Mario Draghi: An overview of banking in Italy
Address by Mr Mario Draghi, Governor of the Bank of Italy, at the Italian Banking Association
Annual Meeting, Rome, 8 July 2009.
* * *
Credit and the banks
Lending to the private sector has slowed further. In April the change over three months
turned negative: in May it was equal to an annualized contraction of 0.9 per cent. In the last
decade, the average annual rate of growth of lending to the private sector was 9.6 per cent.
The contraction involves credit to firms, while that to households continues to expand,
although at a significantly slower pace than in recent years. The slowdown in lending by the
leading banking groups has been particularly marked.
The Governing Council of the ECB has increased its support of banks' liquidity in exceptional
measure. It has also launched a plan to purchase covered bonds issued by intermediaries in
the euro area for a total of €60 billion, with the main objective of easing the financing
conditions for credit institutions and firms and of encouraging the banks to maintain and
increase lending to their customers. The Bank of Italy is participating in these purchases in
proportion to its share of the ECB's capital.
Following the reduction in the Eurosystem's official rates, the interest rates on bank loans to
Italian households and firms have fallen to the average level for the area, except for
consumer credit rates, which remain higher. The increase in credit risk has translated into a
widening of the gap in the cost of credit between small and large firms, with an adverse
impact on those that currently have the greatest need for bank financing.
The recession is also affecting credit quality. In the first quarter of this year, the ratio of new
bad debts to total bank loans outstanding reached 1.6 per cent, the highest level this decade;
it had risen to more than 3 per cent following the recession of the early 1990s. The increase
in non-performing loans and overdue instalments prefigures a further deterioration.
In the South of Italy, borrower risk is on average greater than in the Centre and North, but in
March the rate of growth of bank loans in the South exceeded that in the other parts of the
country, even though the cost of a loan was 1.7 percentage points higher on average.
The deterioration in loan quality is increasingly affecting bank profits. In the first quarter of
this year, the loan loss provisions of the main banking groups more than doubled, absorbing
half their operating profits. Profits fell overall by 40 per cent; the ROE on ordinary operations
halved to 4.5 per cent.
The factors that are constraining bank profitability today will become more intense,
responding to the recession with the usual lags. The commitment to curbing costs must be
intensified and the economies foreseen in business plans must be achieved more quickly.
The banks will be decisive in determining whether the crisis we are facing is more or less
long-lasting, more or less deep. It is necessary to reconcile prudent management and capital
soundness with the need not to deny financial support to firms with good potential for growth
and a real ability to weather the crisis.
It would be dereliction of duty if the banks and the Bank of Italy were to stray from the path of
rigorous evaluation of creditworthiness. A healthy banking system is essential to growth; it
safeguards the savings entrusted to banks.
However, it is equally important that in deciding on loans banks use all the information
available, that they supplement statistical scoring methods which lose some of their
predictive power at times of crisis with direct knowledge of customers and their real potential
for growth and profitability in the long term. A banking system with local roots is of great
value; it needs to be exploited and where it has been lost it must be rebuilt. Banks must take
advantage of their grass-roots knowledge of customers and avoid over-reliance on automatic
processes. There is ample scope for improvement. Some banks, some of them large ones,
are beginning to move in this direction, reviewing their organizational models and their
decision-making procedures.
What prudential supervision requires of banks
Capital
Italian banks' own funds are well above the regulatory minima and have remained so even
through the worst of the financial crisis. The capital ratios of the leading banking groups
increased in the first three months of this year.
I have said, and I say again, that a strengthening is nonetheless necessary. It is not just a
question of maintaining strong safeguards for stability; we must compete on an equal footing
with the foreign banks which have had to resort to massive injections of public money in
recent months; we must be prepared, as of now, to operate with a capital endowment that
future regulations will require to be larger than at present. Above all, capital strengthening is
indispensable in order to face the deterioration in the macroeconomic situation without
neglecting to give firms, households and the economy the support they need.
During this phase the Bank of Italy does not allow banks to make early redemptions of capital
instruments without a plan for their replacement with resources of equivalent quality and
quantity.
The quality of the Italian banks' capital is high by international standards. We are also aware
that the rigour with which we evaluate the inclusion of financial instruments in regulatory
capital has appeared, in the past, to put Italian banks at a disadvantage with respect to the
situation in other countries. We deliberately maintained this policy, even when the market
seemed to tolerate particularly high levels of risk.
These practices, these evaluation criteria, which have been put to the test in the last two
years, have so far brought benefits to banks, the economy, and the public finances.
Liquidity
The system's liquidity is still guaranteed by the massive injections of funds from the central
banks. The oversight policy we introduced in 2007 has helped Italy's banking system to
weather the severe strains of the last part of 2008 without major shocks. We continue to ask
the banks to ensure that foreseeable outflows are covered over a broad range of maturities.
The tools of analysis and intervention are being continually improved. The ten leading Italian
banking groups were asked to conduct a liquidity stress test, the results of which have shown
that the largest groups have a high resistance to stress.
In international cooperation fora, work is under way to draw up common safeguards against
liquidity risks. The Bank of Italy favours a system based on two instruments: on the one side,
the requirement permanently to keep sufficient liquid reserves to ensure that, even in the
presence of stress, outflows are covered for an adequate period of time; on the other side,
the maintenance of a minimum structural equilibrium between the duration of liabilities and
that of assets. Opinion is broadly converging on these positions.
The one-year financing operation recently conducted by the Eurosystem has achieved
records both in the number of counterparties (1,121) and in the amount allotted (more than
€442 billion). The participation of Italian banks amounted to less than 3 per cent of the total.
Stress testing bank assets
For the quality of loans, and more generally of bank assets, thorough stress testing,
performed in a coordinated manner under the guidance of the supervisory authorities, is
likewise essential in order to verify the soundness of the single banks and of the system as a
whole, to improve the transparency of their balance sheets, and to restore the credit circuit to
normal operation.
In the United States, in the weeks immediately following the publication of the stress test
results the 19 banks concerned were able, in part by selling non-strategic assets, to raise
almost $65 billion of new equity capital and issue over $20 billion of bonds without
government guarantee. The effect spread to all the US banking sector, which jointly placed
almost $90 billion of new shares in the quarter just ended.
Ahead of a similar coordinated exercise planned at the European level, in recent weeks we
completed a stress test of the Italian banking system by estimating the loan losses that would
occur in the period 2009-10 in even more unfavourable macroeconomic conditions than the
present ones: the portion of losses not covered by operating profit would equal about one
fifth of the system's end-2008 excess capital; overall, the outcome confirmed banks' capital
adequacy.
For the time being, the diversity of intermediaries, methodologies that are still too varied, and
difficulties in comparing results make it impracticable to publish the individual results of the
stress tests under way at European level. I believe, however, that this objective cannot be
deferred for long without delaying the necessary return of banks to the private capital market.
Good rules, the right incentives
Banks' governance
Rigorous risk management, the safeguarding of banks' reputations, the verification of correct
conduct and compliance with the rules require reliable and effective systems of corporate
governance and internal controls: these, even before the Bank of Italy's supervision, are the
first line of defence for the stability of banks and the system as a whole. Last year we issued
rules with which banks had to comply by 30 June, where appropriate by amending their
bylaws.
Bylaws require our approval; the interaction with banks has been intense. While respecting
every bank's autonomy in choosing its own model of governance, we stressed the need for
consistent and uniform approaches, clear rules, and a proper balance of power. We called on
banks to simplify their governance structures by limiting the number of directors, avoiding
overlapping tasks and administrative bodies. We asked that the Chairman act as coordinator
and guarantor in a dialectical relationship with top management and laid down the conditions
for his correct activity within the executive committee, whenever this was established. For the
first time, we requested the inclusion of independent members on the boards of directors of
unlisted banks.
Owing to the distinctive traits of the shareholder base and governance structures of
cooperative banks, we paid special attention to the mechanisms for appointing their
governing boards, aiming to maintain their strengths (social responsibility, close ties with
households and the productive fabric) and curb the risk of management being excessively
self-referential. In keeping with the spirit of mutualism and the egalitarian principle underlying
these banks' structures, we promoted voting mechanisms capable of giving voice to
significant minorities among shareholders; favoured an enlargement of proxy voting; and
suggested other instruments to enable more effective participation by shareholders.
Significant, if uneven, progress has been made; but more remains to be done.
Remuneration and incentives
One of the lessons to emerge from the crisis is that bad systems for compensating
management and those responsible for key functions in banks can favour the excessive
accumulation of risks. People paid on the basis of short-term results pursue immediate gain
without taking account of the associated risks. The result is a false accounting of profit that
generates a deadly risk spiral.
Starting last year the Bank of Italy, first among the authorities of the leading countries,
introduced specific rules on compensation schemes as part of the rules for banks'
governance. In April this year the Financial Stability Board issued the principles underlying
sound compensation practices.
First and foremost, provision must be made for an adequate balance between the fixed and
variable components of compensation; moreover, pay should be related to actual profits over
the longer term, taking the related risks into proper account. Special precautions must be
taken to protect the integrity and status of banks' control function; the governing bodies, and
shareholders especially, must be involved in setting compensation policies and in verifying
their implementation.
The Bank of Italy has formed a task force to assess current compensation schemes and call
for correctives when required. The supervisory area is attentive to any international practices
that might emerge in applying the principles and recommendations recently issued.
The prevention of money laundering
Last year the Bank of Italy took over direct responsibility for the anti-money-laundering
controls that had previously been carried out by the Ufficio Italiano dei Cambi.
Cooperation with the magistracy and the Finance Police is essential to the success of the
Financial Intelligence Unit (FIU), to which the Bank of Italy allocates adequate resources for
its increasingly demanding tasks.
Anti-money-laundering controls have become a regular part of the Bank of Italy's onsite
inspections of financial institutions. In 2008 the Supervision Area and the FIU carried out 191
inspections at banks, investment firms, asset management companies and other
intermediaries. A number of recurrent failures to comply fully with the rules were found:
insufficient checking of customers, incomplete record-keeping, inadequate assessment of
anomalous transactions, poor staff training, and methods of control lacking in incisiveness.
Sanctions, reprimands and numerous reports to the law enforcement authorities show that
the banks underestimate the need for full compliance with the rules, for strict performance of
their obligations. A change of attitude is necessary. Corporate bodies and officers must take
responsibility for the proper functioning of the anti-money-laundering systems. The control
bodies have specific duties for which they can be called to account, including in the course of
inspections.
This anti-money-laundering strategy is beginning to produce effects. The number of reports
of suspicious transactions that intermediaries transmitted to the FIU increased by 16 per cent
to around 14,600 in 2008, and in the first four months of 2009 there was a further sharp rise
of about 50 per cent compared with the same period of the previous year.
Customer protection
The crisis has accentuated the need for continuing action to raise the standards of
correctness and transparency in relations with the public, to resolve disputes between banks
and customers quickly and to promote the informed use of financial instruments by savers
and investors. The stability of the financial system hinges on customer confidence.
The Bank of Italy's new rules on the transparency of banking and financial services represent
a thorough overhaul with respect to the past. Customers must be provided with information
that is easy to understand and effectively useful for determining whether the transactions
proposed are in their interest and for assessing the correctness of the person making the
proposal. The rules require intermediaries to institute internal procedures that guarantee
correct conduct.
The comments received in the course of the public consultation that was completed in May
confirmed the validity of the reform, which will be issued this month.
As a complement to the civil justice system, a Banking and Financial Arbitrator has been
created to give customers an economical and rapid means of obtaining impartial rulings in
disputes over banking and financial services. Three boards will be instituted, one for the
North of Italy, one for the Centre and one for the South. Bank customers will also be able to
appeal to the boards through the branches of the Bank of Italy, which will provide the
facilities and technical support for the Arbitrator.
I raised the question of the fee charged on a customer's maximum overdraft at the beginning
of 2007, calling on the banks to abandon a practice that is almost indefensible in terms of
transparency and efficiency. The law gave the Bank of Italy only the power to make sure that
these clauses were applied transparently - not the power to replace them with different
contractual provisions. Repeated acts of moral suasion were only effective with the major
banking groups. Legislative intervention was necessary, although the reordering of the
various provisions governing relations between banks and customers remains desirable and
is provided for in the Community law recently passed by Parliament.
The banks must now solve the problem at the root. Let them, of their own accord and once
and for all, supplant these complex, opaque fees with reasonable commitment fees based on
the amount of funds made available. For the rest, everything must be brought back to the
transparent application of interest rates.
From the beginning of 2010 the threshold rates for anti-usury purposes will include all
accessory charges: the maximum overdraft fee, if it is still being charged, commitment fees,
mediation fees, and any other costs in connection with the loan.
Non-bank intermediation
Among more than 1,000 non-bank financial intermediaries registered under Article 106 of the
Consolidated Law on Banking and 160,000 financial agents and loan brokers, more than a
few are marginal, fragile, of doubtful professionalism and sometimes dubious legality. In the
public interest and in the interest of the more responsible, qualified operators, it is urgent to
set the situation to rights.
We have begun a rigorous selection, intensifying the checks at the time of entry in the
registers and those on continuing satisfaction of the minimum standards set by law and
compliance with the rules. The Report that we recently submitted to Parliament and the
Government gives an account of this.
We have struck more than 11,000 financial agents from the register. In cooperation with the
Finance Police, we have begun extensive checks in the sectors at greatest risk. Acting on
our proposal, the Ministry for the Economy and Finance has deregistered more than 30
financial companies for which significant anomalies were found; many of them had been
engaged in providing guarantees and sureties. Controls are being carried out on the
intermediaries specialized in granting loans secured by a pledge of one fifth of the borrower's
salary and have already given rise to sanctions.
Recent measures of the Ministry for the Economy and Finance and the Bank of Italy have
begun to make the criteria for entry in the registers more stringent. But more far-reaching
interventions are essential to update obsolete provisions and fill regulatory gaps. We are
ready to offer the Government our technical support.
Asset management
The crisis has exacerbated the longstanding problems of the Italian asset management
industry.
For years, the Bank of Italy's watchwords for the industry have been consolidation and
independence.
A competitive repositioning of the largest asset managers is under way at international level.
Some steps towards rationalization are also beginning to be taken in Italy. Recent months
have seen spin-offs by banking groups aimed at creating independent operators.
Consolidation can yield efficiency gains, which need to be transferred to investors in order to
reduce the costs borne by them and fuel the resumption of investment.
Management companies' full autonomy remains essential. We have just begun a
consultation on new regulations concerning the management and coordination exerted by
bank parent companies on their asset management subsidiaries. Besides clearly defining the
strategies they pursue in the sector, banking groups will have to ensure the genuine
independence of asset management companies as regards their investment choices and
marketing policies.
I have repeatedly underscored the disadvantage that derives from the difference between the
tax regime for the sector in Italy and abroad. This needs to be revised.
The reform of European supervision
Supervisory colleges that oversee the consolidated position of international groups, uniform
supervisory rules and practices, and a close relationship between the European Central
Bank and national supervisory authorities are the three pillars of future European
supervision.
The proposals put forward by the de Larosière group largely meet these needs but envisage
a complex architecture.
A European Systemic Risk Board, in which central banks and supervisory authorities will
participate, will be responsible for macroprudential analysis and supervision. It is important
that it be headed by the president of the ECB, that its activity go beyond merely warning
about risks, that it be able to verify implementation of its recommendations and promote the
introduction of countercyclical measures.
Supervision of all banks, including European groups, will remain a national responsibility.
The overall context must change, however. The objective is: common rules, common
practices, a common culture, with a single rulebook applicable throughout Europe, and a
strong coordinating role for the supervisory colleges.
Equally important is the harmonization of depositor-guarantee schemes, of the instruments
for intervention in crises, and of the rules for the transfer of liquidity between the units of a
banking group.
The Bank of Italy is already at the forefront in promoting concrete progress for the groups for
which it is home supervisor. Joint and coordinated inspections in the various subsidiaries of a
group, conducted together with the host-country authorities, are becoming standard practice.
Just a few years ago, such progress was inconceivable.
Best practices must be disseminated as supervisory authorities continue to converge. The
particularly incisive approach to inspections and supervision that typifies the Italian tradition
is a valid reference point.