The challenges still facing Italy's banking system

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October 12th, 2015

The assessment of European banks carried out by the ECB last year highlighted the Italian banking system as one of the weakest: 8 of the 15 banks examined failed their asset quality review and displayed capital shortfalls in the stress test's baseline scenario. Although many have now increased their capital buffers to reverse these shortcomings, Italy's banking industry is still under great pressure as the quality of its assets is continuing to deteriorate. Since the start of the crisis, the NPL ratio has tripled, reaching 17.7% of all loans in 2014, and problematic assets account for 22% of GDP. Given this situation, the IMF has published a series of recommendations to urge the authority to take action in this area. In response, Matteo Renzi's government has already started to implement some measures that should help to speed up improvements in banks' balance sheets.

Traditionally the Italian banking business has been closely linked to the granting of credit to the business sector, mostly made up of SMEs. This business model explains why banking was hit so hard when there was a shock to the real economy. Unlike countries such as Spain or Ireland, Italy did not suffer a real estate boom so that banks started the crisis with healthy balance sheets. But as business activity worsened, bad debt rocketed, reducing the profitability and solvency of banks and limiting their capacity to take on more credit risk. In turn, this lower credit capacity among banks limited investment and slowed up the country's economic recovery.

The IMF estimates1 that improving banks' balance sheets in Italy would substantially improve their credit capacity. However, several factors have slowed up the progress made in this area. Particularly economic factors such as a heterogeneous portfolio of bad debt that makes it difficult to value and a taxation system that discourages loan-loss provisions due to limitations on tax deductions. Notable legal factors are the slow judicial system which prolongs the time taken to resolve such cases.

In order to get credit flowing again, and as soon as possible, the government has started to work on a package of measures. For example, it approved a Royal Decree to facilitate and speed up procedures for loans when they have been declared impaired and amended tax laws to allow provisions to be tax deductible in the year in which they occur and not over five years as was the case previously. The government is also negotiating with the European Commission to create a «bad bank» with state participation that would acquire doubtful loans granted to companies, which would clarify the solvency of banks and improve their credit capacity. But there are still questions of a technical nature to resolve, such as how assets acquired by the institution can be valued and how this body can be financed without harming public accounts to any great extent. Although this series of measures is in the right direction, it should be accompanied by improvements in corporate governance to improve mechanisms to manage risk and thereby prevent the situation from being repeated. Along these lines, the government approved a Decree-Law that requires cooperative banks with more than 8 billion euros in assets to become listed banks, which could help to consolidate the banking system and modernise governance.

In short, the Italian government's action plan would help to reduce the high levels of non-performing loans, which would improve the solvency of banking institutions. Moreover, the start-up of Europe's banking union and the ECB taking on the role of bank supervisor will help to make the Italian banking system more transparent and credible, improving its position to support the country's economic recovery.

1. Resolving nonperforming loans in Italy: a comprehensive approach, Italy: Selected Issues 2015, Country Report No. 15/167.