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, 9 July 2008.
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Rising inflation and the outlook for the world economy
Expansionary monetary policies together with severe tensions in the market for oil are at the
origin of the present international economic and financial difficulties. The protracted monetary
expansion in the United States and other countries spread to the main emerging countries
because their currencies are pegged to the dollar. The fragilità of the markets originated in
the gaps in the regulatory framework and was worsened by perverse incentives that fueled
the tumultuous growth of the financial industry. But, as with the weakness of the dollar, the
roots can also be found in overly accommodating monetary policies. The massive flight of
capital from no longer profitable financial investments and the depreciation of the dollar have
contributed to the rise in the price of oil, which is based on the structural tensions underlying
this market.
The price of crude oil has been rising since the beginning of the decade; in real terms it has
already gone beyond its previous all-time peak in 1979-80; it is still rising. The fundamental
cause has been the sharp increase in the emerging countries' demand for energy, with
supply struggling to keep up. Demand is inelastic in the short term owing to technical
constraints. Supply is even more inelastic because of the increasing cost of discovering and
developing new fields, rigidity in refining and transport, and unresolved geopolitical
difficulties. But this is not enough to explain the latest price surges. That abundant liquidity
worldwide has played a part is confirmed by our estimates, which indicate that the fall in real
interest rates since last summer may explain about a quarter of the subsequent rise in world
crude oil prices.
This not only puts pressure on current and expected inflation, it also poses a threat to world
growth itself. The transfer of resources to the oil-producing countries, only offset in part by an
increase in their imports, is holding down growth in the industrialized countries. Higher
inflation, due also to food prices, is depressing the real value of wages and therefore
consumption.
International financial markets, influenced by the more uncertain economic outlook and the
increases in the price of crude oil, remain fragile. After a return to lower levels in March, risk
premiums for corporate bonds and banks' credit default swaps have begun to rise again. The
market for structured credit products has not recovered; money market spreads are still wide.
The major international banks have begun to put their balance sheets in order, by reducing
their exposure to the riskiest instruments and to a large extent covering their losses by
injections of capital. But this capital strengthening is not yet sufficient, it threatens to be
hindered by further falls in house and stock market prices. In the United States, rising
insolvency rates and the possibility that poor economic conditions could undermine the
quality of corporate loans are causes for concern.
It is important not to repeat the economic policy errors made in response to the oil shocks of
the 1970s. In some countries, an initially expansive monetary policy destabilized inflation
expectations; a sharp restriction had to follow. The consequences, partly because of
widespread indexation, were persistently high inflation, enormous fluctuations in real interest
rates and severe repercussions on economic activity.
Compared with thirty years ago, an oil shock has less of an effect on the economies of the
consumer countries today, not only thanks to greater energy efficiency and more flexible
markets but also because of the credibility that monetary policies have acquired. We
estimate that with monetary union the impact of an increase in the price of oil on consumer
price inflation in Italy has been reduced fivefold by comparison with the 1980s and 1990s.
The credibility of monetary policy has contributed to this achievement. It needs to be
preserved in the advanced countries and pursued in the emerging countries, by heightening
awareness of the seriousness of the risk of inflation and the growing inadequacy of pegging
exchange rates to the dollar.
Inflation and monetary policy in Europe
The rate of inflation has increased in all the major countries. Although "core" inflation -
excluding energy and food products - is lower, the warning signals are growing.
Consumer price inflation in the euro area had already reached the highest level since the
start of the 1990s in May (3.7 per cent); on the basis of provisional data, it rose to 4 per cent
in June. There has been a sharp acceleration in Italy, too. According to Eurosystem
forecasts, the rise in inflation in the area will be temporary but more persistent than was
predicted several months ago. Inflation is now expected to subside only gradually in the
course of 2009, remaining higher than 2 per cent for quite some time.
The idea that the rise in inflation is permanent must not take hold. On the eve of the meeting
of the Governing Council of the European Central Bank on 3 July, the risks of an increase in
inflation appeared to have grown. Albeit in a context of wage moderation, the first signs of an
acceleration in costs were visible. Other warning signals were coming from market
expectations: inflation expectations measured on the basis of long-term index-linked
government bonds were tending to rise; the prices of inflation swaps signaled growing fears
of inflation for long-term maturities as well. Against this background, the Governing Council
of the ECB decided to raise reference rates by 0.25 percentage points. In the days following
the rate hike, inflation expectations derived from the financial markets ceased their upward
trend; it appears that they are now beginning to fall back.
By taking timely action we intend to help to avert the risk that the rise in the international
prices of energy and food products might set off a spiral between expectations and the
setting of wages and prices, and to bring inflation gradually back down to levels consistent
with price stability in the medium term.
Households' disposable income is defended by combating the rise in inflation, which erodes
purchasing power, lowers the real value of financial wealth and is a drag on consumption and
growth. We estimate that in Italy the acceleration in prices recorded since last summer has
reduced the growth in disposable income by more than one percentage point, by three points
if the losses of the real value of financial wealth are also taken into account; it can reduce
consumption by more than two points by the end of next year.
Average per capita earnings of employees, after tax and social security contributions, are not
much higher today in real terms than they were fifteen years ago. Meanwhile, unit labour
costs have increased by more than 30 per cent, compared with about 20 per cent in France
and practically nil in Germany. This gap between the spending capacity of workers and the
competitive capacity of firms reflects the meagre growth in productivity, the persistently high
level of taxation and social security contributions, and the effect of inflation; it is at the root of
the stagnation of our economy.
Price stability is a prerequisite for the resumption of growth. A price-wage spiral would be an
illusory remedy and one that monetary policy must oppose. If monetary policy is credible,
even if it cannot insulate the economy from the fluctuations of commodity prices, it can
cushion their effects on expectations and domestic prices. A prompt monetary adjustment
reduces the risk of tardy but violent corrections.
Italian banks' income and capital
Excluding capital gains and extraordinary income, the profits of the five largest Italian
banking groups fell in the first three months of this year by about a third compared with the
same period of 2007; the rate of return on equity fell on an annual basis by nearly five
percentage points, to about 9 per cent. The deterioration began in the third quarter of last
year. Contributory factors included the decline in fee income, caused mainly by the
contraction in asset management activity, the losses on securities trading and portfolio
writedowns.
In 2007 the tier 1 capital ratio of the largest groups fell slightly, from 6.8 to 6.5 per cent on
average, although it remained above the regulatory minimum.
Loan quality has remained stable up to now. The ratio of non-performing loans to balance
sheet assets for the groups as a whole remains close to 5 per cent; for bad debts alone, the
ratio is close to 3 per cent. More than 60 per cent of the nominal value of bad debts is
covered by write-downs. The ratio of new bad debts to outstanding loans holds at about 1
per cent for firms and 0.8 per cent for consumer households, levels that can be considered
normal.
The impact of the international financial turbulence on the accounts of Italian banks has been
relatively limited so far. However, income and profitability will continue to be affected if the
tensions do not ease. The cost of funding on international markets remains high. The
slowdown in economic activity could have an impact on loan growth and quality, weighing on
profitability on a risk-adjusted basis. The exposure of Italian firms and households to interest
rate risk is particularly large, given the high proportion of loans at short term or indexed to
short-term rates: some 90 per cent of the total for firms and more than 70 per cent of
mortgage loans to households. The uncertainty of the macroeconomic and financial picture
demands that banks adopt a prudent policy of provisioning against future losses.
The measure regarding the partial non-deductibility of banks' interest expense is equivalent
to an increase in funding costs of nearly 10 basis points. It is difficult to predict how this cost
will be divided: depending on the evolution of market conditions, it could fall on the terms and
conditions offered to depositors and borrowers, profits distributed or resources allocated to
reserves.
Banking supervision
The Basel II capital adequacy rules went into force in Italy in January 2007; since the start of
this year they have applied to the entire banking system.
From 2001 onwards the Bank of Italy had asked the major Italian banking groups to overfulfill
the minimum capital requirement, in order to provide for the risks not covered by the Basel I
accounting standards. This ensured that the massive process of concentration within the
Italian banking industry could take place without jeopardizing balance-sheet soundness. With
the new rules of Basel II, however, and in today's market environment, capital soundness
takes on an even more important role, and the banks have been invited to proceed to the
necessary strengthening. This autumn intermediaries will also be required to specify the
additional capital safeguards to be constituted, where necessary, as part of the obligations
laid down under the second pillar of Basel II.
It is essential that banks be in a position at all times to evaluate the impact of improbable but
devastating events on income and on capital as well as to gauge the possible interactions
among different types of risk: credit risk, market risk, liquidity risk and interest rate risk. The
Bank of Italy has asked the leading banks to make stress testing a regular practice. The first
results, although they are reassuring on the whole, revealed that in some cases the liquidity
safeguards against extreme events were not adequate. These banks were asked to restore
an adequate level of liquidity without delay.
New rules on bank governance came into effect recently; one of their provisions requires that
the criteria for the remuneration of bank managers be designed so as to avoid perverse
incentives in the matter of risk taking and risk management. With the cooperation of the
banks' compliance units, we shall assess the consistency of incentive schemes with the
principles laid down by the new rules.
Transparency and information comparability are essential to reducing the uncertainty that
weighs on market trends. In accord with the other G7 national supervisory authorities, and in
implementation of the recommendations of the Financial Stability Forum, on 16 June we
asked Italian banks to include in their mid-year financial statements a detailed treatment of
their risks in connection with subprime mortgage loans and structured finance, thus retaining
and extending a procedure that had already been instituted in Italy for the annual financial
reports for 2007.
In line with the indications of the Basel Committee we have asked the leading groups to
adopt integrated systems of liquidity risk analysis and control providing for effective liaison
between risk management and treasury management.
Preparation for critical contingencies continues. In coordination with the other supervisory
authorities, we are conducting crisis simulation exercises and specifying the data flows to
activate in the event of an emergency.
Coordination between the different countries' authorities and convergence of supervisory
practice reduce the cost of supervision over international banks, helping to foster the
integration of the European market in banking services. This is another reason for speeding
up coordination. At the same time Community directives are progressively harmonizing the
regulation of financial markets and products and consumer protection. But there remain
significant differences in corporate, commercial and bankruptcy law. Action by European and
national legislators is indispensable to strengthen the single market and simplify crisis
response.
The restructuring of the banking system
Our system took full advantage of the opportunity presented by the favourable financial
situation of the past years to conceive and carry out major banking mergers, which would be
much harder to effect in today's market conditions. The end-product must be a system that is
sounder, more efficient, with a wider range of higher-quality services, and in which banking
intermediation is less costly for the economy.
Swift execution of planned mergers and continuous verification of the results are essential,
especially in the current market situation. Above all, the rapid integration of information
systems is a prerequisite not only for efficiency gains but also for risk control, which is
increasingly necessary with the growing complexity of business operations and expansion
into new markets.
It is still early for a full assessment of the impact of mergers on banks and customers. The
data available show that at 31 March this year the economic results of the four main groups
involved in mergers were substantially in line with their business plans. These indicate,
however, that the greater part of the benefits of the mergers carried out in 2007 - estimated
at €3.9 billion a year when fully achieved - will not be realized until subsequent years. The
extraordinary costs of the mergers, consisting largely of severance benefits for redundant
personnel, came to €3.3 billion and were mostly charged to the accounts for 2006 and 2007.
In order for customers to benefit from mergers and acquisitions, it is important that the
increase in concentration not weaken competitive pressures. In the 1990s, a period marked
by intense and growing competition but also by many mergers, the resulting efficiency gains
were passed on to customers, albeit with a lag. In the end the banks involved in the
concentrations offered their customers more favourable terms both on deposits and on loans.
The network economies stemming from mergers enable banks to extend their distribution
channels, with a reduction in charges for some kinds of transaction, such as cash
withdrawals, and to broaden and rationalize their product range. Concrete progress has
already been made. Today, in order to intensify the competitive pressure and enhance
customers' ability to choose, it is especially important to facilitate client mobility.
Contributions to this end have come from the rules introduced in recent years on current
account closing charges and the early repayment and portability of mortgage loans, from the
Bank of Italy's action on behalf of transparency and fairness in banking products, and from
the other authorities' action in defence of transparency and competition.
Local mutual banks continue to have significant weight within the Italian credit system. In
recent years over 400 independent mutual banks have expanded the scope of their business
within the credit market, especially with firms, exploiting their dense network and a banking
model centred on continuity in customer relations.
Globalization heightens the need, for mutual banks, like others, to adapt their services to the
needs of small and medium-sized enterprises, to increase their operating efficiency and to
improve their risk control and management. In other countries mutual banking uses
integrated systems to overcome the disadvantages of small size by centralizing production
and ancillary services. Italian mutual banks must continue their efforts to work out new
organizational solutions that can enhance the integration and efficiency of the network
without prejudice to the independence of individual banks.
Customer relations
I have remarked on other occasions that correct relations with customers, in addition to being
a legal obligation, are a strategic factor in the soundness of banks. The most pressing
problems concern the portability of mortgages, the maximum-overdraft fee, the transparency
of contractual conditions and the regulation of brokers and agents.
Regarding mortgages, the legislation introduced in the last few years and the recent
initiatives undertaken by the Government and the Italian Banking Association have laid the
foundations for the actual convertibility of loan contracts within banks and their external
portability. Banks must implement these initiatives without delay, provide the necessary
assistance to customers and seize the attendant competitive opportunities.
Steps should be taken to replace the maximum-overdraft fee with transparent forms of
remuneration commensurate with the size of the loan commitment.
I believe that by now banks are fully aware of the need to act promptly and effectively on
these two fronts, not least to safeguard the system's reputation.
The present rules on the transparency of contractual conditions for banking customers were
instituted by the Bank of Italy in 2003; in recent years they have helped to increase the
correctness of banking relations. We will hold a public consultation on a revised set of
regulations, which will take account of past experience, the evolution of the market and
legislative developments. We are determined to overcome operational rigidities, make
informative documentation clearer, simpler and more effective and improve the comparability
of the conditions offered by intermediaries. As in the past, consumer associations will be
involved in the process.
The drying up of wholesale supply channels has led banks to place new issues primarily with
retail customers. The more complex and atypical forms of fund-raising are at times
associated with scant transparency and high costs: they must be offered to selected
customers only, who should be made fully aware of the characteristics and risk profiles of the
issues. To avoid legal and reputational risks, banks must adhere scrupulously to this
principle; it is essential that the compliance functions initiate their operations.
In recent years in Italy, as in the rest of Europe, banks and other intermediaries have turned
increasingly to credit brokers and financial services agents, above all to establish initial
contacts with potential customers. In some cases this activity can lead to irregular practices
and weigh heavily on transaction costs. The correctness and professionalism with which it is
performed is crucial for the reputation of intermediaries that use these services; the objective
of extending the sales network must go hand in hand with that of providing appropriate
services and assuring transparency and economy. We have already drawn the attention of
banks to the need to activate all the necessary safeguards. There is, however, an equally
pressing need for the adoption of legal measures to raise the standards of professionalism
and transparency of brokers and agents, so as to address the considerable rise in their
number and avoid any risk of proximity with usury and other illegal activities. Here, the
transposition of the European directive on consumer credit represents an opportunity for
legislators.
Between 2003 and 2007 we completed over 4,000 controls of transparency at branches of
banks, financial intermediaries and Banco Posta. Last year these inspections were
intensified in frequency (their number increased by over 20 per cent), and in the criteria
applied, which focused to an even greater extent on verifying substantive compliance. In
addition to imposing the fines for non-compliance, where appropriate the Bank of Italy called
on intermediaries to reimburse any charges that had been improperly debited to customers.
From 2007 onwards a much more dynamic approach has been adopted to the handling of
complaints sent to the Bank of Italy by bank customers who believe they have been treated
incorrectly. There are nearly 5,000 such complaints per year. The Banking Supervision
Department checks that the banks involved respond promptly and adequately.
However, for the protection rules to be fully effective, it is necessary to create the conditions
for an increase in bank customers' knowledge of the characteristics of the financial products
in which they invest their savings, the yields they can expect, and the nature and size of the
risks they run. Several surveys have shown the existence of gaps to be filled. Recently,
authorities, trade associations - including ABI - and consumer associations have taken
initiatives in this field. As of last year the Bank of Italy has devoted a section of its website to
financial education; in addition, we have launched, in cooperation with the Ministry of
Education, a training programme for school teachers, so that economic and financial
education can be included in the syllabus.
The governance of banks
On the basis of the rules the Bank of Italy laid down in March, banks must submit a
governance plan and approve the necessary bylaw amendments by June 2009.
The Bank of Italy does not prefer one or another of the board models provided for by civil
law; it nonetheless takes a firm line in ensuring that, no matter which mode is chosen, the
principles of sound and prudent management are complied with in the bylaws and in
practice.
To the same end, the rules that we have adopted require banks to introduce limits on the
positions that their corporate officers can hold on other governing bodies; they also prohibit
members of control bodies from having operating responsibilities in other group companies
or strategic affiliates. The presence of persons on more than one board of directors is to be
considered natural within a group. Responsibility for assessing any competition issues
arising from the presence of directors on the boards of more than one company lies with the
Antitrust Authority, with which we are ready to cooperate, so as to coordinate interventions in
the matters for which we are respectively competent.
The prevention of conflicts of interest is also achieved through limits and conditions for
banks' assumption of related party risks. A set of rules has just been submitted to the
Interministerial Committee for Credit and Savings. For its part, Consob is drawing up rules,
applicable to all listed companies and companies with shares widely distributed among the
public, which assign a key role to the independent directors in transactions with related
parties. Together with Consob, we shall ensure that the rules are coordinated and limit the
compliance burden on intermediaries.
Overcoming the asset management crisis
The group that we established with asset management companies, and with the participation
of the Government and Consob, to propose measures to counter the decline of the Italian
asset management industry, is about to complete its work.
A first conclusion is that it is necessary to intervene on the tax distortions that penalize Italian
investment funds. As is the case elsewhere, they should be taxed on distributed profits and
realized capital gains, not on their accrued results.
The distortions produced by transparency legislation, which is particularly stringent for
investment funds, must be eliminated. It is not a question of reducing the safeguards
applicable to investment funds, but of increasing, substantively and not just formally, those
applicable to other financial products. In particular, for insurance policies of a financial
nature, more information must be disclosed on their liquidity; for bank bonds, customers must
be given clearer and more complete information on the costs, risks and liquidity of the
investment and on the yield of the instrument compared with that of other securities. The fair
value determined by the issuer bank must be reported periodically to the purchasers,
especially for unlisted instruments for which the issuer's commitment to buy them back is the
main guarantee of the possibility of liquidating the investment. New rules on fairness and
transparency for the distribution of illiquid financial products have been announced by
Consob; intermediaries will have to comply with them without delay.
The independence of asset management companies is essential. The reduction of conflicts
of interest must be furthered by a self-regulatory code of conduct that strengthens this
characteristic. It is indispensable that independent directors hold the majority of seats on
these companies' boards. By the autumn, using our powers, we will adopt measures to
separate the running of bank-controlled asset management companies more completely from
that of the banking group to which they belong, by clarifying the limits and purposes of the
parent company's powers of guidance.
Lastly, and I come to the hardest task, it is necessary to upgrade the manner in which
financial products are offered to investors, in order to realize in full the principle contained in
the Consolidated Law on Finance that intermediaries must act in the customer's interest. The
service of providing financial advice must be defined more sharply and made more
professional, promoting competition and transparency. The provision of investment advice
must be clearly distinguished from the placement of own products, carried out in the
customer's interest and not be limited to pushing house products. Savers who do not intend
to incur the cost of advice must nonetheless be given, in the course of placement activity, a
simple but effective explanation of risks, costs and returns, with a check, calibrated to the
complexity of products, on their suitability to the characteristics of the customer. An
appropriate degree of professional competence must be ensured not only for financial
salesmen but also for counter staff. The role of self-regulation is essential in this field, too.
New rules are necessary but not sufficient. The renewed growth of the financial industry
depends ultimately on the competitiveness of operators, on the promptness with which they
grasp the opportunities offered by innovation and respond to the challenge of the
everincreasing integration of the sector's markets and productive structures, including by means
of mergers. It is necessary to look far ahead. It has been clear for years that defending a
local niche, a captive clientele, is no longer a winning strategy. Today, it is not even an
effective means of defence.