With an asset quality review and stress tests fast approaching, Italy's banks are under pressure to clean up their books, improve their provisions on bad loans and reduce operating costs. The largest banks will probably manage to attract additional capital and scale down some operations. The main threat to the system, however, will come from small and midsized banks, which have unreliable statistics and complex administrative networks that make them difficult to reform.
Many of Italy's smaller banks will disappear or merge with others, and some will probably need state assistance. During this process, credit conditions for households and companies will remain tight, limiting Italy's prospects for economic growth.
The European Banking Authority will start stress tests on European banks in the coming weeks, with results expected by October, and the European Central Bank will get the results of an upcoming "assets quality review" on the banks before the year is up. The ECB wants to complete both assessments before taking over as supervisor for the eurozone's largest banks by the end of 2014 — a move that represents the first phase of the creation of the EU banking union.
The Italian central bank has begun preparing for the review, pushing local banks to clean their books, attract investment and rebuild capital. The Bank of Italy says nonperforming loans in Italian banks reached 160.4 billion euros ($223 billion) in January, up from 155.9 billion euros the previous month. Nonperforming loans currently represent roughly 15 percent of total customer loans, considerably below Eastern European countries such as Romania (about 22 percent) but higher than in crisis countries such as Spain (about 14 percent). Countries measure nonperforming loans in different ways, so the statistics could be misleading. That is something the ECB will try to correct in its review of European banks.
A Fragile Banking Sector
Italy's largest banks hold almost two-thirds of these bad loans. For instance, Intesa Sanpaolo and UniCredit SpA hold 55 billion and 47 billion euros' worth of nonperforming loans, respectively. Meanwhile, Italy's third-largest bank, Banca Monte dei Paschi di Siena SpA, received a controversial government bailout in 2013 in the wake of a scandal about the alleged use of hidden derivatives to conceal losses. UniCredit and Monte dei Paschi di Siena recently announced significant losses during the final quarter of 2013.
Different reports estimate that Italy's banks will need anywhere from 15 billion to 25 billion euros for recapitalization. The five largest banks are seeking a capital increase for an aggregate amount of 7 billion euros. In addition, Intesa Sanpaolo and UniCredit have reached an agreement with U.S. private equity fund KKR & Co. L.P. Intesa is also working on an internal bad bank for its bad loans, while UniCredit has sold bad debt to Cerberus Capital Management, L.P. and AnaCap Financial Partners LLP.
As difficult as the situation is, it will probably be worse for smaller banks. Most of these banks will start fundraising in the coming weeks, but they will be competing to attract a limited number of investors. This is one of the many problems of the Italian banking sector: It has too many banks for an economy that has seen low growth rates for more than a decade. Italy has almost 700 banks, employing 310,000 people in 33,000 branches. By comparison, the United Kingdom, which has a few million more people than Italy, has half as many banks.
Most of these banks have deep links to their local communities, serving small companies and households, and have strong ties to politicians and unions. But the European crisis is seriously challenging this business model, and something has to change.
According to the Bank of Italy, nonperforming loans in small banks are above the Italian average, while their coverage ratio (their ability to absorb potential losses from nonperforming loans) is below average. Italy's five largest banks have a nonperforming loan ratio of 15.2 percent with a coverage ratio of 41 percent. The smallest banks in Italy, by contrast, have a nonperforming loan ratio of 15.5 percent with a coverage ratio of 28.3 percent. Combined with the fact that some of these smaller banks are likely hiding or disguising their real problems, their weak position makes these banks the most fragile lenders in the system.
Low Household Debt
Italian household debt levels are relatively low compared to those of other eurozone nations. Italy's household debt grew substantially in the early years after the introduction of the euro, climbing from 33 percent of gross disposable income in 1998 to 74 percent in late 2012. It still remains below the eurozone average of 109 percent. The International Monetary Fund reports that about 25 percent of Italian households had debt outstanding in 2013, compared with 40-50 percent in other major eurozone countries. Italy also has a high level of home ownership (roughly 70 percent compared with the eurozone average of 60 percent) and a relatively low level of mortgage debt.
Despite these positive signs, Italian households are feeling the effects of the banking crisis. Household debt relative to disposable income has increased continuously since the beginning of the crisis as more and more Italians find it harder to save money. Nonperforming loans are also on the rise.
With these facts in mind, bank credit to households has decreased since the crisis began. According to the Bank of Italy, a combination of tighter credit standards by banks and lower loan demand by households has led to a general decline in credit. In essence, banks are afraid to lend and households are afraid to spend, with the result being lower supply of (and demand for) credit. This is hurting Italy's economy because banks are the main source of financing for households and companies alike.
Companies Struggle to Survive
The European economic crisis has severely affected Italian companies, particularly small and medium companies. Italian firms' leverage is among the highest in the eurozone, and a large share of debt has short maturity because of the banks' tighter credit conditions. IMF data shows that bank loans to Italian firms began to slow in 2011 and turned negative in mid-2012. According to Italy's central bank, loans to nonfinancial companies fell by 5 percent year-on-year in January after a 5.2 percent year-on-year contraction in December.
Italy's long recession has made things worse for companies. Profitability has been falling for several years. As with households, both demand and supply factors have affected credit. In June 2013, the share of firms' loans that are considered nonperforming reached 25 percent, according to IMF data.
This is why the number of business closures and bankruptcies has increased significantly in recent years. The situation is particularly bad for the construction and real estate sectors, which have been on the front line of exposure to the economic downturn and weak investment.
In an attempt to mitigate the impact of the crisis, the Italian government has been helping companies face their debt problems. Rome authorized moratoriums on the repayment of small and medium-sized companies' debt in 2009, 2012 and 2013. While this means some companies are getting more time to pay back their loans, it also means the problems are being postponed instead of solved.
No Solution in the Short Term
The main threats to the stability of Italy's banks will come less from households and more from small and medium-sized companies. Consolidation will occur, with larger banks scaling down operations and some smaller banks closing or merging with other lenders. To an extent, Italy will resemble Spain, whose banking sector has significantly consolidated since the beginning of the crisis, shrinking from 50 to 12 banks between 2009 and 2013.
The process will not be easy. The Italian banking sector is a complicated web where cooperatives, nonprofit foundations, unions, local politicians and regular shareholders are deeply interwoven, making the system resilient to reform. The government will likely have to intervene, pushing some banks to merge and providing financial assistance to others.
Italian banks are also increasingly dealing with the fragility of their foreign branches. With Italian banks under political pressure in Hungary and financial pressure in unstable countries such as Slovenia (and now Ukraine), Italian lenders will probably see negative results from their foreign operations in the next few years. Operations within Italy are and will remain the largest source of revenue for Italian banks.
In this sense, Italian lenders are different from their Spanish peers. Spanish banks such as Banco Santander SA and BBVA are mostly relying on their Latin American operations to cope with the crisis at home.
Another component to the problem is that with the European Central Bank promising to intervene in sovereign debt markets if necessary, Italian debt has become more attractive. Italian bond yields have dropped substantially since their peak in November 2011, when the country was on the brink of default, but they are still above those of relatively safer countries such as Germany or France. In addition, the ECB has been providing eurozone banks with cheap liquidity.
The result is that Italian banks are buying Italian debt, getting cheap money from the ECB and relying on their largest and most trustworthy customers. Italian banks currently hold roughly 400 billion euros in Italian government bonds, nearly double what they had at the end of 2011. As a result, they do not need to loosen credit conditions in the short term.
While this is good for Italian banks, it is bad for the Italian economy. With credit conditions likely to remain tight, the economy will continue to lack one of its main drivers of growth. In turn, this will weaken the ability of households and companies to repay their debt. The banks' growing reliance on Italian debt also potentially exposes them to Italy's constant political crises.
The promise of ECB intervention has thus far weakened the connection between political uncertainty and financial market instability. Should Italy sink into another deep political crisis, however, the ECB program will be tested, restoring the strong possibility of a eurozone-wide contagion like what characterized the first stage of the European crisis. With weak economic growth prospects for the future, the Italian banking sector will remain fragile for some time.
