Italy
Detailed Assessment of Compliance with the Basel Core Principles for Effective Banking Supervision

This paper reviews findings of the Detailed Assessment of Italy’s Compliance with the Basel Core Principles for Effective Banking Supervision. The Italian banking system seems to exhibit a high degree of resilience to possible macroeconomic shocks, as supported by the evolution of some financial soundness indicators and by the results of various model simulations. Despite significant improvements over the last few years, the quality of banks’ loan portfolios remains moderate. Cost-cutting and restructuring remain key challenges for Italian banks, with several conjunctural factors putting pressures on costs and income.

Abstract

This paper reviews findings of the Detailed Assessment of Italy’s Compliance with the Basel Core Principles for Effective Banking Supervision. The Italian banking system seems to exhibit a high degree of resilience to possible macroeconomic shocks, as supported by the evolution of some financial soundness indicators and by the results of various model simulations. Despite significant improvements over the last few years, the quality of banks’ loan portfolios remains moderate. Cost-cutting and restructuring remain key challenges for Italian banks, with several conjunctural factors putting pressures on costs and income.

I. Background

A. General

1. An assessment of the Italian supervisory system’s compliance with the Basel Core Principles for Effective Banking Supervision (BCPs) was conducted on-site during June 16–27, 2003 by Mr. Keith Bell and Ms. Maria Nieto as part of an IMF-led mission.1 The Italian supervisory system was found to be of a high standard, achieving full compliance with 24 of the 30 BCPs. The Banca d’Italia (BI) conducts a comprehensive, sophisticated, and continuous process of off-site monitoring, closely integrated with a cycle of thorough on-site inspections. The cycle of on-site inspections is long; for small banking institutions identified by off-site monitoring as being without significant weaknesses, inspections are conducted on a three-year cycle and at longer intervals (not more than six years) for large banks. In line with the rapid developments in the scope and complexity of the banking industry, the BI is increasingly relying on focused and thematic inspections, especially regarding the large bank groups. Taking into account thematic inspections, the inspection cycle for large banks has recently been shortened to no longer than three years. There are areas where further regulatory strengthening is recommended, including loan evaluation and loan-loss provisioning, connected lending, and legal protection of supervisors.

B. Information and Methodology Used for the Assessment

2. The assessment is based on several sources: (i) a self-assessment prepared by the Italian authorities in March 2002; (ii) detailed interviews with senior officials and their technical teams at the BI; (iii) laws, regulations, and other documentation on the supervisory framework and on the structure and development of the Italian financial sector; and (iv) meetings with officials of the Ministry of the Economy and Finance (MoE), ISVAP and Consob, market participants, and representatives of selected financial institutions, industry associations, and members of the accounting and auditing professions.

3. The assessment was performed in accordance with the guidelines set out in the Core Principles Methodology.2 The assessment of observance of the BCP is not, and is not intended to be, an exact science. Banking systems differ across countries, as do their domestic circumstances. Furthermore, banking activities are changing rapidly around the world, and theories, policies, and best practices of supervision are swiftly evolving. Nevertheless, it is internationally acknowledged that the BCPs are seen as minimum standards.

4. The detailed assessment is based on the legislation in force at the time of the assessment and does not address proposed plans of reform of the Italian financial sector, initiated after the mission left the site but before the final publication of the report.

5. The assessment focuses only on the regulatory and supervisory framework of Italy’s banking sector. A number of other issues relevant to the soundness of the banking sector as a whole—including interlinkages of the banking sector with other financial sectors, the role of banks as “brokers” for financial instruments, related transparency issues, and regulation in nonbank financial markets—are beyond the scope of this assessment and shall be dealt with fully in the context of the upcoming FSAP requested by the authorities.

6. The assessors had full cooperation from the Italian authorities and received all the information necessary for the assessment.

C. Institutional and Macro Prudential Setting, and Market Structure Overview

7. Since 1990, the Italian banking system has undergone a rapid process of consolidation. The number of banks in Italy fell by 26 percent from 1,100 in 1990 to 814 in 2002; in the same time span 583 mergers and acquisitions operations took place. In 2002, there were 253 commercial banks (representing 80 percent of total bank assets); 461 mutual banks (5 percent of total bank assets); 40 cooperative banks (11 percent of total bank assets); and 60 branches of foreign banks (4 percent of total bank assets) (Table 1). The Italian financial sector included also 158 securities firms; 142 asset management companies; and 316 supervised financial companies. A large number of financial institutions are organized in groups operating over an interregional or nationwide network. In 2002, these groups represented 87 percent of total bank assets, of which the top three and five Italian bank groups accounted for, respectively, 38 percent and 52 percent of total bank assets.

Table 1.

Financial Sector Structure, 1992–2002

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Source: BI

Banks controlled by the State or by other public entities.

Participation of Foundations in banks.

Since 1999 total assets for Asset management companies include amounts relative to individual portfolio and pension funds. These data are netted out of the amounts of individual portfolios that are invested in mutual funds.

Participation in financial companies.

Includes only financial companies listed in the Special register held by BI.

8. The banking sector remains a core funding source for the domestic economy. Households hold almost three quarters (70 percent) of their liabilities in the form of short-, medium- and long-term bank loans, while firms hold less than one third of their liabilities in bank loans, with the remaining being primarily held in shares (around 50 percent). Between 1996 and 2002, household indebtedness (as a percent of GDP) rose from 19 percent to 24 percent, largely driven by real estate investment.3 The leverage of the corporate sector (debt as a percent of equity) fell from 103 percent in 1996 to 56 percent in 2000 before rising to 69 percent in 2002. While Italian corporate bonds are held primarily by private investors (95 percent),4 Italian government securities are held by a broader set of investors, including private investors (45 percent), nonbank residents (43 percent) and domestic banks (9 percent).

9. Since 1992, the state has significantly reduced its direct ownership in the Italian banking system. While in 1992 banks controlled by the state or by (nonprofit) foundations (Fondazioni) accounted for 66 percent of total bank assets, successive waves of privatization have drastically shrunken the share of state ownership in the banking system to 10 percent in 2002. As of end August 2003, Fondazioni have lost control in all large bank groups and own a majority stake5 in only 18 small banks representing less than 4 percent of total bank assets.6 Market discipline has improved with the greater transparency regarding the ownership structure of banks and the reduction in cross-shareholdings.7 There are still a few cases where cross-shareholdings allow a group of Fondazioni to control jointly more than 50 percent of a bank’s capital.

10. Over the last decade, Italian banks’ asset management products grew strongly, providing an important source of growth in commission income. This trend is reflected in banks’ greater income diversification. At the start of the 1990s, over 75 percent of banks’ gross income came from the traditional banking business of deposit-taking and lending. Ten years later, net interest income accounted for only 52 percent of gross income.

11. The integration between the banking and insurance sector is increasing, although financial conglomerates remain relatively less developed than in other large financial systems. Italian banks have expanded the range of their financial services to respond to customers’ greater demand for diversified investment products, in line with a general trend in Europe as well as worldwide. The major cross-linkages between insurance companies and banks take place mainly through commercial agreements that allow banks to sell standard life insurance products.8 So far, the creation of major bancassurance groups has not taken place in Italy, as has been the case in some other European countries. At end-2002, Italian banks had equity holdings in 74 insurance companies, of which they controlled 32 (representing less than 20 percent of insurance companies total assets). Insurance companies held interests in 32 Italian banks, including controlling interests in seven small banks (representing 0.4 percent of total bank assets).

12. The life insurance industry grew rapidly over the last few years, more than doubling its total premium from 26.5 million in 1998 to 55 million in 2002, representing 4.4 percent of GDP. At end-2002, 202 insurance companies (life and nonlife) were operating in the Italian financial sector, of which eight were companies incorporated abroad (five in the EU, and three in non-EU countries) and ten were listed on the stock exchange. In 2002, life insurance companies held up to 92 percent of their investment in bonds and less than one percent in real estate. Re-insurance activities remain limited, accounting for 4.4 percent of total life insurance premium.

Italy’s financial stability framework

13. The Italian banking system seems to exhibit a high degree of resilience to possible macroeconomic shocks, as supported by the evolution of some Financial Soundness Indicators (FSIs) (Table 2) and by the results of various model simulations, including stress tests, conducted by the BI. The mission did not conduct an independent assessment of the soundness of the banking sector, its potential vulnerabilities, and the main risks it faces. However, the evolution of Italy’s FSIs and discussions with the authorities and industry representatives suggest some key challenges looking forward. These include managing the high level of nonperforming loans and maintaining adequate provisions for credit losses and sustaining cost-cutting and restructuring efforts.

Table 2.

Financial Soundness Indicators, 1996–2002 1/

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Sources: Bank of Italy; and Eurostat.

Some data were provided directly by the Bank of Italy and have not been sourced to a published document.

Consolidated data.

Net earnings include the net change in the fund for general banking risks; capital and reserves are calculated as centered 13-month average.

Including loans to nonresidents and excluding bad loans.

Special administration and private preemptive agreements.

14. Despite significant improvements over the last few years, the quality of banks’ loan portfolios remains moderate. The ratio of nonperforming loans net of provisions to capital fell to 25 percent in 2002 from its record high of 64 percent in 1996, but it remains high relative to other European countries. Non-performing loans (“sofferenze”) and Substandard Loans (“incagli”) account for 3 percent of banks’ assets. Securitization has allowed some Italian banks to reduce the level of problem loans in their portfolios and better manage credit risk.9 Looking forward, continuing slow economic growth in Italy and abroad and increasing corporate indebtedness could contribute to pressures on the quality of the banks’ loan portfolio.10 In 2002, the largest share of credit exposure of the banking system was the nonfinancial sector (59 percent), followed by the household sector (21 percent), the financial sector (15 percent), and the government sector (5 percent).

15. Rising capital buffers mitigate banks’ vulnerability to external shock. Given the significant increase in subordinated liabilities and strong credit growth, in 2001 the BI called for a significant increase in the capital of the main banking groups. In response, between 2000 and 2002, on the aggregate the largest 14 bank groups increased their Tier 1 capital ratio from 5.4 percent to 6.1 percent and their overall capital ratio from 8.7 percent to 10.3 percent.11 The solvency ratio of the banking system, which had fallen progressively from 12 percent in 1994 to 10.1 percent in 2000, rose to 11.2 percent in December 2002.

16. Despite the improvements achieved so far, cost-cutting and restructuring remain key challenges for Italian banks, with several conjunctural factors putting pressures on costs and income. Since the mid-1990s, banks progressively reduced their operating expenditures, and the ratio of non-interest expenses to gross income fell from 67 percent in 1996 to 55 percent in 2001. More recently, however, with the poor performance of the financial markets, non-interest income, particularly commission-related activities, slowed down and the ratio of non-interest expenses to income increased again to 60 percent in 2002.12 With net interest income also declining generally since 1996, Italian banks experienced a 7.5 percent reduction in operating profits in 2002 and return on equity declined to 6.2 percent. In the current low interest rate environment, and with deposit interest rates being sticky downward, any further fall in interest rates would translate primarily into lower interest rate margins. A sharp reduction in operating costs, or an increase in productivity would therefore be necessary to balance the impact of downside risks of a further reduction in interest rates.

17. The prospects for costs and income, in conjunction with the ongoing and envisaged structural changes, translate into pressures for further consolidation in the Italian banking sector. Achieving a critical mass would be a key factor determining the success of Italian banks in facing future challenges in the banking industry.

18. The BI has a sophisticated system for monitoring the stability of Italy’s financial system. It has established a highly comprehensive reporting system, which requires banks to submit very detailed data on the activity performed domestically and at the foreign branches, both on an individual and consolidated basis. This data allows the BI to monitor the evolution of a wide range of financial indicators. For example, in its Central Credit Registry (CCR), the BI records detailed information on individual credit relationships.13 Also, the BI monitors the distribution of bank credit to firms by statistical estimates of borrowers’ bankruptcy risk, by matching credit information contained in the CCR with financial statements collected in private data bases (the Company Accounts Data Service and Cerved Data Service).14 At the microprudential level, the monitoring system focuses on banks’ risk areas and their organizational structure. A rating methodology, whose acronym is PATROL, focuses on five components: capital adequacy, asset quality, organization, profitability, and liquidity. An overall rating for each bank is derived based on the five components and additional available qualitative information.

19. At the macroprudential level, the BI examines four broad types of risks: credit risk, market risk, country risk, and interest rate risk. Given its access to a large pool of highly detailed data, the BI has adopted a “bottom-up” approach to financial surveillance. For credit risk, the BI monitors the overall credit quality (bad loans, and sectoral exposures) and estimates one-year default probabilities (PDs) over one business cycle of corporate borrowers. Based on these indicators, the BI conducts various types of model simulations and stress tests on a yearly basis.15 For interest rate risk, the BI conducts periodic stress tests according to the standard Basel procedure, which estimates the economic loss as a share of regulatory capital due to a given shift (from 100 b.p. to 60 b.p.) in the yield curve. The BI measures also banks’ exposure to market risk on a continuous basis, and assesses exposures to country risk on a quarterly basis.

20. Preparations for Basel II and the adaptations for the new IAS have provided a major push toward strengthening credit risk management. The large banks are at an advanced stage of preparation for adopting Basel II and IAS requirements, supported by the BI and the Italian Banking Association (ABI). At this time, two banks, accounting for roughly 30 percent of the system’s total assets, have had their market risk models validated by the BI and a few more banks are in the process of submitting their models to the BI. Reflecting the specifics of the Italian credit granting practices and loan recovery environment, Italy was allowed a five-year transition period to use 180-day past-due as the basis for estimating default rates (instead of the proposed 90-day past-due criteria in Basel II).16 The transition period will provide a valuable opportunity for banks, the BI, and the government to align credit practices, credit risk monitoring, and loan recovery arrangements with international practices. The BI works in close cooperation with all major banks to follow their progress in strengthening their data systems and credit processes in order to adopt the IRB approach to capital adequacy; most of these banks are already using internal rating systems in the credit evaluation process of corporate customers.

21. All insurance undertakings, including mutual insurance companies, are supervised and regulated by ISVAP (the Istituto per la Vigilanza Sulle Assicurazioni Private e di Interesse Collettive). Since 1998, ISVAP is a fully autonomous public institution established by law. Its responsibilities include the solvency of insurance companies, the sound development of the insurance sector, and transparency and fairness in customer relations.17 The promotion of competition is regulated by the Antitrust Agency, to which ISVAP sends, upon request, its non-binding opinion. ISVAP conducts both off-site (based on annual accounts and market data) and on-site examinations. In the case of violations, ISVAP has the power to propose sanctions to the Ministry of Production Activities and to impose them. The major supervisory challenges include the implementation of supervision on a consolidated basis,18 the prevention of cross-sectoral regulatory arbitrage,19 and the adoption of risk management techniques in line with new financial products, such as securitization operations.20

22. Italian securities market is supervised and regulated by the Italian Companies and Stock Exchange Commission (Consob), It aims at ensuring: (i) transparency and correct behavior of securities market participants; (ii) disclosure of complete and accurate information to the investing public by listed companies; (iii) accuracy of the facts represented in the prospectuses to offerings of transferable securities to the investing public; and (iv) compliance with regulations by auditors entered in the special register. Moreover, it conducts investigations regarding potential infringements of insider dealing and market manipulation laws. Consob manages its operating expenses autonomously on the basis of an annual budget approved by the Commission and its annual accounts are audited by the State Audit Office.

D. Summary of Assessment of Observance of the BCPs

23. The 30 BCPs are grouped into seven major categories as follows: (i) preconditions for effective banking supervision (BCP 1(1)–1(6)); (ii) licensing and structure (BCPs 2–5); (iii) prudential regulations and requirements (BCPs 6–15); (iv) methods of ongoing supervision (BCPs 16–20); (v) information requirements (BCP 21); (vi) formal powers of supervisors (BCP 22); and (vii) cross-border banking (BCPs 23–25).

24. Overall, Italy’s observance of the BCPs is high. The Italian supervisory system was found to be in compliance with twenty-four BCPs; largely compliant with five; and noncompliant with one BCP. On BCP 8 (Loan Evaluation and Loan-Loss Provisioning), BCP 10 (Connected Lending), BCP 14 (Internal Control Audit), BCP 19 (Validation of Supervisory Information), and BCP 21 (Accounting Standards), the system was assessed as “largely compliant.” On BCP 1(5) (Legal Protection for Supervisors), the system was assessed as “non-compliant.”

Preconditions for effective banking supervision (BCP 1(1)–BCP 1(6))

25. The broad objectives and responsibilities of the credit authorities are set out in the legislation (BCP 1(1)).21 Under the law, the Inter-Ministerial Committee on Credit and Savings (ICCS) is the administrative body, which issues broad guidelines on prudential supervision in the area of credit activities and the protection of savings. In practice, the BI takes the initiative in recommending regulatory and supervisory policy and has operational independence on day-to-day application of supervisory methods (BCP 1(2)). The BI has the legal responsibility to promote competition in the banking sector, in addition to fostering the overall stability of the financial system (1993 BL, Art.5(1)).

26. The BI’s supervisory program is wide-ranging. It covers prudential supervision (both on- and off-site) of deposit-taking institutions (many of which are components of large and complex financial groups), as well as of other financial companies, assessment of transparency controls in banking and financial transactions (other than investment services), promotion of competition in banking, and cooperation with the judicial authorities in various matters, including the prevention of financial crime.

27. The legal framework and practices governing the entry of credit institutions (BCP 1(3)) and the enforcement powers of the bank supervision authorities (BCP 1(4)) are satisfactory. The BI’s enforcement capacity, derived from well-designed coordination arrangements between on-site and off-site supervisors and sound legal enforcement powers (BCP 1(4)), is generally adequate. The BI, ISVAP, Consob, the Pension Fund Supervisory Authority (COVIP), and the Italian Foreign Exchange Office (UIC) are required to cooperate through ongoing formal and informal contacts, and may not invoke official secrecy against one another. To ensure an adequate cross-border information exchange, the Italian supervisory authorities have signed bilateral Memoranda of Understanding (MoUs) with their EU counterparts; Memoranda of Understanding and bilateral confidentiality agreements have been signed with a number of non-EU countries (BCP 1(6)).

28. The Italian system does not offer legal protection to its supervisors against court proceedings stemming from measures adopted in the performance of their functions in good faith (BCP 1(5)). The BI’s practice to cover the costs of legal defense for its employees represents a form of protection for its employees in performing their functions, but it is not fully equal to legal protection.

Licensing and structure (BCPs 2–5)

29. The framework and practices governing the activities of credit institutions, their licensing and investment criteria, as well as their ownership structure are satisfactory.

Prudential regulations and requirements (BCPs 6–15)

30. Prudential regulations are in line with established best practices and close consultation between the regulators, and the banking community facilitates the smooth introduction of regulatory reforms. Capital requirements (BCP 6) comply with the current Basel Capital Accord, and the regulatory framework regarding the internal controls of credit institutions and the monitoring by the supervisory authorities of their implementation (BCP 7) is satisfactory. Prudential supervision of large exposures (BCP 9), country risk and market risk (BCPs 11 and 12) are of a high standard. The supervisory and regulatory framework to ensure sound internal controls and risk management systems and to control money laundering (BCPs 13, 14, and 15) are satisfactory, with the caveat that the supervisory authority lacks sufficiently clear legal authority to require expeditious change in the composition of a bank’s board of directors and management whenever an incumbent no longer meets “fit and proper” criteria. Further areas where regulatory strengthening is required concern the classification of nonperforming loans and their related provisioning (BCP 8), and connected lending (BCP 10).

31. In comparison to practices in other G–7 countries, the impairment of loans and cessation of interest accrual appear to be recognized later in Italy. The BI’s guidance for loan classification, particularly regarding the classification of ‘substandard loans,’ leaves scope for Italian banks to overstate their performing loans and income in their reporting to the public and to the BI,22 although the BI’s monitoring of loan performance (and crosscomparison of loan classifications by different lenders to one borrower) through the CCR is a mitigating factor. On-site inspections, which occur on a cycle of up to six years for large banks (three years if thematic inspections are taken into account), often lead to the BI’s downward re-classification of loans from the ‘performing’ status accorded by the bank. The BI may wish to consider revision of the applicable supervisory instructions on loan classification so that they more closely match the practice in other G–7 countries, and provide further guidance on provisioning policies to be adopted by banks. In the context of the ‘New Basel Capital Accord,’ the Basel Committee has granted Italy, on the basis of its local credit conditions, a five-year transition period to use a 180-day past-due definition for impaired loans (as opposed to the standard “more than 90 days past-due” criteria).23 We note that the BI acknowledges the need to introduce more stringent objective criteria for the classification of impaired loans, notably with regard to “substandard” loans.

32. Securitization of loans is monitored comprehensively by the BI through very extensive reporting requirements, both to the BI and in banks’ annual reports (BCP 8). Securitization has allowed banks to improve credit risk management, and the BI regulatory approach allows it to accurately assess the capital requirements of banks involved in this type of transactions. This, in turn, will facilitate the adoption of Basel II requirements on securitization.

33. There is no comprehensive definition of, or limits on, “connected lending or lending to related parties” (BCP 10). Discretion is granted to the supervisors to make judgments about the existence of connections between the bank and other parties only in the context of large exposures. In order to minimize possible conflicts of interests, the 1993 BL and the related supervisory instructions provide for particular procedures for loans granted to banks´ connected and related parties. However, there is no provision (in law or regulation or supervisory instruction) requiring that exposures to connected or related parties only be granted on market terms. Neither do special reporting nor do limits exist on this type of lending, except those made in the context of large credit exposures.24 The authorities are strongly recommended to issue a comprehensive regulation on connected lending to address its definition, overall limits, and reporting to the BI.

Methods of Ongoing Supervision (BCPs 16–20)

34. The information available to the supervisor for monitoring and early detection of troubled institutions is abundant and timely. Integrated on-site inspections and off-site analysis (BCP 16), coupled with very detailed statistical data requirements (BCP 18) and frequent contact with banks’ management and staff (BCP 17), allow the BI to keep well informed on banks’ financial condition and management quality.

35. The BI can, and does, request auditors to examine specific aspects of banks’ financial accounts, but it does not rely on external auditors for the purpose of on-site inspections (BCP 19). The cycle of on-site inspections is long; for small banking institutions identified by off-site monitoring as being without significant weaknesses, inspections are conducted on a three-year cycle and at longer intervals (not more than six years) for large banks. Taking into account thematic inspections, the inspection cycle for large banks has recently been shortened to no longer than three years. In order to complement the BI’s reliance on its comprehensive process of off-site supervision, and taking into account the limitations on the frequency of on-site inspections, the BI should review the means by which it may derive greater benefit from the work of external auditors in the execution of its own mandate. Revising the 1993 BL would be desirable, so as to obtain the authority to revoke the appointment of the external auditors of a bank when their performance is deficient and to establish the standards of banks’ external audits and the scope of bank’s audit programs. In light of the rapid changes in the banking industry and risk management technology, the BI should continue to keep the adequacy of resources under review.

36. For banks that do not issue securities listed on a regulated exchange, there is no requirement to have external auditors examine and validate key supervisory reports and aggregates, or financial statements as a whole. Key supervisory aggregates, such as regulatory capital ratios, large exposures, or impaired loans, are included in the notes on the accounts but, at present, only those banks with securities listed on a regulated exchange, and the banks controlled by them (overall, 166 out of 814 banks as of December 2002), are required to have their accounts audited by external auditors. There are about a further 180 banks that have their accounts audited on a voluntary basis, leaving approximately 470 banks, mostly very small, that, for the time being, do not produce audited financial statements. However, the banks subject to external audit account for over 90 percent of the system’s total assets, and the current requirement for audit of accounts by external auditing firms is to be further expanded in January 2004.

37. In the course of on-site inspection of large banks the BI, in addition to its judgmental methods, may want to extend the use of statistical sampling methodologies for the evaluation of the credit risk of homogeneous categories of loans, which is at present applied only to consumer credit banks. This would ensure that its assessment of credit risk is based on a statistically representative sample of loans. The scope for thematic inspections could also be expanded.

Information Requirements (Accounting Standards (BCP 21))

38. Accounting rules and regulations are in line with EU Directives. However, the mission’s discussions with banks’ managements suggest that the system currently in use delays the recognition of impairment in the performance of a loan and the suspension of recognition of income from impaired loans. As noted above (paragraph 29), Italian banks will have a transition period of five years to move to the Basel II “default” definition. The adoption of the new IAS in 2005 (and in particular IAS 39) will also help align loan-loss recognition with international practices.

Formal Powers of Supervisors (BCP 22)

39. The BI’s enforcement capacity is adequate (BCP 22). The power of the BI derives from a flexible and comprehensive set of notification and corrective action procedures, effective bank resolution procedures, and sound enforcement powers.

Cross-Border Banking (BCPs 23–25)

40. Prudential regulations for banking groups are in line with established best practices and the close cooperation between the BI and foreign regulators supports the growth of sound cross-border financial activities. The regulatory framework for globally consolidated supervision over internationally active banking groups is satisfactory (BCP 23). Coordination with foreign supervisors to cover foreign operations by Italian banks (BCP 24) and operations in Italy by foreign banks (BCP 25) is adequate.

General preconditions for effective banking supervision

41. In the past five years, the Italian financial system was affected by major structural changes, including the creation of the European Monetary Union and the introduction of the Euro in 1999. With the launch of the Monetary Union, the BI has become an integral part of the Eurosystem, which comprises the European Central Bank (ECB) and the 12 national central banks (NCBs) of the Monetary Union. As a member of the European System of Central Banks (ESCB), the BI no longer conducts independent monetary policy. It participates in formulating monetary policy within the Eurosystem, and implementing the decisions at the national level. Also, the BI is responsible for managing its foreign exchange assets and performs all of the government’s treasury functions.

42. The 1993 BL and the 1998 Consolidated Law on Financial Intermediation (CLFI) define the general principles governing the activity of both bank and nonbank financial intermediaries. Detailed technical rules are deferred to secondary legislation, allowing for prompt adjustments to the evolving needs of financial intermediaries and markets. The institutional arrangements defining Italy’s financial system regulatory and supervisory framework are summarized in Table 3.

Table 3.

Regulatory and Supervisory Institutional Arrangements, 2003

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Sources: BI and ECB

In 2002, the assets of banks controlled by public entities or by foundations amount to 10 per cent of total bank assets.

Consob is the exclusive supervisory authority for investment services in matters regarding transparency and proper conduct.

BI is responsible for prudential supervision; whereas Consob is responsible for matters regarding transparency and proper conduct.

UIC is the Italian exchange office (Ufficio italiano dei cambi).

Consob is the Italian Companies and Stock Exchange Commission.

MoE stands for Ministry of Economy.

ISVAP is the supervisory authority for private insurance companies (Istituto per la Vigilanza sulle Assicurazioni Private e di Interesse Collettivo).

COVIP is the supervisory authority for pension funds.

BI is responsible for banks’ internal pension funds.

Since February 1998, the Post Office is a company, entirely owned by the Ministry of Economy.

43. The BI has extensive powers and responsibilities as the supervisor of the banking system. It is also responsible for supervising the financial markets that are relevant for monetary policy purposes, such as wholesale markets for government securities and interbank markets. The BI plays also a pivotal role in the drafting of regulations, the settlement of interbank payments, and the oversight of the securities clearing and settlement procedure. It is legally required to cooperate closely with Consob, the securities market authority responsible for matters regarding transparency and proper conduct of business, and has signed a protocol with ISVAP, the insurance sector supervisory authority, establishing a formal procedure for mutual cooperation between the two institutions on matters of common interest.25

44. The Italian corporate insolvency regime results in lengthy judicial proceedings, and a slow realization of collateral in the event of borrowers’ default. In the case of legal procedures, the main issues are lengthy bankruptcy procedures (lasting 6 to 7 years), costly recovery proceedings (approximately 2 percent of total operating expenses), and low recovery rates (around 38 percent of total amount owed, gross of legal fees).26 Banks prefer private out-of-court arrangements, which have a shorter settlement horizon (2 years versus 6 to 7 in the case of legal procedures) and a higher recovery rate (70 percent of total unsecured assets versus 20 percent in the case of legal procedures). But private agreements provide no legal protection to the creditors if the borrowers are eventually declared bankrupt. In 2000, the ABI issued a code of practice to promote private agreements. The government is examining a legal reform aimed at simplifying legal proceedings and maximizing the value of the distressed enterprise through restructuring. Significant changes in the legal framework for corporate insolvency would be needed to reduce the cost and time involved in loan recovery and to contain the loss given default (LGD).27 In contrast, the insolvency regime for individual banks, based on administrative procedures led by the BI, is fast and efficient, supported by deposit insurance and a framework for public intervention designed to prevent the distress in one bank resulting in systemic stress.

45. The legal framework for the liquidation or restructuring of single credit institutions is well defined. The BI plays a key role in the management of bank resolution. In the case of a bank liquidation, a strict coordination system is in place between the relevant parties, which procedures derive from rules and agreements set out in EU Directives and the ESCB legal framework.28 When a bank encounters serious problems, the BI can propose to the responsible minister that it be placed under ‘special administration,’ in essence a program for the bank’s rehabilitation. Should it be determined that rehabilitation is not possible, the bank may be taken over by another bank (or group of banks) or, in the alternative, the BI can propose that the bank be placed in “compulsory administrative liquidation” (CAL), a procedure equivalent to the bankruptcy of a commercial enterprise.

46. The BI determines the type of intervention and transmits its proposal to the Minister of the Economy and Finance. In the case of a proposal for the compulsory administrative liquidation of a bank, the BI Banking and Financial Supervision Department (BFS) coordinates with other relevant BI departments so that they are able to prepare in a timely fashion the necessary measures for managing a bank’s crisis before the actual proceedings begin. In particular, the Payment System Department ascertains whether the insolvent bank is a direct counterparty in the Italian payment system; the Monetary and Exchange Department ascertains whether the bank is a direct counterparty in the monetary operations; and the Market Oversight Office ascertains whether the bank is a direct counterparty in Italian markets. The relevant deposit insurance scheme is also informed about the BI’s proposed intervention. To minimize the disruption on the international payment system in the case of cross-border payment activities, the “International Contact Point” within the BI payment system is immediately notified. After the Minister of the Economy and Finance has signed a ministerial decree validating BI’s proposal, the BI appoints the special body or liquidating body, depending on the suggested solution. The BFS also gives notice of the date of issue of the ministerial decree (i.e., the effective intervention date) to the relevant parties, including agencies outside of the BI such as Consob (to inform the financial markets), Monte Titoli (to exclude the bank from its retail payment activities and securities settlement), the Casse di Compensazione e Garanzia (to exclude the bank from its clearing activities); the deposit insurance schemes (to initiate their guarantee intervention); and the International Contact Point (to transmit the information abroad to other competent authorities).

47. Italian banks benefit from a relatively generous deposit insurance scheme. Depositors in all banks incorporated under the Italian law (a total of 297 institutions), with the exception of mutual banks, are protected by the Italian Interbank Deposit Protection Fund (IDPF).29 The EU Directive 94/19 requires member countries to offer a minimum deposit insurance coverage of €20,000 per depositor. In Italy, the IDPF provides a much higher coverage than the required minimum, protecting deposits up to €103,291 per depositor.30 The IDPF can pay-off depositors, cover the shortfall between assets and liabilities in case of transfer of the failing bank to a third party, or provide support interventions such as credits, guarantees, and acquisitions of equity. These interventions can only be initiated when a bank is put under special administration. The money paid out by the IDPF is funded by the surviving banks, which are charged, on an ex-post basis, a riskadjusted premium calculated on the basis of the size of their protected funds and risk of their portfolio.31 Members’ commitment ranges between 0.4 percent and 0.8 percent of total reimbursable funds (or, between 0.4 percent and 0.8 percent of €332 billion). All interventions of the IDPF are subject to the authorization of the BI and the choice of intervention is determined by the “least-cost” principle. Since its creation, the IDPF has been activated in only six cases.32 In addition to the guarantees provided under the IDPF, the BI has used public funds to substitute or complement the coverage of the IDPF (resolution of December 23, 1986 of the ICCS and law 588/96).33 So far, the IDPF seems to have worked well under the strict surveillance of the BI. However, the relatively generous coverage, including its various guarantee and credit facilities, may need to be further revised in light of growing consolidation in the banking industry.

48. The IDPF does not have supervisory powers. It monitors the overall situation of its members on the basis of a number of financial ratios. If a member does not comply with the IDPF’s guidelines (in particular, regarding the bank’s risk profile and unpaid contributions), the IDPF can impose four types of sanctions. It can suspend a member’s voting rights at the General Meeting; remove a bank’s representative; impose pecuniary sanctions; and exclude a member from the IDPF. The latter action can only be imposed with the prior agreement of the BI. Since its creation, the IDPF has suspended a member’s voting right in only two cases and has never expelled a member.

49. The BI conducts its supervisory policies with a high degree of transparency, with confidentiality considerations to preserve both the effectiveness of its actions and the market sensitivity of information regarding individual financial institutions. The BI makes public the principles and criteria of its supervisory activity; establishes the time limits for the adoption of measures; and specifies the person responsible for each administrative procedure. The BI also publishes an annual report on its supervisory activity and disseminates continuous information on the state of the Italian banking and financial system. An abridged version of the BI’s annual report is available in English in hard copy and on the BI’s web site.

50. Prospective changes in transparency and disclosure framework for banking will further strengthen market discipline. Banks already disclose a highly detailed set of data to the BI, which uses this information both for micro- and macroprudential surveillance purposes. In addition, listed banks are required to disclose a large body of information to the markets. A key challenge is to continue to strengthen the transparency and disclosure of banks’ balance sheets and income statements as well as corporate governance practices. Further efforts in facilitating cross-country comparisons and investors’ analysis of this information would contribute to enhance market discipline. The market disclosure requirements for banks (currently governed by BI regulations issued following EC Directives in 1992) are in the process of major changes in order to implement IAS by 2005, and the prospective changes under Pillar III of Basel II. While a range of Financial Soundness Indicators (FSIs) and their analysis are presented in the BI’s Annual Report and other publications, a more systematic dissemination of the BI’s macro-prudential surveillance and financial stability analysis could also contribute to making market discipline more effective.

II. Detailed Assessment of Observance of the BCPS

A. Principle-by-Principle Assessment

51. The assessment of each principle is made on a qualitative judgment basis using five categories: compliant, largely compliant, materially non-compliant, non-compliant, and not applicable.

52. A principle will be considered compliant whenever all essential criteria are generally met without any significant deficiencies. A principle will be considered largely compliant whenever only minor shortcomings are observed, which do not raise any concerns about the authority’s ability and intent to achieve full compliance within a prescribed period of time. A principle will be considered materially non-compliant whenever, despite progress, the shortcomings are sufficient to raise doubts about the authority’s ability to achieve compliance. A principle will be considered non-compliant whenever no substantive progress toward compliance has been achieved. Principles will be considered not applicable whenever the BCP does not apply given the legal, structural, or institutional features of a country.

53. For each principle there is a descriptive part, which sets out the pertinent laws, regulations, policies, and practices. Based on this, and on its implementation, the assessment is concluded. There is also a comment section, specifying the character of any deficiency and providing guidance on how it might be remedied in order to improve compliance with the principle.

Table 4.

Detailed Assessment of Compliance with the Basel Core Principles for Effective Banking Supervision

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