Luigi Federico Signorini: 54th Credit Day
Speech by Mr Luigi Federico Signorini, Senior Deputy Governor of the Bank of Italy, at
the 54th Credit Day, Rome, 3 November 2022.
* * *
The economic and monetary situation
1. We are living through difficult times. A series of violent shocks, of a kind not seen in
Europe for a very long time (the pandemic, the war unleashed by Russia, the hike in
energy prices, the uncertainty of their supplies), has taken our societies by surprise. It
has caused unprecedented human and economic damage; it has led to extraordinary
fluctuations in real and nominal variables; and it has confounded both analysts and
forecasting models.
2. During the pandemic, the fiscal policies adopted in many European countries
managed to mitigate the impact of these shocks on households and firms, at the price
of a sizeable increase in government debt. Monetary policy accompanied and
supported the fiscal expansion driven by the emergency and averted the outbreak of
financial crises in times of heightened market volatility by injecting liquidity into the
system to an unprecedented extent.
3. Following the easing of the health restrictions, the rebound of the economies, not
least that of Italy, has been remarkable. Our country seems to have demonstrated an
underlying robustness, even in the most recent period. Despite being affected by
problems in the sourcing of energy and commodities, as well as by all the other
consequences of the ongoing crisis (difficulties in international trade, deteriorating
confidence), economic activity rose by 6.7 per cent in 2021, exceeding its pre-pandemic
level in the fourth quarter of the year. It continued to expand in the first half of this year,
albeit at a slower pace.
4. According to the preliminary estimate released by Istat on 31 October, GDP
increased slightly (0.5 per cent) in the third quarter too, once again surprising analysts,
who had, at most, expected stagnation. The upturn was supported by the growth in
services, the economic activity of which is more difficult to predict than it is for the
manufacturing industry, given the reduced availability of effective and timely indicators,
such as energy consumption and goods transport. Tourism and leisure activities, which
were hit hardest by the public health emergency, have continued to recover.
Consumption appears to have been temporarily driven by the savings accumulated
during the pandemic.
5. Italy's economy will inevitably be influenced by the worsening of the international
outlook. Global economic activity is, in fact, slowing down and growth estimates for next
year have been progressively revised downwards by leading international institutions.
The deterioration in the outlook continues to be affected by higher inflation, marked
uncertainty over the Ukraine conflict, worsening financial conditions and the weakening
economy in China.
6. Nevertheless, despite the challenging situation, based on the projections in the latest
issue of the Bank of Italy's Economic Bulletin - which will likely be revised slightly
upwards in light of the new data - the baseline scenario assumes a slight growth on
average for the year 2023; only in a stressed scenario (with a total freeze on Russian
gas imports) would there be a decrease on average over the year. However, economic
uncertainty remains exceptionally high because of the extreme and unpredictable
nature of some risks, especially those linked to the war.
7. The surge in inflation, which has reached levels unmatched for decades in the
advanced economies, is of grave concern. According to the latest available data, the
increase in consumer prices exceeded 8 per cent in the United States in September
and, based on a preliminary estimate, neared 11 per cent in the euro area in October.
In Italy, inflation is running at an even faster pace than the average: according to the
harmonised definition, it was 12.8 per cent in October.
8. In response to the strong acceleration in prices, central banks have started a
normalisation of monetary conditions in order to reabsorb the high degree of
accommodation decided upon to offset the effects of the pandemic. This is necessary to
keep inflation expectations anchored and bring inflation back in line with the definition of
medium-term price stability adopted in the leading advanced economies.
9. In the euro area, following the end of its net asset purchases, the ECB Governing
Council started increasing its key interest rates, by 2 percentage points overall since
July, thus bringing the deposit facility rate back from negative values to 1.5 per cent.
The Council has announced that it expects to raise them again at its next meetings, at a
pace and to a level that will be determined on the basis of new data and on revisions to
the inflation and growth outlooks.
Markets and non-bank intermediaries
10. The normalisation of monetary policy, which is necessary to give a firm and
unequivocal signal on inflation, is coinciding - in this difficult global situation - with
heightened market volatility and occasional episodes of illiquidity.
11. Over the past few months, following the onset of the war and given the concerns
over the procurement of some strategic commodities, severe tensions have been
observed in the energy (gas, oil) and commodity (nickel) markets, with spikes in
volatility similar to those observed on the financial markets at the outbreak of the
pandemic. Some intermediaries have had to post considerable resources to meet
margin requirements on their derivative positions, given the high and extremely volatile
prices. This resulted in severe turbulence and, in one instance, in the temporary closure
of the market. Non-financial firms that use commodity derivatives to hedge against risks
and not for speculative purposes have also been affected.
12. The growth in government debt, coupled with the prospect of interest rates
recovering from the exceptionally low levels reached during the pandemic, has stoked
tensions in the sovereign bond market, especially for bonds issued by countries that are
more fragile and/or have the highest debt-to-GDP ratios. Since the spring, the spread
between Italian and German government bond yields has widened, with peaks close to
250 basis points; this has been partly reversed in the last few weeks. Liquidity
conditions in the secondary market for government securities have become less
relaxed; this trend, which emerged at the end of last year, is common to other countries.
13. Tensions have also spread to government securities considered to be at low credit
risk, such as UK gilts, whose yields soared when the government announced an
exceptionally large fiscal expansion. The rise in yields was amplified by the demand for
collateral on leveraged positions and derivatives of a number of defined-benefit pension
funds (which use these investment strategies to balance expected pension payments
with the performance of returns on their assets). In order to cope with such demand,
pension funds would have had to sell large amounts of government securities under
challenging market conditions, which could have triggered a destructive spiral. Only the
emergency intervention of the Bank of England - which temporarily suspended its
planned quantitative tightening and introduced extraordinary measures - was able to
restore orderly conditions.
14. Private sector bond spreads also widened in the main currency areas. The gap
between euro-area and US risk premiums has extended, due to the greater exposure of
European firms to the energy crisis. The spread on BBB-rated bonds of euro-area
nonfinancial corporations is now close to 250 basis points, well above the long-term
average. Looking ahead, the main rating agencies and markets seem to expect a
deterioration in credit risk, although the corporate default rate has not increased
significantly so far. Any downgrades would mainly affect investment grade corporate
bonds close to the BBB rating threshold, which would be exposed to the risk of forced
sales by investors with mandate restrictions.
15. Anumberoffinancial stability risks lurk inthesectorswithalarger shareofnon-bank
financial intermediaries, which in recent years have grown to the point of holding around
half of global financial assets. These intermediaries often have features that can cause
them to amplify market tensions, for instance a structural mismatch between the
duration or liquidity of assets and liabilities. No regulatory intervention can completely
eliminate the possibility of spirals forming on the market because of pro-cyclical
behaviour on the part of investors. However, from a macro-prudential perspective,
actions can be taken on the structural amplification mechanisms inherent to collective
investment instruments in order to mitigate their effects on financial stability.
16. Last year, I took the opportunity provided by this event to look back at the banking
regulation reform that followed the financial crisis of 2008. I argued that, although
imperfect, as is everything human (and not yet complete), the reform has genuinely
strengthened the banking system, enabling it to play a stabilising role during the most
recent turmoil. This is a statement which I believe can be confirmed by the
far-frompeaceful events that have occurred in the past year.
17. I wish I could say the same for the reform of non-bank financial regulation, which
has not made sufficient progress yet. Important steps forward have been taken, also at
the instigation of the Italian G20 presidency in 2021, especially with regard to money
market funds. However, although the international discussion has started, it is moving
far too slowly on other fronts, most notably open-end investment funds. We never tire of
repeating that faster and more decisive progress is needed in this area.
18. Protecting market stability in the event of severe stress cannot be a task left solely
to the ex post intervention of central banks: not only in light of the well-known moral
hazard problems, but also because of the risk of causing tension between the needs of
market stabilisation and the primary objective of monetary policy, i.e. price stability.
Financial stability must also be able to rely on ex ante safeguards consisting of a sound,
robust and resilient non-bank financial intermediation system.
19. This issue is particularly relevant at a time like this, when central banks are moving
away from the ultra-accommodative monetary policies of the recent past, as the British
gilt episode clearly shows. Regardless of the fiscal policy issues that triggered it, the
episode stems from a structural mismatch between the maturities of the assets and
those of the liabilities of local pension funds. In order to avoid its destabilising potential,
the Bank of England was forced to act in a way that made the implementation of its
monetary policy exit strategy more complicated. Easing such trade-offs would help
make the simultaneous pursuit of monetary and financial stability more effective.
Banks
20. The banking system is also affected by the normalisation of monetary policy.
21. The impact of the new stance will be visible firstly - and to some extent it already is
- on net interest income. Long hindered by low interest rates and a flat yield curve,
traditional banking is making a comeback as a significant contributor to profitability. In
the first six months of this year, when policy rates had not yet been changed but
tightening expectations were already being incorporated, at least in part, into market
rates, Italian banks' net interest income rose by 9 per cent compared with the same
period a year earlier. The increase in policy rates and in the slope of the yield curve will
lead to further net interest income growth, at least in the short run.
22. This positive effect is likely to fade as rate hikes feed into interest expenses as well.
Some 20 per cent of total bank bonds outstanding will mature in the coming year.
These securities have already seen their secondary market yields rise substantially
since the beginning of this year, in line with money market yields. Furthermore, bond
funding is set to increase in compliance with MREL requirements and to replace, at
least in part, TLTRO III refinancing operations.
23. However, the effect of this on net interest income is expected to be positive overall.
Our estimates, which incorporate the Bank of Italy's most recent macroeconomic
projections, suggest that net interest income could rise on average by around one fifth
per year over 2022-24.
24. Secondly, the increase in interest rates has a negative impact on the valuations of
securities held for trading. This will weigh on the income statement, in terms of profit or
loss from trading, and directly on capital, in terms of unrealised losses on assets
measured at fair value, which affects 'other comprehensive income'. However, the total
accounting impact should be limited, as the share of securities held by banks in their
trading books is not very high.
25. Thirdly, interest rate hikes, especially if coupled with an economic downturn, may
affect debt service payments and, as a result, the quality of bank loans. This effect
normally lags behind somewhat, and there are no clear signs of it so far. At a later
stage, however, we may reasonably expect an increase in loan losses. Our economists
estimate that they could double in 2023-2024 compared with this year. Around half of
this increase would be attributable to higher lending rates for households and firms, the
other half arising directly or indirectly from the cyclical slowdown. Given the very low
starting point, this increase, though not negligible, would leave the level of loan loss
provisions still far from the peaks reached following the financial and sovereign debt
crises.
26. All in all, even taking into account the fact that operating costs - which have fallen
significantly in recent years - are expected to rise again, reflecting the spike in inflation,
and with all the uncertainty surrounding any forecast in these unsettled times, there are
now the conditions for the Italian banking system to achieve adequate profitability in the
near future.
27. Despite the uncertain economic outlook, bank lending to firms has accelerated
since the spring of last year, reflecting both the higher working capital requirements,
stemming from higher input costs, and lower bond issuance. However, this trend must
also be assessed in light of the price increases. The latest surveys of banks and firms
point to a tendency to tighten credit supply policies, which banks expect to continue in
the latter part of the year.
28. The level of capitalisation of the Italian banking system is now adequate overall.
The ratio of common equity tier 1 to risk-weighted assets (CET1 ratio) stood at 14.8 per
cent in June. The depreciation of government bonds measured at fair value is likely to
have a manageable impact on capital: our estimates suggest that an upward parallel
shift of 1 percentage point in the yields on these bonds would reduce the CET1 ratio by
around 20 basis points.
29. The European Systemic Risk Board (ESRB) has recently signalled heightened
vulnerabilities in the financial system throughout the European Union, identifying three
major risks to financial stability: a worsening macroeconomic outlook associated with
tighter financing conditions; a sudden slump in asset prices; and the fallout of a
worsening economic outlook on asset quality and on profitability in the banking system.
30. In such uncertain times, maintaining a sound capital position is key to preserving
the ability of the banking system to support the real economy even if and when risks to
financial stability materialise. Prudent choices are of the essence, such as accounting
for expected losses without delay and the timely adjustment of capital levels to deal with
adverse scenarios. In the coming months, supervisors will pay the utmost attention to
ensuring that banks act in line with these principles, also based on the ESRB's warning.
31. As I mentioned earlier, the implementation of the Basel reforms is still incomplete.
We now need to update the European rules, thus fully enacting the last reform package.
It is now one year since the European Commission published its legislative proposal. In
implementing the new prudential rules, it preserves some of the specificities of the
current rules, including the seniority of loans to small and medium-sized enterprises.
Once again I express the hope, as I did on this very occasion a year ago, that the
debate on the prudential treatment of individual risks will not be reopened, and that the
overall compliance of European rules with international standards is ensured, in line
with what was requested in September last year in a letter signed by the vast majority of
governors and supervisors of EU Member States.
Beyond the economic cycle: banks and technological innovation
32. The cyclical challenges facing the banking system in the coming months should not
overshadow the longer-term ones.
33. These challenges are quite serious, but I would not dream of announcing here the
imminent death of the commercial bank model, so often dreaded, proclaimed or
threatened in the past, based on the presumed pincer movement of competition from
new technologically fierce intermediaries and the strict regulation of the banking sector.
For banks, innovation is certainly nothing new, and so far this announcement has been
greatly exaggerated, as they say. Wherever innovation poses a challenge, there are
opportunities for the farsighted and lucky entrepreneur, including the banking
entrepreneur, just like everyone else. Nevertheless, we should bear in mind that there
are challenges, which do pose serious risks if overlooked, and require targeted
responses.
34. To emphasise the complexity of the decisions we face, I shall mention but one
example, without overlooking its problematic aspects: the deployment of artificial
intelligence and machine learning, and the use of big data to measure creditworthiness.
When these technologies began to spread, many thought they would sweep away the
banks, which were slow in embracing the new techniques and unable to make full use
of their wealth of customer information, to the benefit of non-bank operators with
formidable databases and proven processing capabilities.
35. While this has not yet happened, or at least not on a large scale, what is to say it
will not happen in the future? A recent report published by the Bank of Italy shows that
the use of innovative data analytics by Italian banks for assessing creditworthiness,
1
though still relatively uncommon, is expanding. Recourse to these techniques will
require adequate investment in human and technological resources. Evidence shows
that they can improve both the effectiveness and the operational efficiency of the
assessment techniques, especially for standardised small-amount funding.
36. However, banks that have chosen or will choose this path should also be aware that
it is not without its pitfalls, as the report I mentioned earlier highlights. The difficulty in
interpreting the results of algorithmic selection involves, in the absence of specific
safeguards, the risk of losing control over the determinants of decisions. It makes it
more difficult to explain to customers why their application for credit was unsuccessful.
The risk of unfair discrimination against individuals or categories of customers must be
dealt with, also in view of forthcoming regulatory interventions regarding artificial
intelligence. These difficulties do not only affect banks, but apply to anyone who uses
similar techniques to grant credit. Banks have the cultural resources to deal with them,
but if they want to take up the challenge, they need to be adequately equipped.
37. In general, much remains to be done to adapt banks' business models to the
numerous challenges of technological innovation. Operators know they can rely on the
active support of the Bank of Italy, using the now well-known tools (the Fintech Channel
and Milano Hub, together with our collaboration with the Italian Ministry of Economy and
Finance and the other authorities in the regulatory sandbox), as well as the whole range
of supervisory and regulatory activities.
38. Here I must also remind you that it is essential to keep cyber risks under control.
Such risks have presumably increased with the outbreak of the conflict in Ukraine. It is
therefore all the more necessary for them to be closely monitored by both banks and
the main, often concentrated, technology service providers they use.
* * *
39. Let me conclude by going back to the most pressing current issues.
40. The sharp rise in inflation requires the full attention of economic policymakers. If it is
not stopped in a timely manner, it risks devaluing incomes and depleting savings. To
counter this, all policies need to work together, with monetary policy at the forefront.
Should price expectations lose the anchor of stability, even the easing of exogenous
cost pressures, though desirable, would not be sufficient to halt the process.
41. For the central bank, price stability is the primary, constitutionally imperative
objective. The ECB has taken the path to calibrated but firm monetary normalisation
and has announced that this path will continue. This will not be easy due to the new
challenges, the inherent complexities of monetary policy interventions, affected by 'long
and variable' delays, the uncertainties of the global macroeconomic outlook, and the
potential fragilities underlying financial markets.
42. In Europe, rising interest rates and the gradual phasing out of quantitative easing
require careful and forward-looking policies on the part of everyone to avoid the
emergence of tensions and possible fragmentation. The Governing Council stands
ready to use all the flexibility necessary in reinvesting securities under the pandemic
emergency purchase programme (PEPP), and has set up a dedicated monetary policy
transmission protection instrument (TPI) that will be activated, if necessary, in the event
of fragmentation not due to imbalances in the public finances or in the macroeconomic
conditions.
43. Policies will have to be consistent at national level. As far as Italy is concerned, I
can only repeat the words spoken a few days ago by Governor Visco: 'This makes it all
the more important to set out a realistic path to continue the process of gradually
reducing the high public debt-to-GDP ratios initiated in the past two years.'
44. Banks must not fail to support the economy with prudent lending. The conditions are
already in place: sound balance sheets, adequate capital, and non-performing loans
amounting to a fraction of what they were ten years ago. If we had been able to foresee
at that time today's situation, which has resisted and is indeed stronger despite two
crises of historic proportions, we would probably have been quite amazed. Praise
should go to those who led the banks, to the market that spurred them on, and perhaps
(if I may say so), to some extent, to the authorities that regulated and supervised them.
45. What we need today, however, is not self-congratulation but a renewed
commitment, and the awareness that bank credit is still an irreplaceable tool for keeping
the economic engine of a society running, as long as it is used with competence,
caution, a willingness to embrace the new, and a deep-rooted sense of reality.
1
'Artificial intelligence in credit scoring: an analysis of some experiences in the Italian
financial system', Questioni di Economia e Finanza (Occasional Papers), 721, October
2022.