequential reduction of official interest rates that it had pursued since the crisis of the fall of 1992 (Chart 25). The discount rate was lowered in February and then in May in conjunction with similar moves by the Bundesbank; another downward move of German official rates, in April, was not followed in Italy.


ITALY: Selected Interest Rates

Citation: IMF Staff Country Reports 1995, 036; 10.5089/9781451819687.002.A004

Sources: IMF, Research Department; International Financial Statistics; and Bank of Italy.1/ German 3-month interbank discount rate.

During this period, long-term interest rates were driven by both international and domestic factors. As occurred in a number of other countries with weak fiscal positions, Italian bond markets amplified the effects of the U.S. Federal Reserve’s first increase in interest rates in February, with a widening differential against deutsche mark interest rates. Then, following March elections, interest differentials narrowed, reaching a low of 250 basis points in April.

During the summer, with adverse news on fiscal and political fronts, long-term interest rate spreads widened, concomitant with downward pressure on the lira. At the same time, other indicators, including surveys of inflationary expectations, suggested heightened inflationary pressures. The Bank of Italy initially responded by tightening liquidity conditions and pushing up market interest rates. Money market rates on repurchase agreements rose above the rate on fixed-term advances, thus out of their notional band. 2/ In mid-August, the Bank of Italy raised official interest rates by 50 basis points. The initial market response was unfavorable: the long-term interest rate spread vis-à-vis German rates widened to over 450 basis points, and the lira dropped to record lows against the deutsche mark. The widening long-term rate spread apparently reflected market expectations of further increases in interest rates. Some observers attributed the markets’ reactions to a perceived conflict between monetary and fiscal policy.

During the autumn of 1994, official interest rates were held steady, while market interest rates fluctuated with shifting prospects for political stability and for parliamentary approval of the 1995 budget. The differential between short and long rates narrowed in September, as did the premium on German long-term rates, as these prospects improved, and then widened in late November with difficulties over the parliamentary budget process and further in December with the political events leading up to the fall of the Berlusconi Government.

Associated with these changes in the overall level of interest rates was the maintenance of the relatively low spread between average deposit and loan rates (Chart 26) which had emerged toward end-1993 (6.5 percent versus, for example, 9.5 percent at end-1992). This reflected in part the greater responsiveness of loan rates than deposit rates to movements in market interest rates. A more competitive banking environment associated with liberalization may also have played a role (see Annex IV).


ITALY: Bank Interest Rates

Citation: IMF Staff Country Reports 1995, 036; 10.5089/9781451819687.002.A004

Source: Bank of Italy.

2. Money and credit

Monetary aggregates showed considerable short-term variability during 1994. Early in the year, growth of broad money (M2) was above the Bank of Italy’s 5-7 percent target range (Chart 27). This pattern was apparently in considerable part due to the continuing decline in short-term interest rates. Growth of M2 began to decelerate in April, however, with an increasingly large component of growth coming from the more liquid instruments comprised in narrow money Ml. For the year as a whole, M2 growth (at 2.8 percent, on the 3-month moving average basis used for target monitoring) was significantly below its target range, also making a notable deceleration from 1993. This may have reflected the widening spread between bank deposit rates and yields on public debt instruments, associated with less aggressive liability management on the part of the banks, which in many cases were flush with cash due to weak loan demand. The deceleration of growth of certificates of deposit (CDs) occurred despite a lowering of reserve requirements, which would normally have been expected to make CDs more attractive relative to alternative assets. Both narrow and broad money continued to account for a declining share of total domestic financial assets, associated with continued growth in the importance of repurchase agreements, bonds, and mutual fund shares. In particular, medium- and long-term government bonds accounted for the lion’s share of growth in domestic financial assets.


ITALY: M2 Money Supply

Citation: IMF Staff Country Reports 1995, 036; 10.5089/9781451819687.002.A004

Source: Bank of Italy.

Money demand in Italy has recently shown some indications of, at the least, greater short-run variability around its predicted value. In late 1992, there was an underprediction of money demand, which continued through 1993; then, in mid-1994 this switched to an overprediction (see Annex III).

Credit meanwhile grew quite slowly with credit to the nonstate sector, in particular, remaining essentially flat. This was largely due to cyclically weak loan demand and greater recourse to self-financing by enterprises; banks’ caution in lending in the face of high loan losses may also have played a role. The share of foreign-currency-denominated loans in total credit declined to 13 percent in September 1994 compared with 17 percent a year earlier; this reflected borrowers’ increasing unwillingness to expose themselves to exchange-rate risk in order to obtain a lower interest rate. The counterpart of slow credit growth was increased bank holdings of securities, and in particular of medium- and long-term government bonds. As in the previous two years, a substantial part of these bond holdings was financed through repurchase agreements.

The monetary base rose by 5.7 percent during 1994 when adjusted for changes in reserve requirements. On an unadjusted basis, it declined by 3.4 percent in the first 11 months of 1994, mainly due to the reduction in reserve requirements which are discussed below. The major part of the reduction in the monetary base came from the Treasury, associated with the abolition of the Treasury’s overdraft facility at the Bank of Italy. In addition, the Treasury overfunded itself during 1994, in anticipation of large redemptions of medium- and long-term bonds during 1995. The Bank of Italy offset the effect of these Treasury operation on the monetary base through open market operations.

3. Monetary policy instruments

This was the second year that Italy’s monetary policy was without an exchange-rate anchor. An official target range of 5 to 7 percent had been announced for growth of broad money M2 during 1994. There were also official forecasts of growth of credit to the nonstate sector of 6 to 7 percent, and 7 to 8 percent for both total domestic credit and total financial assets. These targets or ranges were rarely mentioned in official statements explaining interest rate changes, however, and in the event, they were all undershot during 1994.

For 1995, the Bank of Italy discontinued the practice of announcing a target range for M2. Instead, it indicated point figures in the context of “the programming framework for financial flows,” of 5 percent for money growth, as well as 5 percent for growth of total financing and 6 percent for growth of total financial assets.

Important changes in Italy’s system of reserve requirements were introduced in June 1994, associated with a new banking law that eliminated the former legal distinction between banks (which were confined to short-term deposit-taking and lending) and special credit institutions (confined to medium- and long-term activities). With the new law, reserve requirements apply equally to banks with short and with medium- and long-term deposit bases. However, CDs with maturities over 18 months, which can now be issued by all institutions, are not subject to reserve requirements, and there is an exemption for deposits in amounts over Lit 200 billion. Reserve requirements were also lowered to 15 percent (on the monthly change in deposits) from 17.5 percent. 3/ The rate of remuneration on required reserves was changed to a uniform 5.5 percent from a system under which a higher rate was paid on required reserves held against CDs. Finally, a system was phased in under which a bank could mobilize up to 10 percent of its required reserves to meet its liquidity needs, provided that it satisfied its required average level of reserves over the month; previously, the fraction that could be mobilized was 5 percent. These changes move in the direction of establishing a level playing field between institutions differing in their maturity specialization, reducing the tendency toward market segmentation by maturity. They also end a situation where reserve requirements and other regulations contributed to distort the maturity composition of assets and liabilities.

In November 1993, a law was passed abolishing the Treasury’s overdraft account with the Bank of Italy, in compliance with the Maastricht Treaty’s prohibition of direct central bank lending to the Treasury. In its place, a new interest-bearing account, called the Treasury payments account (conto disponibilità) was established to effect Treasury payments and receipts and enable the Treasury to ride out fluctuations in its net payments needs. The use of the account is subject to thresholds to ensure that the balance remains at a safe level. If the balance at the end of any month is less than Lit 15 trillion, the Treasury must bring it back to that level within the following three months. If any end-month balance is less than Lit 15 trillion, or if the balance is below Lit 30 trillion for three successive months, the Treasury must report the reasons to Parliament and describe any corrective measures planned; in the first case, this must be done by the fifth day of the following month.

4. Financial markets

The structure of Italy’s financial markets underwent some important changes in 1994. One was the introduction in late 1993 of a streamlined procedure for refunding withholding tax to nonresidents. This reduced the segmentation between resident and nonresident investors, and stimulated the involvement of the latter in Italy’s domestic bond markets. However, because tax refunds were not available to residents of all countries, some distortions remain, creating opportunities for tax arbitrage. 4/ Another important change was the December 1993 abolition of stamp duty on securities transactions on regulated markets.

Some notable steps were also taken in early 1994 to reform the electronic market for government securities. Nonresident operators were given direct access to the screen market, although they were not allowed to operate as primary dealers. A new category of primary dealers, called specialists, was established subject to a minimum capital requirement and minimum participation in both primary and secondary markets. 5/ Another reform was to improve the procedures on the electronic market for processing large orders, eliminating an anomaly whereby large transactions had to be split up into several smaller ones, resulting in wider spreads for large transactions and encouraging large transactors to use the over-the-counter market instead. Provisions for the establishment of inter-dealer brokers were promulgated, to enable anonymous trading of lots between specialists. Settlement procedures were improved, linking them directly to execution of transactions. Another innovation was the introduction of screen-based auctions for Treasury securities, whereby bids can be submitted electronically; this has been accompanied by speeding up the period between when bids are submitted and auction results announced. The thrust of these reforms is to increase the efficiency, liquidity, and depth of the government securities market, with a view to ensuring a smooth issuing activity and reducing the costs of financing the public debt.

ANNEX III: Stability of Money Demand 6/

Beginning in 1984, the Bank of Italy each year announced a target range for broad money (M2). Until September 1992, these targets were subordinated to the exchange rate bands associated with the exchange rate mechanism (ERM) of the European Monetary System. The importance of money supply targets did not apparently increase with the lira’s departure from the ERM, however: during 1993 through the spring of 1994, the Bank of Italy continued to lower official interest rates despite the fact that money supply was growing above the target range; in August 1994, in contrast, official rates were raised despite the fact that growth of M2 was decelerating below the target range. Official communiques announcing official interest rate changes also did not refer to M2 growth in their explanations. For 1995, the Bank of Italy did not announce an explicit target range, but indicated that, consistent with the programming framework for financial flows, “the money supply will continue to expand at a moderate rate, currently estimated at around 5 percent.” 7/

A key empirical question underlying the use of monetary targets is whether there exists a stable demand for money function. 8/ Stability of money demand is needed if a target for money supply growth is to bear a predictable relationship to output and inflation that are of more fundamental interest to policy-makers. Moreover, instability of money demand would vitiate the controllability of the money supply through the interest rate control mechanism typically employed by central banks. Empirical work addressing the stability of money demand in Italy has generated ambiguous conclusions. In addition, there is reason to believe that, with further financial innovations, the predictability of money demand will deteriorate further in the future.

Some Italian empirical work published in the early 1980s (e.g., Caranza, Micossi, and Villani (1983)) produced encouraging results on money demand, and supported the case for money supply targeting. Several subsequent papers found indications of instability in money demand, apparently associated with changes in monetary policy regime or with financial innovation; these papers sought to account for apparent structural shifts empirically with a view to finding a specification that would remain stable over a long period.

There are several factors that have been identified in the literature as possibly leading to structural changes. These include:

(1) the change in policy regime in 1969, when the Bank of Italy ended its commitment to supporting bond prices (Bagliano and Favero (1992));

(2) the change in the behavior of inflation in the mid-1970s, when inflation accelerated into the double-digit range and its variability increased (Bagliano and Favero (1992));

(3) financial innovation, associated with disintermediation of government borrowing from the non-bank public in the 1970s and 1980s. This involved the easing of portfolio restrictions on banks which had been used to induce them to hold government bonds; as well as the introduction of new government financial instruments such as BOT and CCT (Muscatelli and Papi (1990); Mastromatteo (1991)); and the liberalization of the market for certificates of deposit (CDs) (Dooley and Spinelli (1989));

(4) the greater financial market volatility (and possibly the large volume of capital flows) following the lira’s departure from the ERM in September 1992 (Angelini, Hendry, and Rinaldi (1994)); and

(5) the reduction of reserve requirements on CDs in 1993, which might have led to a portfolio shift into CDs (included in M2) and out of other liquid assets that are not included in M2.

The resulting possible structural shifts in money demand have been addressed in several ways. One approach is to include additional variables in the money demand equation capturing the financial innovations. For instance, Dooley and Spinelli (1989) and Muscatelli and Papi (1990) included variables incorporating the public’s holdings of BOT and CCT; the former found that money demand was still unstable even when these variables were incorporated, while the latter found that the inclusion of these variables, in their specification was sufficient to achieve stability. Mastromatteo (1991) used the deposit-loan rate spread and the ratio of liquid assets to GDP as measures characterizing financial system development; he found that with this specification there was no structural shift in the early 1980s. 9/

A second general approach is to capture possible changes in monetary regime through a more appropriate dynamic specification. Some researchers have followed a buffer stock approach, in which money holdings act as a temporary abode of purchasing power before funds are allocated among alternative assets, so shocks to money supply and income initially impinge on money demand (Papi (1989)). At a more formal level, Bagliano and Favero (1992) investigate the empirical properties of a money demand equation explicitly incorporating costly portfolio adjustment with forward-looking expectations. This approach generated plausible coefficient estimates using instrumental variables; the forward-looking specification—unlike a backward-looking specification which the authors also estimated—did not show a structural break in 1969 (when the Bank of Italy stopped supporting bond prices), but both specifications nonetheless had a structural break in 1974 (when inflation accelerated and became more variable).

A third approach involves examining the behavior of alternative monetary aggregates, weighting each component of a broad monetary aggregate by a measure of its “moneyness” rather than taking the simple sum of each component. The construction of a Divisia index assigns to each component of broad money a weight based on the interest that must be sacrificed to hold it rather than alternative assets. Gaiotti (1994) constructed a Divisia index of money for Italy, and found that it had desirable properties as an indicator—in particular, that it experienced slower growth than conventional M2 in 1993, a period when conventional money demand equations were subject to underprediction.

A fourth approach is to use a deterministic trend to model the structural break, rather than attempting to account for the break in terms of economic variables. This is the approach taken in the Bank of Italy quarterly model, which specifies a money demand equation over the 1974-84 period spanning different states of the financial system (Bank of Italy, 1986). The model assumes that demand for money up until the early 1980s incorporated a large portfolio element, implying that wealth was an important scale variable for money demand; following the financial liberalization of the early 1980s, demand for money was largely transactions-related, and thus mainly related to current income. Money demand is assumed to adjust from one specification to the other according to a logistic trend—a rather ad hoc exercise, but one that yields a stable specification. 10/ Angelini, Hendry, and Rinaldi (1994) incorporate this transition model into a more sophisticated dynamic specification, using the error correction approach; their specification is stable over the 1983-1992 period, and its forecasting performance is satisfactory through the first half of 1992.

Existing money demand equations have performed less well in explaining the behavior of money demand since 1992. In the period of high interest rates and volatile financial flows in the latter part of 1992 and early 1993, most equations underpredicted money demand: essentially, the high interest rates of that period did not choke off money demand as much as was predicted by the equations. A possible interpretation is that, because the magnitude of the shocks exceeded those found in the data used to estimate the equations, the estimated dynamics did not stand up well. Most equations continued to underpredict through much of 1993, which may also have been partly attributable to the lowering of reserve requirements which may have made certificates of deposit closer substitutes for alternative assets not included in M2. Some preliminary work at the Bank of Italy also suggests that the poor performance of money demand equations in 1992-93 may be explained, in part, by an increase in the riskiness of alternative assets, and by movements in long-term interest rates (Grande and Rinaldi (1994)). In 1994, in contrast, money demand turned out below predicted levels; this appears to have been at least partly attributable to liability management on the part of banks, reflected in a widening spread between CD rates and money market interest rates. Some degree of persistent overprediction of money demand in 1993, and underprediction in the second half of 1994, is found even with relatively sophisticated money demand specifications (Chart 28). 11/


ITALY: Money Demand: Predictions and Outturn

(Monthly percent changes; in real terms)

Citation: IMF Staff Country Reports 1995, 036; 10.5089/9781451819687.002.A004

Source: Bank of Italy.

Looking to the future, further financial innovation is in store in Italy, and it is to be expected that this may be associated with further increases in the volatility of money demand. The reductions in reserve requirements, particularly on CDs in 1993 and 1994, and their abolition on CDs with maturities exceeding 18 months, as well as the 1993 elimination of the prohibition on banks’ issuing CDs with maturities exceeding 18 months, have not yet had their full effect. The restructuring of the banking system, and increased public access to equity markets associated with the privatization program, may also change the range of assets that are substitutes for money, thereby altering the influence of interest rates on money demand. When these changes have progressed further, they may make the money stock less reliable as a monetary target or indicator than at present.

ANNEX IV: The Banking Industry: Liberalization and Performance 12/

The past year has been characterized by many observers as a “black year” for the Italian banking industry, with a confluence of narrowing spreads, exceptionally slow growth of deposits and loans, record high nonperforming loans, and capital losses on bond portfolios—in contrast to previous years, when losses in one area were offset by unusually high returns in others (Chart 29). As a result, commercial banks’ gross profits fell to an estimated 0.35 percent of total assets in the first half of 1994, following a steady decline from 1.08 percent in 1990. 13/


ITALY: Variables Affecting Bank Performance

Citation: IMF Staff Country Reports 1995, 036; 10.5089/9781451819687.002.A004

Source: Bank of Italy.

The banking industry’s adverse circumstances were mainly the result of the recession and the turning of the interest rate cycle. However, they have also drawn attention to longer-term issues associated with liberalization and structural change of the banking system in the first half of the 1990s.

1. Liberalization and restructuring

The liberalization of the Italian banking system received much of its impetus from the move toward the single European financial market, including both the liberalization of capital movements in 1990 and the Second Banking Directive which came into effect in 1993. These developments posed a potential threat of competition from banks and financial markets in other EU countries, as well as leading to the establishment of uniform minimum standards of prudential regulation throughout the EU. The response was a major departure from the existing framework. The existing banking environment was founded on the 1936 banking law, which prescribed a rigid differentiation of institutions according to maturity and function, with banks engaging in short-term deposit-taking and lending and special credit institutions dealing in longer maturities. Most of the largest institutions were state-owned, in two main categories: “public law banks” mainly owned by charitable foundations; and “banks of national interest” owned by state holding companies. Banks’ functions were also differentiated, with some institutions (especially the banks of national interest) slanted heavily toward commercial activities and others (especially the savings banks) relying heavily on the household sector. These arrangements, together with tight regulation of bank branching and mergers, resulted in a situation where Italy was “overbanked and underbranched.” Italian banks’ performance also typically varied according to size: the medium-size banks, with strong regional ties and close customer relations, have in many cases been very profitable, while the large banks have often spread themselves too thin and in some cases incurred substantial losses on their international activities.

Under the Amato Banking Law of 1990, banks were permitted to form universal banking groups, which combined banks, special credit institutions, and other institutions; they were also given special tax concessions covering their reorganization. An element in this reorganization was that public law banks were legally separated from the charitable foundations that owned them, with the foundation owning a holding company which in turn owned the bank. In this connection, banks were given tax exemptions for the revaluation of assets valued at low historic cost. The separation of foundations from their holdings, and the associated revaluations, were needed to prepare for the coming into effect of the EU’s Solvency Ratio Directive at the beginning of 1993. The law also provided tax incentives for mergers, with a view to encouraging some degree of consolidation of the banking industry. These tax incentives were extended in successive years, and have now been extended into 1995. In addition to the general provisions of the law, the Treasury also provided support to recapitalize a few problem banks in anticipation of the implementation of the EU’s capital adequacy standards. 14/

In the early 1990s, the Bank of Italy also liberalized its regulation of branch expansion: as a result, over 4,000 new branches were established in 1990-92 alone. 15/ In addition, some regulations governing banks’ activities were liberalized: for instance, the percent of residential property that could be financed by mortgage was raised from 50 to 75.

With these changes, Italian banks are likely to face an increasing degree of competition. Competition may already have begun to intensify, as a result of the branch expansion, the openness of capital markets, and increasingly efficient financial markets of which both savers and borrowers made greater use. Competition may help explain the modest decline in average interest spreads between assets and liabilities from 700-725 basis points in 1988-1991 to less than 650 basis points in 1994 (Chart 29); however, the more dramatic drop in spreads from 1992 to 1994 mainly reflects unusually wide spreads in 1992.

The legally-enforced maturity segmentation of the financial system was also finally abolished with the 1994 banking law, which eliminated the legal distinction between banks and special credit institutions. This followed the 1993 law, under which banks were allowed to issue longer-maturity deposits and loans, and uniform reserve requirements were imposed on similar deposits issued by all deposit-taking institutions. This would be expected to increase further the degree of competition among different types of financial institutions. The goal of the reform is that Italy should move toward the universal banking model, dominated by large banks spanning the maturity spectrum as well as offering a wide range of assets, liabilities and services.

It is also intended that many of the banks will be privatized. In the case of the banks of national interest, this involves their sale by state holding companies. In late 1993 and early 1994, Credito Italiano and Banca Commerciale Italiana, two of the ten largest Italian banks, were privatized through public share offerings. The government also publicly sold a minority interest in Istituto Mobiliare Italiano (IMI), one of the largest medium- and long-term credit institutions. A decree law promulgated in December 1994 provides fiscal incentives for the foundations owning the public law banks to sell part or all of these banks, so that they would hold a diversified portfolio of assets. Many observers view the privatization of banks as a precondition for the efficient functioning of the banking system.

The tax incentives for mergers under the Amato Banking Law, together with a more tolerant regulatory attitude, were associated with an unprecedented level of merger activity. Some 125 mergers took place during 1991-93, compared with only 75 in the previous 5 years. In 1994, there were also the first attempted hostile takeovers (one already successful) of important regional banks by newly-privatized national banks. There were also several smaller acquisitions designed to expand branch networks, as well as purchases of small banks in difficulties. Bank mergers are subject to approval by the Bank of Italy with regard to their banking aspects; by the Anti-Trust Authority (Autorità Garante della Concorrenza e dei Mercati) with regard to their implications for competition; and by the CONSOB (Commissione Nazionale per le Società e la Borsa) with respect to their implications for securities trading and corporate governance. The authorities have viewed some consolidation of the banking system through mergers as inevitable, and conducive to enhancing the system’s competitiveness in a European setting. The result envisaged is a system dominated by large universal banks which carry out banking activity on a national and international scale.

2. Problem loans and capital losses

There was some concern that the increased branching and more liberal regulations would lead to a decline in loan quality as banks entered unfamiliar markets and competed for marginal loan customers previously unable to obtain credit—although much of the branch expansion was defensive, with banks opening additional branches to consolidate already-dominant market positions. In the event, loans expanded rapidly in the early 1990s, but decelerated in each year from 1989 through 1994 (Chart 29); there was also an increase in problem loans. Loan losses as a share of total bank loans rose by some 27 percent in the 12 months to September 1994, reaching 9 1/2 percent of total loans outstanding. Nonperforming loans, together with the other factors, resulted in a valuation adjustment of about 1 percent of banks’ total assets, a substantial amount but not enough to generate losses for the system as a whole. 16/ About one-fifth of the banks are estimated to have incurred losses in 1994.

Although total nonperforming loans were high in 1994, the flow of new bad loans started to decline in the latter part of the year; bank analysts have estimated, based on past experience, that it would likely take 2-4 years to overcome the problems. Substandard assets (loans to borrowers in temporary difficulties—partite incagliate) declined for some major banks in 1994, partly because some large corporate restructurings had moved the affected loans back out of the substandard category. Consumer lending, including for housing, played some, although not a dominant role in the mounting loan losses: the incidence of nonperforming consumer loans on total consumer loans rose from 10.8 percent in 1991 to 12.1 percent in 1993, raising their share in total nonperforming loans from 15.8 to 16.8 percent over the same period. Unlike in the Nordic countries’ banking crisis, problem loans were not concentrated in any one sector such as real estate.

Capital losses on bond portfolios emerged in 1994 mainly because banks had deliberately maintained maturity mismatches between predominantly short-term deposits and assets that included a long-term component. Much of the bond portfolio was normally hedged, but early in 1994, many had decided not to cover, due to expectations that interest rates would continue to decline. More recently, banks had decided to hedge their duration exposure, in at least one case by issuing bonds with similar duration to that of the bond portfolio. Some banks’ true portfolio losses may turn out to be somewhat larger than reported, due to the use of repurchase agreements for “window dressing.” Banks are only required to mark-to-market the portion of their bond portfolio that is actively traded, but the Bank of Italy has established a monitoring system that requires banks to report changes in the value of all assets and liabilities.

3. Disintermediation

Another development affecting the banking system is the slow growth of bank assets and liabilities. Bank lending fell off sharply in 1993 and the first part of 1994, but began to recover moderately in the second half of the year with the recovery of investment spending, especially by medium-size enterprises. The slow growth of lending was largely attributable to weak loan demand. In part, this was due to an increased role of retained earnings and other means of finance: especially, some export-driven companies were cash-rich, and some also launched successful equity issues earlier in the year. Bank lending was also characterized as more cautious, but there was no indication of a credit crunch induced by capital requirements, which were not a constraint on lending, at least for large banks. The fact that supply as well as demand was at work was reflected in the decrease in credit lines granted (credit accorded) as well as in credit used; a decrease in the ratio of credit drawn to credit granted and narrowing in spreads between lending rates and market interest rates are consistent with the view that the decline in loan demand played the dominant role.

The prevalence of foreign or offshore financing of bank lending decreased during 1994. Previously, there had been a substantial amount of funding of domestic loans through the Eurolira market, but this essentially ended with the abolition as of June 1994 of the reserve requirement on CDs with maturity over 18 months. 17/ Foreign-currency domestic credit also declined: prior to September 1992, many domestic borrowers had chosen to accept the exchange rate risk in order to obtain a lower interest rate, but such loans gradually declined as experience highlighted the magnitude of these risks.

At the same time, bank deposits grew relatively slowly. Particularly striking was the slow growth of CDs, despite the easing of maturity restrictions which allowed banks to issue CDs of any maturity. This was widely attributed to banks’ reluctance to compete for funds given the slow growth of lending. The spread between CD and Treasury bill rates widened by some 2 percentage points during the course of 1994, inducing the public to shift into Treasury bills. At the same time, the market for repurchase agreements with customers grew rapidly, enabling banks to finance their bond portfolios; the market had previously been restrained by a size limit, but this limit was lowered in 1994 to 1 billion lire (about $625,000) per transaction.

In conclusion, the slow growth of bank lending and deposits, which helped depress bank profits in 1994, is to a certain extent a temporary phenomenon associated with cyclical developments affecting investment and the mode by which this investment is financed. However, it also reflects, to a significant extent, the longer-term trend toward disintermediation and securitization also experienced in other countries, as developing financial markets offer firms more advantageous means of financing their activities as well as offering households a more diversified array of assets.

Some 20 percent of the banks made losses in 1994. The banks’ losses have not brought banks’ capital adequacy down to dangerously low levels: at end-1993, average bank capital adequacy reached 11 percent, and as of late 1994 was expected to remain significantly above the 8 percent minimum required by the EU. Within the average there was of course some variation of individual banks’ performance, and about a dozen had inadequate capital by late 1994. The problem of loss-making banks had a particular regional dimension, associated with the regional bifurcation of the Italian economy: on the whole, banks in the South experienced much greater loan losses and had weaker capital positions than those in the Center-North. The problems of banks in difficulties, particularly in the South, were addressed in two ways: for some small banks, takeovers were arranged with larger and solvent banks. For two large banks, some direct Treasury support was provided in connection with the Amato Law, and a further infusion may be needed, together with restructuring of the banks, to restore their capital to adequate levels.


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  • Grande, Giovanni, and Roberto Rinaldi, “Properties of Money Demand (M2) in Recent Years,” mimeo, Bank of Italy (1994).

  • Mastromatteo, Giuseppe, La domanda di moneta in Italia: Una nuova evidenza empirica,” Rivista Internazionale di Scienze Sociali 99 (April-June 1991), pp. 275292.

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  • Muscatelli, Vito Antonio, and Luca Papi, Cointegration, Financial Integration, and Modelling the Demand for Money in Italy,The Manchester School 63, No. 3 (September 1990), pp. 242259.

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  • Papi, Luca, Sviluppi recenti della domanda di moneta: 1’approccio del buffer stock,” Rivista di Politica Economica 74 (Series 3), No. 2 (January 1989), pp. 3972.

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See Lane, Timothy, Alessandro Prati, and Mark Griffiths, An Inflation Targeting Framework for Italy, forthcoming in the PPAA series.


The rate on fixed-term advances does not in practice put an actual ceiling on repo rates, since arbitrage between the two rates is not riskless due to asynchronous timing: the fixed-term advances are not allocated until the end of the day, when the repo market is closed, so a bank that wants to use a fixed-term advance to finance the purchase of a repo would have to purchase the repo first and then, at the end of the day, apply for a fixed-term advance to cover the resulting liquidity shortfall (taking the risk that the Bank of Italy would not give the advance).


The ratio was lowered in February 1993 to 17.5 percent from 22.5 percent. From March 1993 through May 1994, a lower ratio of 10 percent applied to CDs with maturities under 18 months.


Notably, U.S. residents were still subject to Italian withholding tax.


The latter requirement, however, led some institutions to undertake artificial transactions to boost their trading activity—so-called “whipped cream”—apparently wishing to become specialists more for the status than with the intention of participating as actively in the securities markets as this status implies.


Prepared by Timothy Lane.


Bank of Italy, Bolletino Economico, October 1994, p. 76.


Notwithstanding the mixed empirical evidence on stability of money demand, it is conceivable that money would perform better than alternative monetary indicators. Angeloni and Cividini (1990) examine the informational value of alternative financial indicators, and find that M2 out-performs other variables examined. Their analysis, however, is in the context of the Bank of Italy quarterly model, whose structure may favor M2 over other financial variables.


These studies vary in their dynamic specifications. Muscatelli and Papi (1990) use the Johansen approach to test the order of integration of the variables and estimate cointegrating equations. Mastromatteo (1991) uses the traditional lagged-dependent-variable approach, which may result in inconsistent estimates when (as is typical) the variables are nonstationary. Dooley and Spinelli (1989) use the traditional permanent income formulation.


In the Bank of Italy’s monthly model, estimated over a shorter period (1981-85), only the transactions-based specification is assumed.


Chart 28, based on Grande and Rinaldi (1994), plots actual month-to-month real M2 growth against the predictions of an equation in which explanatory variables include real GDP, interest rates (the own return on money, Treasury bill, and Treasury bond rates), a measure of variability of the T-bond rate, and total financial wealth.


Prepared by Timothy Lane.


Data refer to banks taking short-term deposits.


In some cases this was done by assuming pension liabilities.


These included many so-called “light branches”, small banking outlets specialized in deposit-taking.


By way of comparison, in 1991 the adjustment for non-performing loans reached 0.93 percent of commercial bank assets in Finland, 4.14 percent in Norway, and 1.83 percent in Sweden. (In Sweden, the losses of the savings banks were proportionately larger.) In all these Nordic countries unlike in Italy, however, the nonperforming loans resulted in losses for the banking system as a whole. For further discussion, see Burkhard Drees and Ceyla Pazargasioglu, “The Nordic Banking Crises: Pitfalls in Financial Liberalization?” (mimeo, IMF, 1995).


This followed two previous changes in reserve requirements: in February 1993, all reserve requirements were lowered to 17.5 percent; in March 1993, the rate on CDs with maturities in excess of 18 months was lowered to 10 percent.

Italy: Background Economic Developments and Issues
Author: International Monetary Fund