This Selected Issues paper analyzes the conditions under which Italian banks can earn sufficient profits to grow out of their asset quality problems, rebuild capital buffers, and finance the real economy. A bottom-up analysis of the 15 largest Italian banks suggests that restoring sustainable profitability depends heavily on the growth outlook. Many banks are expected to become more profitable as the economy recovers, but their capacity to lend depends on the size of their capital buffers. However, a number of smaller banks face substantial profitability pressures, highlighting the need to reduce the large stock of nonperforming loans and for further cost cutting and efficiency gains.

Abstract

This Selected Issues paper analyzes the conditions under which Italian banks can earn sufficient profits to grow out of their asset quality problems, rebuild capital buffers, and finance the real economy. A bottom-up analysis of the 15 largest Italian banks suggests that restoring sustainable profitability depends heavily on the growth outlook. Many banks are expected to become more profitable as the economy recovers, but their capacity to lend depends on the size of their capital buffers. However, a number of smaller banks face substantial profitability pressures, highlighting the need to reduce the large stock of nonperforming loans and for further cost cutting and efficiency gains.

Profitability and Balance Sheet Repair of Italian Banks1

Elevated levels of nonperforming loans (NPLs) are weighing on bank profitability in Italy. This paper analyzes the conditions under which Italian banks can earn sufficient profits to grow out of their asset quality problems, re-build capital buffers, and finance the real economy, taking account of continued pressures from high provisioning and operating costs and declining net interest margins from negative policy rates. A bottom-up analysis of the 15 largest Italian banks suggests that restoring sustainable profitability depends heavily on the growth outlook. Many banks are expected to become more profitable as the economy recovers, but their capacity to lend depends on the size of their capital buffers. However, a number of smaller banks face substantial profitability pressures, highlighting the need to reduce the large stock of NPLs and for further cost cutting and efficiency gains.

A. Background

1. Italian banks face significant asset quality challenges and low profitability. In 2015, total NPLs reached about 18 percent of total loans (over €360 billion), and profitability was relatively low compared to other EU banks with return on equity averaging 3.1 percent. Although recent data suggest that NPLs appear to be stabilizing and that profitability has started to improve, the high stock of NPLs and the associated need for provisioning have dragged down banks’ earnings capacity,2 which in turn has limited the buildup of capital buffers and slowed the repair of balance sheets. Alongside anemic demand, impaired balance sheets have weighed down credit growth and the economic recovery. There is also a risk of amplifying asset quality challenges in instances where profitability of new lending is insufficient to offset the declining interest income from the existing loan book.3

A01ufig1

Loan Loss Reserves/Net Income, end-2015

(percent)

Citation: IMF Staff Country Reports 2016, 223; 10.5089/9781498355575.002.A001

Sources: Haver. Note: 1/ 2015 Q2 2/ 2015 Q3. 3/ 2014.

2. Repairing bank balance sheets is a policy priority, not least to facilitate new lending and support the incipient economic recovery. The cross-country experience of growing out of a debt overhang is generally that the economy grows, e.g., from an export-led recovery that increases the capacity of borrowers to service their obligations or reduces the relative share of impaired assets on bank balance sheets; or the economy inflates, reducing the real value of impaired claims; or the public sector bails out the banking sector. Within the euro area, neither inflation nor public sector bail-outs appear feasible, putting the onus on other approaches to invigorate the “self-healing powers” of a highly cyclical and fragmented banking system—such as facilitating bank consolidation and paving the way for cost-cutting, reforming insolvency regimes to enable workouts, and setting up other mechanisms to assist banks (e.g., GACS and Atlas, see Box 1).4 Crucial to the success of these approaches, however, is the ability of banks to be profitable to absorb the cost of reforms and build capital buffers to increase lending and enhance their resilience.

A01ufig2

Cost-to-Income Ratio, end-2015

(percent)

Citation: IMF Staff Country Reports 2016, 223; 10.5089/9781498355575.002.A001

Sources: EBA Risk Dashboard.

3. This paper evaluates quantitatively the current and prospective profitability of Italian banks and draws conclusions about the factors likely to drive the repair of the banking sector. It asks the following questions:

  • How profitable is extending credit for the 15 largest Italian banks that are supervised by the Single Supervisory Mechanism (SSM) under current funding and lending conditions?

  • By how much would profitability of current lending improve if all of the 15 largest banks were able to achieve a cost structure similar to the EU average or median?

  • What is the likely impact of the ECB’s TLTRO II on funding and lending rates, and how does it affect or improve banks’ prospects for profitability?

  • How will the profitability of new lending evolve under alternative growth projections given the lending-based business model of Italian banks?

  • Do banks for which lending is still profitable under conservative provisioning have enough capital to lend and support the recovery (and, thus, strengthen their own resilience as a result)?

4. The paper is organized as follows: Section B describes the data and methodology used. Section C presents the results, taking stock of the profitability of lending of Italian banks under current conditions and under an ECB TLTRO II scenario. It also presents some analysis of the profitability of new lending going forward under alternative growth scenarios and examines available capital buffers for potential loan growth. Section D offers policy considerations.

B. Data and Methodology

5. The paper uses publicly available data from the SNL database of S&P Global Market Intelligence for the 15 largest banks in Italy that are supervised by the SSM. These banks account for about 60 percent of system-wide assets.5 End-2015 quarterly data from SNL are used or, if not available, the latest available annual data.6

  • For each of the 15 banks, profitability is calculated as the net return on equity (RoE)7 based on net interest margins (NIMs), commissions/fee income, and operating expenses in the reported profit and loss statement of each bank, after accounting for firm-specific capitalization.8 The net RoE in year t is thus calculated as
    (1τ)CARt×RWAt¯((netinterestincomet+feesandcommissionstaverageassetst)(1operatingcosttnetincomet)LLPt1*),

    where τ is the tax rate, LLP* denotes the soon-to-be-adopted forward-looking provisioning standard9 (based on expected rather than incurred losses)10 implied by the average risk-weighted assets (RWA) reported by each bank for end-June 2015 in the recent Transparency Exercise of the European Banking Authority (EBA), and CAR denotes the capital adequacy ratio to determine the implicit regulatory leverage.

  • Using historical bank level data, we also compare lending spreads (derived from NIMs) and provisioning expenses contemporaneously to assess ex post whether banks would have been able to maintain their profitability under expected loss provisioning in the face of rapidly rising asset impairments over the last 10 years (between 2006 and 2015) so that
    actuallendingratet1(1τ)(lendingspreadt+feesandcommissionst(operatingcostt+LLPt1*)operatingincomet)0.11minimumlendingrate

Beyond the 15 banks, the latest system-wide data from the Bank of Italy (2014) are also used to draw lessons (as of end-2015, there were over 640 banks in the Italian banking system, of which 33 were cooperative banks and 365 were mutual banks). For the forward-looking analysis, lending rates are considered variable and adjust to the current marginal policy rate and the expected term spread compression consistent with the estimates in Elliott and others (2016).

6. Corresponding to the questions above, the following analyses are conducted to evaluate the impact of different variables on profitability:

  • Loan loss provisions (LLPs). Current and prospective provisioning affect projections of banks’ earnings. In the first analysis below, forward-looking LLPs that reflect expected losses are used, along with reported LLPs (using data from SNL on provisions relative to operating income). Forward-looking LLPs are calibrated to the default risk of the overall loan portfolio (consistent with a forward-looking accounting approach according to the forthcoming IFRS 9 accounting standard), which was obtained from the granular firm-specific credit risk weights published by the European Banking Authority’s latest Transparency Exercise (EBA, 2015) (with a cut-off of end-Q2 2015).12 In most cases, the forward-looking LLPs are higher than reported LLPs.

  • Operating costs. Recent reforms to consolidate banks would need to generate sizable cost savings. Italian banks have relatively high operating costs related, e.g., to their business models (they devote a larger part of their assets to lending to households and firms than in other countries) and the high number of branches per capita. Operating costs for the Italian banking system overall are marginally higher than the weighted average of EU banks (65 percent compared to 63 percent) (Bank of Italy, 2016) but significantly higher than the EU median (53 percent). Moreover, there is considerable variability of cost structures with some sample banks reporting significantly higher operating costs than others. The paper investigates how profitability changes if the cost-to-income ratio for each of the 15 largest banks declined to (i) the EU weighted average or (ii) the EU median, with the exception of a small number of banks whose cost-to-ratios are already below that benchmark.13

A01ufig3

Commercial Bank Branches per Capita

(Per 10,000 adults, 2014)

Citation: IMF Staff Country Reports 2016, 223; 10.5089/9781498355575.002.A001

Sources: World Bank.
  • ECB’s TLTRO II. To investigate the effect of credit easing on the profitability of lending, a scenario is constructed in which all Italian banks are assumed to participate in the ECB’s new targeted longer-term refinancing operations (TLTRO II) as of June 2016. It is further assumed that all banks cease to remunerate deposits, reducing their funding cost to as low as the ECB’s marginal refinancing rate (MRO) of zero percent.14 At the same time, lending rates are considered variable that adjust in response to the decline of the marginal policy rate (i.e., ECB deposit rate) and the historical pass-through of term premia to NIMs. These effects are estimated to lower the NIMs of Italian banks by 11 basis points on average (Elliot and others, 2016).15

  • Macroeconomic conditions. Three alternative macro assumptions are considered for assessing the impact of changes to the growth outlook on bank profitability: (i) staff’s baseline scenario, (ii) a severe downturn scenario, in which real GDP growth declines by more than 2 percentage points over the first two years (but recovers above baseline after that), and (iii) a stagnation scenario in which annual GDP growth is one-half of that in the baseline scenario (Annex, Figure A3). This forward-looking analysis is completed for the main components of net operating income (net interest margins) and asset impairments of the overall banking system keeping all other profit and loss elements unchanged, using the latest (2014) system-wide data from the Bank of Italy. The historical sensitivity of loan default probabilities to nominal growth is used to forecast changes in expected loss provisions,16 consistent with staff estimates of the relevant macro scenarios for Italy.17 Future lending rates and funding costs are aligned to projected changes in short- and long-term interest rates over a five-year forecast horizon, accounting for the funding mix of Italian banks at end-2015,18 while a gradual phase-in of TLTRO as a funding source is assumed.

  • Capital. Finally, the paper investigates the amount of new bank lending that can be supported by available capital buffers. Even if lending were profitable, capital buffers may be adequate for only a certain quantum of new lending. To this end, the available capital buffer is calculated, taking into account Pillar I and II capital requirements under the recent ECB’s Supervisory Review and Evaluation Process (SREP). Potential net loan growth is then calculated assuming unchanged CAR and overall credit quality of the loan portfolio and a minimum capital buffer of 2 percentage points over the minimum of 12.7 percent.

C. Results

Profitability of Current Lending and Provisioning Levels

7. Current lending is profitable for the larger sample banks—including under the assumption of forward-looking provisions19—but some smaller banks are likely to continue generating losses, owing to low interest earnings (including from high NPLs) and high operating costs.

  • Under expected LLP, current lending by about half of the banks in the sample—about 83 percent of the banking sector in terms of total outstanding loans—generate profits amounting to a system-wide weighted-average annual net return on equity (RoE) of 0.7 percent at end-2015. However, a disaggregated analysis reveals that a number of smaller banks (representing about one-eighths of total loan volume of all banks in the sample) are likely to experience losses. While the cost of funding is broadly comparable to those in other euro area countries, the high level of LLPs in relation to net income reveals the fundamental problem of lack of profitability in core business caused by high provisioning expenses and operating costs.

  • The calculations above are robust to the use of reported provisioning according the existing accounting standard (IAS 39), and confirm that several smaller banks face particular challenges. For the 15 largest banks, the weighted average net RoE improves to 2.1 percent, but three smaller banks (accounting for about 5 percent of the outstanding stock of loans in Italy) still generate losses from current lending (Figure A2). For the system of a total of over 640 banks, the net RoE is somewhat lower at −1.6 percent in 2014 according to the latest available data published by the Bank of Italy (and rises to 1.4 percent if projected to 2015 consistent with the performance of the 15 SSM banks in the sample).20 These results highlight that there are a number of smaller banks in the system with weaker asset quality and lower profitability than the 15 SSM banks.

A01ufig4

Italy: Estimated Net Return on Equity of Current Lending and Expected Loss Provisions

(percent), end-2015 1/

Citation: IMF Staff Country Reports 2016, 223; 10.5089/9781498355575.002.A001

Sources: Bloomberg L.P., SNL and IMF staff calculations.Note: */ The sample was split into three tiers (of 5 banks each), ordered by expected loss provisions (end-Q3 2015), weighted by total loans.

8. In that regard, in recent years, the deterioration of asset quality in the Italian banking sector seems to have outpaced sustainable provision coverage. Extending the analysis to historical data for the 15 sample banks—and assuming that banks would set aside provisions according to expected losses21—suggests that, since 2012, lending rates on average were far below what would have been required for banks to fund sufficient loan loss reserves ex post. Or put differently, if credit conditions reflected subsequent loan performance, the rise of NPLs (and resultant provisioning needs) in the past would have implied a higher minimum lending rate for banks to maintain their profitability.22 The picture looks somewhat better based on reported provisioning, although the general trend is the same (Figure A2). Past lending growth seems to have been associated with higher NPLs and, thus, lower net RoE for smaller banks on average (Garrido and others, forthcoming). A high degree of banking sector competition in an environment of excess supply might also have contributed to lower lending rates than what would have been warranted by banks’ existing cost structure and risk tolerance.

9. Greater operational efficiency and incentives to raise loan loss reserves in good times would help enhance the resilience of the banking sector. The conclusion of this partial equilibrium analysis is not that raising lending rates or tightening credit standards would have solved the profitability problem, as doing so would have dragged down real economic activity, in turn further worsening bank asset quality and raising funding costs. Rather, alternative solutions are needed, such as significantly lowering costs and enhancing provisioning standards. Improving the operational efficiency of all 15 SSM banks to the euro area weighted average cost-to-income ratio of 63 percent would result in a significant improvement of banks’ earnings capacity from current (and future) lending, improving the weighted average net RoE by more than 40 percent. If Italian banks were able to improve operational efficiency to that of the EU median (53 percent), the weighted average net RoE would triple.

A01ufig5

Italy: Difference between Actual and Breakeven Lending Rates for Sample Banks (Expected Loss Provisioning)

(percent, weighted average) 1/

Citation: IMF Staff Country Reports 2016, 223; 10.5089/9781498355575.002.A001

Sources: Haver, SNL and IMF staff calculations.Note: 1/ weighed by total loans (as of end-2015); expected loss provisions derived from risk-weighted assets (RWAs) as per methodology described in Annex, Box A1.
A01ufig6

Italy: Estimated Net Return on Equity of Current Lending (with and without improvement in cost efficiency)

(percent), end-2015

Citation: IMF Staff Country Reports 2016, 223; 10.5089/9781498355575.002.A001

Sources: SNL and IMF staff calculations.Note: The sample was split into three tiers (of 5 banks each), ordered by RoE and weighted by total loans; 1/ assuming that all banks improve their cost-income ratio to the euro area median (53 percent).

Potential Impact of Monetary Easing

10. Credit easing would improve overall bank profitability, but it is not expected to materially alter the negative earnings outlook for some smaller Italian banks. The ECB’s TLTRO II facilitates the pass-through of lower bank funding costs to credit supply while mitigating the potentially adverse impact of negative rates on banks’ profitability. We find that the weighted-average net RoE improves to 2.8 percent under expected loss provisioning, assuming sufficient loan demand. However, for one-third of the banks in our sample, current lending would still be unprofitable. Using reported provisioning improves overall system profitability to a weighted-average net RoE of 4.0 percent, but there are still some banks with weak profitability and three banks that generate sizable negative returns from current lending (Figure A2).

A01ufig7

Italy: Estimated Net Return on Equity of Current Lending under Expected Loss Provisioning (with and without funding benefit due to TLTRO II)

(percent), end-2015 1/

Citation: IMF Staff Country Reports 2016, 223; 10.5089/9781498355575.002.A001

Sources: SNL and IMF staff calculations.Note: Note: 1/ Funding rate at MRO (0%) via TLTRO II (and full rollover of existing TLTRO); any new deposits at 0%; lending rates adjust according to marginal policy rate (since end-2015: -20 bps) and expected pass-through from term spread compression at historical elastivcity of NIMs banks maintain their capital ratio as of end-2015.

11. These results suggest that there is significant heterogeneity among the SSM banks. There are some relatively profitable banks both under current conditions and TLTRO II; some banks that generate little or slightly negative profitability from lending under current conditions but may be helped by monetary accommodation (e.g., TLTRO II) and improvements in operational efficiency; and some banks that would experience very negative profitability even under optimal funding conditions.

A01ufig8

Italy: Estimated Net Return on Equity from Current Lending and New Lending under Baseline Scenario (with and without funding benefit from TLTRO II) 1/

(percent)

Citation: IMF Staff Country Reports 2016, 223; 10.5089/9781498355575.002.A001

Sources: SNL and IMF staff calculations.Note: 1/ Funding rate at MRO (0%) via TLTRO II (and full rollover of existing TLTRO) any new deposits at 0%; lending rates adjust according to marginal policy rate (since end-2015: -20 bps) and expected pass-through from term spread compression at historical elasticity of NIMs banks maintain their capital ratio as of end-2015; 2/ end-2015 and historical prov.=backward-looking provisioning (IAS 39);3/ expected loss provisioning (consistent with IFRS 9); and 4/ based on aggregate data reported by Banca d’Italia for end-2014, projected for 2015 as starting point for the scenario-based analysis.

Profitability of New Lending Under Different Scenarios

12. Current profitability challenges reflect the pro-cyclical nature of Italian banks’ business model. Italian banks devote a large part of their assets to lending to household and firms; among the latter, small and medium-sized enterprises (SMEs) play a more important role than in other countries, which imposes a more rigid cost structure and limits the extent to which banks can seize scale economies. Thus, the lending-based business model accounts for an important part of the low profitability, with banks performing worse in recessions. Conversely, improvements in the growth outlook might change the profitability for Italian banks considerably—and potentially more so than for peers in more heterogeneous financial systems.

13. A scenario-based assessment of profitability suggests profitable new lending in the near term, but only a significant reduction of NPLs and robust growth would help shore up the resilience of the banking sector (Figure A3).

  • Results under staff’s baseline scenario show that banks would, on average, make profits from new lending over the next five years (even under conservative provisioning). The projected average annual net RoE of 3.2 percent over the next three years would, however, remain far below the pre-crisis average of 13.8 percent.

  • Under the downside and stagnation scenarios, the projected average annual net RoE for the banking sector would decline to −8.4 and 0.8 percent, respectively, over the next three years. Default risk would overwhelm any benefit from risk mitigation over the short and medium terms.

Credit Growth and Capital Buffers

14. For larger, more profitable banks, higher credit growth is crucial to improve bank profitability in an environment of declining interest rates. Given the wide deposit base of Italian banks and the high proportion of variable rate loans, the extent to which deposit rates are sticky has a direct impact on how the low interest rates affect bank profitability. Thus, even if Italian banks were to fund themselves increasingly via money markets, lower wholesale funding costs will benefit only new lending and does not offset the negative impact of lower rates on existing loans if credit growth is insufficient. As noted earlier, the ECB’s recently expanded asset purchase program and the negative marginal policy rate have flattened the yield curve and are estimated to lower the NIM of Italian banks by 11 basis points on average (Jobst and Lin, 2016). For banks to maintain profitability over the amortization period of their current loan book, this potential reduction in the NIM implies ceteris paribus a need for higher lending growth by at least 3.6 percent annually (or about 3.0 percentage points above current credit growth).23 Hence, lower profitability from financial intermediation—amplified by current structural challenges affecting bank performance—might override possible mitigating effects from higher asset prices and pricing frictions.

A01ufig9

Annual Loan Growth Required to Maintain Current Net Interest Margin, end-2015

(y/y percent change) 1/

Citation: IMF Staff Country Reports 2016, 223; 10.5089/9781498355575.002.A001

Sources: Bloomberg L.P., EBA Transparency Exercise (2015), ECB, SNL, and IMF staff calculations.Note: 1/ based on the historical pass-through of policy rates and the elasticity of net interest margins to changes in term premia between Jan. 2010 and Feb. 2016; total mortgage and corporate loans at end-2015 to EA residents.; scenario is based on the estimated impact of the increase of monthly asset purchases (until Sept. 2017) by the ECB and a reduction of the deposit rate by 10 bps (as per ECB decision on March 10).
A01ufig10

Italy: Potential Loan Growth Exhausting Available Capital Buffer

(percentage share of total loans), ordered by relative share, end-Q3 2015 1/

Citation: IMF Staff Country Reports 2016, 223; 10.5089/9781498355575.002.A001

Sources: Bloomberg L.P., EBA, ECB, SNL and IMF staff calculations.Note: 1/ assumes unchanged capital adequacy ratio (CAR) and overall credit quality of loan portfolio, subject to a capital buffer of 2 percentage points over the minimum of 12.7% (based on Pillar I (4.5%), capital conservation buffer (2.5%), and Pillar IIA and IIB requirements of 2.7% and 3.0%, respectively); 2/ lending growth needs to be 2.5% (or higher) over a two-year period for banks to access TLTRO II funding from the ECB at the marginal policy rate (i.e., deposit rate).

15. From a macroeconomic viewpoint, capital and/or credit demand may not be high enough to allow sizable new lending to help banks maintain profitability. Most banks exceed the regulatory capital adequacy requirements; thus, from a prudential viewpoint, there is no need for further capital. But while most banks would generate profits from current lending, capital buffers may suffice to support only a limited amount of new lending, constraining the capacity of viable banks to increase profitable lending and rebuild their capital buffers in order to enhance their ex ante resilience to shocks. Indeed, assuming no change to the current capitalization or credit quality of loan portfolios (under the benign assumption that banks exhaust available capital buffers, including any managerial buffers above the regulatory minimum), only a few banks that generate profits from current lending also hold sufficient surplus capital in excess of the regulatory minimum to extend new loans (text figure). On average, potential loan growth would amount to 1.4 percent, which is close to the benchmark lending rate required to access TLTRO II funding (see text figure) at most favorable terms (i.e., at the ECB’s deposit rate of currently −0.4 percent). However, this theoretical maximum remains far below the rate of 3.6 percent required to maintain currently profitability in light of declining NIMs. Moreover, the continued lack of sufficient credit demand could further delay the improvement of banks’ earnings capacity, especially for those banks that struggle with high levels of impaired assets (text figures below).

A01ufig11

Italy: Required Lending for TLTRO-II Benchmark

(Jan. 2015=100)

Citation: IMF Staff Country Reports 2016, 223; 10.5089/9781498355575.002.A001

Sources: Deutsche Bank, ECB, and IMF staff calculations.
A01ufig12

Italy: Potential Loan Growth Exhausting Capital Buffer and Estimated Net Return on Equity of Current Lending 1/2/

(percent of total loans/percent), end-2015

Citation: IMF Staff Country Reports 2016, 223; 10.5089/9781498355575.002.A001

Sources: Bloomberg L.P., EBA, ECB, SNL and IMF staff calculations.Note: */ The sample was split into three tiers (of 5 banks each), ordered by estimated net return on equity, weighted by total loans; Sources: SNL and IMF staff calculations; 1/ based on expected loss provisioning; 2/ assumes unchanged capital adequacy ratio (CAR) and overall credit quality of loan portfolio, subject to a capital buffer of 2 pcp over the minimum of 12.7% (based on Pillar I (4.5%), capital conservation buffer (2.5%), and Pillar 2A and 2B requirements of 2.7% and 3.0%, respectively).
A01ufig13

Italy: Potential Loan Growth Exhausting Capital Buffer and Asset Quality 1/

(percent of total loans), end-2015

Citation: IMF Staff Country Reports 2016, 223; 10.5089/9781498355575.002.A001

Sources: Bloomberg L.P., EBA, ECB, SNL and IMF staff calculations.Note: */ The sample was split into three tiers (of 5 banks each), ordered by reported NPLs (end-2015), weighted by total loans; Sources: SNL and IMF staff calculations; 1/ assumes unchanged capital adequacy ratio (CAR) and overall credit quality of loan portfolio, subject to a capital buffer of 2 pcp over the minimum of 12.7% (based on Pillar I (4.5%), capital conservation buffer (2.5%), and Pillar 2A and 2B requirements of 2.7% and 3.0%, respectively).

16. Moreover, higher loan growth will not solve the profitability challenge of a number of smaller banks in Italy. As noted earlier, high expected provisions against the backdrop of low interest earnings and high operating costs imply that new lending is unlikely to ameliorate losses or cost pressures, under the given conservative provisioning standards going forward. Indeed, the market pressures witnessed since early 2016 appears to reflect investor discomfort with prospects of some banks to be able to get ahead of their profitability challenge, barring strong action, such as for instance on accelerating the disposal of the high stocks of NPLs.

D. Policy Recommendations

17. Profitability in Italy’s banking system remains weak, reflecting elevated NPL levels, low interest earnings, and relatively high operating costs. High levels of NPLs restrict banks’ ability to supply credit to the real economy and support the economic recovery, while reduced bank profitability inhibits a timely repair of balance sheets through retained earnings. Although actions by the ECB have helped improve funding conditions, the results in this paper point to significant heterogeneity among the banks in our sample. A number of banks can profitably support new lending, although the amount of new lending is generally constrained by existing capital buffers. However, some banks are likely to continue struggling to be profitable—even under extremely favorable funding conditions due to the ECB’s monetary easing and/or after considering improvements in operational efficiency—not least because profitability of new lending is insufficient to offset the declining interest income and high provisioning cost associated with the existing loan book.

18. Without countervailing policy measures, the combination of high NPLs and low profitability in Italy will continue to weigh on the recovery. Even if demand for credit were to be lifted from its currently subdued levels, banks’ capacity and willingness to lend are likely to remain modest, particularly as needed provisioning could continue to exert notable downward pressure on profitability going forward. This would weigh on the pace of economic recovery. Reducing NPLs significantly is therefore crucial to spur lending, especially to SMEs that are more reliant on bank financing. Further, “unclogging” the bank lending channel would enhance the transmission of monetary policy to the real economy. Resolving impaired loans would also encourage corporate restructuring and allow the debt of viable firms to be restructured, while accelerating the winding-down of nonviable firms. However, there is still a significant pricing gap between the net book value and the market price of NPLs due to a depressed housing market and structural deficiencies that slow the recovery of collateral for distressed assets. The lengthy foreclosure process has made it difficult for Italy’s banks to sell NPLs because investors value loans by discounting future cash flows (with larger haircuts required the longer the average time for foreclosure); this has been amplified by the absence of a developed market for distressed debt providing a benchmark for pricing NPLs.

19. The authorities are taking steps to address structural obstacles to NPL resolution to enhance the resilience of the banking sector. A recently issued decree law aims to reduce the long average foreclosure time by simplifying bankruptcy procedures and speeding up the recovery of collateral, although this is likely to impact new NPLs and thus would be expected to have its full impact only gradually over time. The time period for the tax deductibility of write-offs and provisions was shortened from five years to just one year. In addition to reforms in the areas of insolvency and bank corporate governance, the establishment of an industry-sponsored backstop fund for recapitalization of troubled banks and for investment in distressed assets (Atlante) and agreement with the European Commission on a scheme for NPL securitization (GACS) can help overcome some of the obstacles to resolving current asset quality challenges (Box 1).24

20. Accelerating NPL resolution can help raise bank profitability and stimulate lending. Banking supervisors should engage banks to provide credible plans to reduce significantly the NPLs overhang over the medium term. At the same time, other complementary measures can support these efforts and enhance the resilience of the banking sector to shocks. Enhanced supervision, advancing insolvency and enforcement reforms, and the facilitation of distressed debt markets will help tackle the large stock of NPLs. Building on recent reforms of large cooperative and mutual banks, the viability of banks not subject to the ECB’s comprehensive assessment should be assessed, with follow-up actions in line with regulatory requirements.

Italian NPLs: Recent Government Initiatives

The Italian authorities recently launched a mechanism, called GACS, to guarantee investment-grade NPL securitization transactions; while private sector actors created an investment fund, called Atlante, to backstop capital issuance of smaller (distressed) banks and possibly buy junior tranches of NPL securitization transactions. In addition, the authorities also adopted a series of measures aimed at expediting foreclosures on NPLs to corporate and small and medium-sized enterprises (SMEs).

Garanzia Cartolarizzazione Sofferenze (GACS). In late January 2016, the Italian authorities agreed with the European Commission on a mechanism for government guarantees to the securitization of impaired assets. The mechanism provides government guarantees for the securitization of bad loans. The authorities had initially sought to create a system-wide asset management company (AMC), but were unable to overcome concerns related to state aid restrictions on public sector support to banks that are not in resolution or restructuring outside stress periods. Under GACS, banks can sell their bad loans at market values to special purpose vehicles for their eventual sale to markets. They can buy public guarantees for the senior tranches of securities issued against these bad loans, as long as these tranches are rated as investment grade. Since the guarantees are priced at market terms based on expected losses, they do not imply any public support subject to EC approval under EU State aid regulations. The full impact of the agreed mechanism is unclear at this moment. Market participants (JP Morgan, 2016; Deutsche Bank, 2016) expect it to have a positive though modest impact. This is because the transfer price for securitizing NPLs with government guarantees via GACS does not seem sufficient to close the pricing gap between the market value and their carrying value in banks’ books (market participants estimate the pricing gap to be around 20 percent, while GACS is expected to close this gap by around 2–3 percentage points only). This highlights the importance of some of the additional reforms in the insolvency framework and other economic measures (Aiyar and others, 2015).

A01ufig14

Italy: Contribution to Atlas Fund and Capital Buffer 1/

(percent), end-March 2016

Citation: IMF Staff Country Reports 2016, 223; 10.5089/9781498355575.002.A001

Sources: SNL and IMF staff calculations.Note: 1/ Capital buffer is approximated as the difference between CAR and SREP.

Overview of Contributions to the Atlas Fund

article image
Sources: Autonomous Research, Bloomberg L.P., ECB, Moody’s Investor Service, and IMF staff calculations.Note: CAR=capital adequacy ratio.

The Supervisory Review and Evaluation process (SREP) refers to bank-specific capital requirement defined by the ECB as part of the SSM. UniCredit’s SREP figure includes a capital buffer of 25 bps as global, systemically important bank (G-SIB).

Atlante Fund. In April 2016, the largest Italian banks, nonbank financial institutions and banking foundations, with minority participation (8 percent) by the mostly publicly-owned Cassa Depositi e Prestiti (CDP) created a fund to act as a backstop facility for ongoing banks’ capital increases. That is, the fund will be a buyer of last resort, and could also buy non-investment grade tranches of NPL securitization transactions, while senior tranches might be more easily sold to the other institutional investors. The fund can also invest in real estate assets. The fund managed to collect €4.25 billion by April 29, 2016. Unicredit SpA and Intesa Sanpaolo Spa disclosed that they would each take a €1 billion stake in the fund, the largest among the participating banks (see table below). Note that the capital impact of contributions scales to the available capital buffer after application of SREP requirements (see chart). Atlante invested €1.5 billion of its resources in the capital raising by Banco Popolare di Vicenza, taking over 99 percent stake in the bank in May 2016. Banks are requested to deduct the amount invested in Atlante from regulatory capital; however, the impact on capital ratios is estimated to be modest.

Enhanced debt enforcement. On April 29, the Italian authorities adopted a series of measures aimed at expediting foreclosures on NPLs to corporate and smaller and medium-sized enterprises (SMEs). The three main changes to the current foreclosure process: (i) a new type of loan contract that will allow banks to sell real estate collateral even if borrowers are subject to insolvency proceedings (so creditors do no longer have to wait for the completion of a lengthy insolvency process before repossessing collateral); (ii) creditors and borrowers can renegotiate existing loan agreements so that this new provision applies to outstanding loans; and (iii) bankruptcy hearings can be done remotely via the internet. The government estimates that it will take less than a year to collect collateral under the new framework.

Appendix

Calculating Forward-Looking Provisions Based on Risk-Weighted Assets

We estimate forward-looking (expected loss) provisioning LLP* by aligning loan loss provisions (relative to operating income) to the average risk density of the current loan portfolio, so that

loanlossprovisionsnetoperatingincome=(0.00092×RWA20.06×RWA+1.662)×lossgivendefault100.

For the historical analysis of provisioning rates (and as benchmark for reported loan loss reserves), we obtain the RWA of performing credit exposures as of end-June 2015 from the recent EBA Transparency Exercise (with the exception of Banca Monte dei Paschi di Siena SpA and Banco Popolare Società Cooperativa for which data from the SNL database were used). For the forward-looking analysis based on different macroeconomic scenarios, we calculate the RWAs of the aggregate loan portfolio of each bank for a given probability of default (PD) using the credit risk assessment for loans under the internal ratings-based approach (IRB) of the Basel III framework (BCBS, 2005) based on1

RWA=K×12.5×EAD

where

K=LGD×[N(11R×G(PD)+R1R×G(0.999))PD]×1+(M2.5)b11.5b(1)b=(0.118520.05478×ln(PD))2

and

R=AVC×(0.12×1e50*PD1e50+0.24×(11e50*PD1e50)).

N(x) and G(z) denote the cumulative distribution function and the quantile function of the standard normal distribution; LGD is the loss given default; EAD is the exposure at default; AVC is the asset value correlation, takes the value AVC = 1.25 if the company is a large regulated financial institution (total asset equal or greater to US$100 billion) or an unregulated financial institution regardless of size; else AVC=1. For our analysis, we set AVC=1 and LGD=45 percent. For simplicity (and due to data constraints regarding the weighted-average maturity of the loan portfolio), we ignore the maturity adjustment in the specification above by removing the term 1+(M2.5)b11.5b (which transforms the formula in equation (1) to that used for the assessment of residential mortgage exposures but retains the AVC term for the determination of the correction factor R).

1 Owing to absence of granular data on the maturity of the loan portfolio, this simplified approach was chosen (without loss of generality).
Figure A1.
Figure A1.

Italy: Estimated Actual and Break-even Lending Rates

Citation: IMF Staff Country Reports 2016, 223; 10.5089/9781498355575.002.A001

Figure A2.
Figure A2.

Italy: Profitability under Reported and Forward-looking Provisioning

Citation: IMF Staff Country Reports 2016, 223; 10.5089/9781498355575.002.A001

Figure A3.
Figure A3.

Italy: Aggregate Profitability under Different Macro Scenarios

Citation: IMF Staff Country Reports 2016, 223; 10.5089/9781498355575.002.A001

Figure A4.
Figure A4.

Italy: Bank Capital under SREP

Citation: IMF Staff Country Reports 2016, 223; 10.5089/9781498355575.002.A001

Sources: SNL and IMF staff calculations.Note: */ The sample was split into three tiers (of 5 banks each), ordered by the capital adequacy ratio (CAR), weighted by total loans.

References

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1

Prepared by Andreas (Andy) Jobst and Anke Weber. We thank staff from the Supervisory and Economics Departments of the Banca d’Italia as well as Rishi Goyal, Phakawa Jeasakul, Kenneth Kang, Dermot Monaghan, Hiroko Oura and Camelia Minou for their helpful comments and suggestions. We are also grateful to staff from the Directorate General for Macro-Prudential Policy and Financial Stability and the Directorates General Micro-Prudential Supervision I to IV at the European Central Bank (ECB) for their feedback on parts of this analysis, which was used in the 2016 Art. IV Consultation Staff Report for the Euro Area.

2

The chart showing loan loss reserves is based on publicly available data reported by Haver. The heterogeneity of the banking sector in different countries and variations in country coverage influences the conclusions that can be drawn from a cross-country comparison.

3

There are also structural needs for more bank capital as a result of ongoing regulatory reform and supervisory actions at a time when operating profitability remains low. Italian banks will need to raise their bail-inable liabilities to meet the requirements of the new bank resolution regime. Banks in resolution can only receive state funding after 8 percent of liabilities have been “bailed-in.” In addition, banks are currently permitted more lenient risk-weights than under Basel rules, suggesting further capital needs when the more restrictive use of internal models for both credit and operational risk is finalized later this year.

4

The legislative reforms introduced in August 2015 and May 2016 are important steps that can help speed up insolvency processes and enforcement, especially for new lending going forward (Garrido, forthcoming).

5

Specifically, the following variables from SNL are used or constructed: net interest income/average assets, cost of funds, cost-income ratio, CAR ((Tier 1 capital + Tier 2 capital)/total risk-weighted assets), credit risk-weighted assets, fee and commission income/operating income, total gross loans, loan loss provisions/operating income, and net operating income.

6

For the quarterly cost-to-income ratios, we use the minimum of Q3 2015 and Q4 2015 since profit and loss statement data for several banks in the sample had been impacted by extraordinary contributions to the national resolution fund in Q4 2015. For the time series analysis, we exclusively use annual data. The results from our analysis of bank profitability as of end-2015 are thus mildly influenced by the choice of data frequency with our annual estimates for net RoE for the largest Italian banks being a bit lower than if we used 2015 quarterly data but the overall conclusions of the paper still hold.

7

The term “return on equity” is used as a generic reference to leveraged income, with equity referring to CAR.

8

A tax rate τ of 35 percent is assumed for all banks.

9

The calculation of the LLP is shown in Annex, Box A1. We also perform the same calculation for reported LLP for robustness. For actual provisions, end-Q3 2015 was chosen where available (otherwise annual 2015 data were used) since most banks reported significant one-off increases in LLPs due to the ECB’s on-site requests or management decisions to increase coverage during the last quarter of 2015.

10

Under the forthcoming IFRS 9 standard, for loans where no significant increase in credit risk has (yet) occurred, provisions are set to the expected losses in the next 12 months. However, if a “significant increase in credit risk” is deemed to have occurred, provisions increase such that losses expected from events over the lifetime of a loan are provisioned against.

11

The lending spread is defined as the difference between the loan rate and the cost of funding; the RWAs underpinning the calculation of expected loss provisions (LLP) were obtained from each bank’s public accounts at end-2015 (rather than the EBA 2015 Transparency Exercise) in order to maintain data consistency relative to the previous years during which separate data on RWAs was not available.

12

If not available, the average for the Italian banks is used from the EBA 2015 exercise or reported provisioning from SNL, when the latter exceeds the estimated provisioning costs.

13

Out of the 15 sample banks, this applies to 5 and 3 banks for the EU-weighted average and median, respectively.

14

Realigning the cost of refinancing to the marginal policy rate under TLTRO II (if banks meet a defined minimum rate of net lending growth) facilitates the pass-through of bank funding conditions to the real economy by encouraging more lending; it also helps maintain bank profitability, especially in countries where banks face high cost of risk and have refrained from lowering lending rates to preserve profit margins without jeopardizing their deposit base.

15

This assumption generalizes changes in the cost of funding, which might overstate the actual benefit from improved funding conditions in some countries. For instance, in the case of Italy, only the largest banks in the sample can access capital markets, and many (smaller) banks are faced with a relatively more challenging liquidity situation.

16

However, the impact of low (real) interest rates on the debt repayment capacity of borrowers is not considered in the current environment of low inflation and monetary accommodation. A decline in the default rates could actually reduce the flow of provisions, which would help stabilize the amount of LLPs.

17

Probabilities of default (PDs) are taken from Garrido and others (forthcoming). The correlation of nominal growth with corporate PDs is estimated at 72 percent. The estimated corporate loan PD for 2014 is 1.8 percent.

18

Staff also assumes that, in the stagnation and downturn scenarios, spreads are 75 bps wider than in the baseline scenario.

19

This reflects expected losses extrapolated from the default risk of the current loan portfolio (consistent with the forthcoming accounting standard IFRS 9). The assumption of forward-looking provisions using past loan performance reflected in RWs assumes that (i) banks do not change their loan origination to improve the average credit risk of their banking book, and (ii) the debt service capacity of borrowers remains unchanged relative to the historical experience.

20

2015 is an estimate based on 2014 system-wide data and 2015 data for the SSM. The actual RoE of the system amounted to 2.6 percent in 2015 according to recently released data.

21

Note that the application of expected loss provisioning is not permitted under current accounting principles but helps illustrate how a rapid decline of loan performance could result in sizable adjustments to provisioning rates ex post, putting increasing pressure on interest rate margins from new lending.

22

This analysis of a “break-even lending rate” assumes a contemporaneous relationship between lending rates and loan performance. In reality, the assessment of whether lending rates are adequate to break even requires a comparison of them with the (ex post) default rate of the underlying loans. Since repayment arrears (and corresponding provisioning expenses) in a given year are largely attributable to loans that were originated much earlier, a cohort analysis for different loan vintages (at different maturity tenors) would acknowledge the inherent time lag of how loan origination affects provisioning. However, given that both actual lending rates and asset quality of most Italian banks have continuously declined over the last four years, the application of contemporaneousness is analytically expedient and consistent with a medium-term assessment of profit sustainability.

23

Note that this analysis assumes that other sources of income as well as operational and provisioning costs remain unchanged. Lower interest rates increase the debt repayment capacity of borrowers and might actually reduce provisioning costs going forward. Similarly, increasing asset prices can result in valuation gains that help improve NIM. However, given the large share of lending in total banking sector assets, the re-pricing effect from a decline in policy rates (and its impact on term spreads) is likely to be the dominant factor determining changes in bank profitability.

24

In addition, the ECB-Banking Supervision’s Task Force on NPLs has concluded its data collection effort and is expected to provide detailed guidance on the asset impairment challenges of directly supervised banks, including Italian institutions. Furthermore, the Bank of Italy has recently launched a new periodic survey to gather detailed information on the stock of bad debts, the related collateral and guarantees, and recovery procedures.

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1

Prepared by Petia Topalova.

2

Social norms influence to a great extent female labor force participation in Italy, due to women’s traditional role as primary care providers for children and older members of the family (OECD, 2015; Colonna and Marcassa, 2015).

3

For cross country evidence on the determinants of female labor force participation, see also Jaumotte, 2003; Thévenon, 2013; Duval and Bassanini, 2005; and Bick and Fuchs-Schündeln, 2014, among others.

4

See Marino and others, 2016 for details.

5

The Parliamentary Budget Office (PBO) estimates that the 80 Euro bonus for low income workers, changes to IRAP rates and the temporary social security exemption for new hires under open-ended contracts have reduced the tax wedge from 48 percent to 33.4 percent for women employed at the average wage, and from 44 to 20.6 percent for women earning two-thirds of the average wage (Parliamentary Budget Office, 2014). The 2016 Stability law introduced a less generous temporary social security contributions cut for newly-hired workers in 2016, which should raise the tax wedge relative to PBO’s calculations.

6

According to a special survey on Conciliation between work and family in 2010 by ISTAT, excessive cost and lack of available childcare services were the main reasons given by respondents with care duties for why they do not provide more labor (EurWork, 2012).

8

Christiansen and others (2016b) uncover a strong positive correlation between the share of women employed full time and the presence of women in senior corporate positions across European countries. This pattern suggests that one of the potential causes for the persistent gender gaps in senior positions may be the limited supply of women willing and/or able to take such positions.

9

Female managers could be better positioned to serve consumer markets dominated by women (CED 2012; CAHRS 2011). Greater gender diversity would increase the heterogeneity in values, believes and attitudes, which would broaden the range of perspectives (OECD, 2012) and stimulate critical thinking (Lee and Farh, 2004).

10

See Croson and Gneezy (2009) for a review of the literature on gender differences in preferences and other factors that might affect managerial style. McKinsey (2007, 2009) argue that certain leadership behaviors were seen more often in women than men, namely, people-development, setting expectations and rewards, providing role models, and participative decision-making.

11

See Rhode and Packel (2014) for a survey of the literature on the gender composition of boards and financial performance.

12

We focus on the sample of firms that report having at least two members in the senior management/board since we are interested in examining the role of gender diversity in senior positions, rather than documenting differences in male vs female entrepreneurs. Economic theory provides some clear channels through which gender diversity may benefit firms which do not extend to single-manager firms.

13

The Orbis database does not provide consistent information on changes in the board or management team over time, which precludes us from examining how an increase in the prevalence of women correlates with changes in firm performance. In the cross section, the share of women in management may be correlated with numerous unobserved characteristics of the firm, which affect its financial performance. It is also difficult to distinguish whether greater presence of women improves firm performance or better performing firms are simply able to attract more women.

15

Prat (2002) and Jehn and others (1999) examine the role of sectoral characteristics, such as the complexity of tasks, in shaping optimal labor diversity. Garnero and others (2014) provide empirical evidence on the heterogeneous effects of workforce diversity across sectors in Belgium.

16

Female intensity is measured as the share of female workers in total employment across 61 distinct ISIC Rev. 3 manufacturing sectors using UNIDO Industrial Statistics Database averaged over all countries and years for which such data are available. OECD annual labor force employment statistics are used to construct female intensity of the remaining non-manufacturing sectors. We use Eurostat’s taxonomy of high- and medium-technology manufacturing sectors and knowledge-intensive services at the NACE 3-digit level.

17

These findings are similar to Flabbi and others (2014).

Italy: Selected Issues
Author: International Monetary Fund. European Dept.
  • View in gallery

    Loan Loss Reserves/Net Income, end-2015

    (percent)

  • View in gallery

    Cost-to-Income Ratio, end-2015

    (percent)

  • View in gallery

    Commercial Bank Branches per Capita

    (Per 10,000 adults, 2014)

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    Italy: Estimated Net Return on Equity of Current Lending and Expected Loss Provisions

    (percent), end-2015 1/

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    Italy: Difference between Actual and Breakeven Lending Rates for Sample Banks (Expected Loss Provisioning)

    (percent, weighted average) 1/

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    Italy: Estimated Net Return on Equity of Current Lending (with and without improvement in cost efficiency)

    (percent), end-2015

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    Italy: Estimated Net Return on Equity of Current Lending under Expected Loss Provisioning (with and without funding benefit due to TLTRO II)

    (percent), end-2015 1/

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    Italy: Estimated Net Return on Equity from Current Lending and New Lending under Baseline Scenario (with and without funding benefit from TLTRO II) 1/

    (percent)

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    Annual Loan Growth Required to Maintain Current Net Interest Margin, end-2015

    (y/y percent change) 1/

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    Italy: Potential Loan Growth Exhausting Available Capital Buffer

    (percentage share of total loans), ordered by relative share, end-Q3 2015 1/

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    Italy: Required Lending for TLTRO-II Benchmark

    (Jan. 2015=100)

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    Italy: Potential Loan Growth Exhausting Capital Buffer and Estimated Net Return on Equity of Current Lending 1/2/

    (percent of total loans/percent), end-2015

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    Italy: Potential Loan Growth Exhausting Capital Buffer and Asset Quality 1/

    (percent of total loans), end-2015

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    Italy: Contribution to Atlas Fund and Capital Buffer 1/

    (percent), end-March 2016

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    Italy: Estimated Actual and Break-even Lending Rates

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    Italy: Profitability under Reported and Forward-looking Provisioning

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    Italy: Aggregate Profitability under Different Macro Scenarios

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    Italy: Bank Capital under SREP