Ignazio Visco: The sovereign debt crisis and the outlook for Italy
Address by Dr Ignazio Visco, Governor of the Bank of Italy, to the 18th Congress of Financial
Markets Operators organised by ASSIOM FOREX (the Financial Markets Association of
Italy), Parma, 18 February 2012.
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Last November the spread between the yield on ten-year BTPs and their German equivalent
reached 550 basis points; yesterday at the close it stood at 365 points; in the first six months
of 2011, it had been mostly below 200 basis points. Tensions remain high in the international
financial markets.
The difficulty in resolving the Greek crisis, evident again in recent days, is transmitting
turbulence to the entire European market. Investor uncertainty over Italian government
securities has eased with respect to the worst moments of the crisis, but has not
disappeared.
The markets' attention is now focused on Italy's ability to make further determined progress
in the restoration of its public finances and simultaneously stimulate its economic growth
potential through structural reforms. The path has been set with clarity of purpose;
international public opinion acknowledges as much; it must now be followed with
perseverance and resolution. But no-one can succeed on their own. To lower the risk
premiums on the government securities of the countries engaged in financial stabilization
and the revival of output, decisions must be taken by common accord. The determination of
all to reinforce the European construction is essential. In recent months Italy's economic
policy has taken steps towards financial sustainability which were once deemed
inconceivable, for example regarding the pension system. Equally bold steps are expected
on other, decisive fronts, to which the Government is already committed: the efficiency of the
taxation system and the fight against tax evasion; the public sector spending review, which
will analyze every item to identify possible redundancies and savings; and the simplification
of laws, institutions and practices that are blocking the country's energies, reducing firms'
competitiveness and frustrating the expectations of the younger generations.
1. The sovereign debt crisis and the outlook for Italy
For two years now the global financial crisis has found a new and dangerous focus in the
euro area. The turbulence was initially confined to Greece, whose budget situation had long
been obscured by the official statistics; it then spread to Ireland, which suffered the
consequences of the profound crisis in its banking sector, and to Portugal, penalized by its
foreign trade deficit.
The limits of euro-area governance have become apparent. Multilateral monitoring of
national economies failed to ensure sufficiently prudent budgetary policies in good times, and
underestimated the macroeconomic imbalances of several countries. The initial lack of
satisfactory instruments for managing and resolving sovereign debt crises has been
compounded by the faltering and scarcely effective progress of the Greek aid programme
and the drawn-out negotiations for governance reform.
Tensions in the financial markets assumed systemic proportions from the summer onwards,
following the announcement of private-sector involvement in the proposed resolution of the
Greek crisis, despite this being presented by the Eurogroup as a unique and exceptional
case. The turbulence spread to Spain, which suffered the consequences of a fall in property
prices, and Italy, with its high public debt and weak growth prospects in the medium term.
The financial markets, which had long underestimated the possibility of default by a
sovereign issuer in the euro area, to the point of tacitly ruling it out, now began to give
excessive credit to this scenario, involving countries whose fundamentals warranted less
negative assessments. The markets - operators, analysts - clearly struggle to produce a
sound interpretation of all the available information, which is sometimes incomplete or
lacking in transparency; above all in the phases of acute uncertainty, operators tend to
engage in the kind of herd behaviour that fuels financial contagion. In turn economic
policy - particularly in the institutional context of the single currency - is hard put, in its
regulations and interventions, to respond rapidly to fluctuations in the prevailing opinions in
financial markets, to curb excesses, and to channel its response towards a stable and
effective equilibrium.
To assess sovereign risks in a timely and independent fashion, taking account of the
conditions and prospects of the public finances, the level and trends in private sector debt,
and countries' growth prospects, is clearly no easy task. It requires the commitment of very
substantial resources and the rating agencies have not always been up to the mark.
Appropriate standards must be defined; there is a need for transparent working relations
between the agencies and independent, national and supranational institutions, charged with
carrying out analogous assessments. The measures adopted by Italy during the summer to
bring budget balance forward to 2013 and the acceleration of the EU governance reform
process with the definition of the "Six-Pack" in the autumn, did not succeed in alleviating the
tensions in the financial market. Instead, the concerns over the adequacy of the European
financial support mechanisms and the fears over the weakening of the international economy
prevailed.
There was a sharp worsening of wholesale funding conditions for banks in Italy and the other
countries exposed to tensions, whose creditworthiness has been treated as equal to that of
their respective governments. US money market funds basically stopped buying commercial
paper; unsecured bond issues dried up. Strong fears were aroused by the large volume of
bank bonds maturing in the first part of 2012. In Italy, as in other euro-area countries, funding
difficulties were increasingly affecting credit supply conditions. There was a real risk of a
severe restriction of funding for the economy.
The Governing Council of the European Central Bank lowered the rate on the main
refinancing operations rate by 25 basis points in November and again in December, bringing
it down to 1.0 per cent. In December, the Council also introduced three-year refinancing
operations, announced an expansion of the range of assets eligible as collateral, and halved
the compulsory reserve coefficient. Carrying out its function as supplier of liquidity to the
banking system with determination, the ECB countered the banks' fund-raising difficulties
and the restriction of credit.
The action of the ECB, the incisive budget measures taken in the countries suffering from the
worst financial turmoil, and the reaching of an agreement for stronger cooperation under the
fiscal compact have succeeded more recently in easing the strains in the government
securities market and in banks' balance sheets.
Monetary policy alone cannot resolve the crisis. Along with a consolidation of public finances
there must be structural reforms for vigorous and balanced growth; the rules of the fiscal
compact must be rapidly implemented. The financial support mechanisms at European level
must be made to work with greater agility and more effectively; the adequacy of their
intervention capacity must be ensured. The threat of dangerous contagion must be
definitively dispelled by resolving the problem of Greece.
In Italy the three budget correction packages passed between July and
December 2011 should lead to a primary surplus on the order of 5 per cent of GDP in
2013 and a reduction in the debt ratio. The adjustment will come mainly from an increase in
revenue but expenditure savings will increase over the three years 2012-14. The pension
reform will immediately reinforce the financial sustainability of the pension system by setting
stricter requirements. In the medium term the Italian economy's capacity for strong and
stable growth must be restored, by making firms more competitive. GDP is still 5 points
below the level reached in 2007, before the crisis; households' real disposable per capita
income is down by 7 points and industrial output by a fifth. The deficit on the current account
of the balance of payments remains large.
The reforms decided must be rapidly completed and put into effect, in particular those to
make the regulatory and administrative structure favourable rather than unfriendly to
economic growth: the liberalization of important service sectors, the effective simplification of
administrative acts, the better functioning of the labour market, special attention to human
capital and innovation, and faster responses by the judicial system. Even if the effects of
individual interventions will arrive gradually, a comprehensive and wide-ranging plan can
have a positive influence on expectations in the short term and so stimulate aggregate
demand and a recovery in investment.
The point is to create favourable conditions for those who invest and create jobs in Italy not
with subsidies but by furnishing suitable intangible infrastructure; not through the shadow
economy but by cracking down on tax evasion. Society pays a high price for corruption and
crime in general in the form of deteriorating civic life and lost economic development.
Combating them, and especially their financial implications, will remove one of the brakes on
growth.
Economic growth favours the consolidation of the public finances, which in any case are
already on a sustainable path, even under unfavourable assumptions concerning growth and
interest rates. With modest real growth of around 1 per cent and a spread on ten-year
government bond yields stable, if high, at 300 basis points, primary surpluses of 5 per cent of
GDP, as forecast for 2013, will reduce the debt ratio by more than is required by the new
European budget rules.
This year will be a year of recession. As we indicated in the forecasting scenarios set out in
our Economic Bulletin in January, we expect a year-on-year decline in gross domestic
product of about 1.5 per cent. But it is important to look ahead, to act in such a way that as
conditions in the financial and credit markets return to normal it will be possible to stabilize
economic activity in Italy already by the second half of 2012 and return to growth next year.
2. Bank liquidity, the extraordinary measures of the Eurosystem and credit to the
economy
Italian banks are sound, but they have been especially hard hit by the sovereign debt strains.
Since last summer short-term fund-raising in dollars and funding on the bond market have
slowed to a trickle, while the fall in government securities prices and the raising of margin
requirements by the main lenders have limited the banks' access to repos.
One factor in market instability and the consequent funding difficulties has been the
operation of automatic mechanisms. This occurred, for instance, on 9 November, when the
French central counterparty, LCH Clearnet SA, drastically raised its margin requirements
against positions in Italian securities, in line with the sovereign risk framework of the British
member of the Clearnet Group. Italy's Cassa di Compensazione e Garanzia, linked to
Clearnet through an interoperability agreement, had to adapt in order to avoid jeopardizing
the orderly functioning of the market. Afterwards, the competent authorities asked the two
central counterparties to review the decision and to develop a common methodology for
assessing sovereign debt risks. The process must be based on an adequate statistical base,
avoid automatic links with rating agencies' assessments, and curb the potential pro-cyclical
effects.
In the course of 2011, while residents' deposits and bonds held by households remained
stable, Italian banks' overall fund-raising from customers and the markets slowed and from
November started to contract. For 2011 as a whole, it declined by 2.8 per cent. At the same
time, the banks' recourse to Eurosystem refinancing increased considerably. A real risk was
emerging that the difficulties of raising funds in the international markets would result in a
contraction of lending, aggravating the cyclical downturn and inevitably triggering feed-back
effects on the banks' balance sheets.
Until November Italian banks' lending to the non-financial private sector continued to expand,
although at diminishing rates. In December, however, loans to firms contracted by about
€20 billion. The decline is very large by historical standards, although it may have depended
in part on the usual volatility of end-year data. Lending to households diminished only
slightly.
Preliminary data indicate a slight further contraction in credit in January.
Certainly firms' demand for credit has declined, given the poor state of the economy, but
surveys of banks and firms indicate a tightening of credit supply terms as well. The Italian
banks participating in the Eurosystem's quarterly Bank Lending Survey confirm that the rise
in lending rates and the strains on credit supply are due mainly to serious difficulties in
raising funds in the markets as well as to growing credit risk.
Firms are now facing the second tightening of lending terms within just a few years. Once
again the banks' ability to assess creditworthiness correctly and not withdraw financial
support from solvent, creditworthy customers will be crucial. Adequate and stable lending
volume is essential to the banks themselves.
In its first three-year refinancing operation on 21 December, the Eurosystem supplied banks
with a total of €490 billion. Considering the contraction in the volume disbursed through other
operations, the net increase in the resources provided to the banking system amounted to
about €200 billion.
This liquidity is circulating. Most of the funds re-deposited with national central banks did not
come from the same banks that had obtained them from the Eurosystem.
With this first three-year operation, Italian banks received gross funding of €116 billion,
corresponding to net refinancing of €60 billion. The inflow of long-term liquidity substantially
eased the funding tensions. The second three-year refinancing operation, scheduled for
29 February, will further sustain the supply of credit.
The operations of the Eurosystem are currently on a full allotment basis; banks' refinancing
capacity accordingly depends on the availability of collateral. In recent months Italian banks
have significantly increased the collateral pool at the Bank of Italy, to about €280 billion at the
end of January. Their eligible uncommitted assets on the same date are estimated to have
amounted to €77 billion after the application of haircuts. Since the total exposure to the
Eurosystem amounted to about €200 billion, the Italian banking system's capacity for further
refinancing can be estimated at more than €150 billion.
Following the recent decisions of the ECB's Governing Council, we have joined other
national central banks in announcing measures aimed at further expanding the range of
assets banks can use as collateral for refinancing operations. In just a few days Italian banks
will be able to deposit a broader range of bank loans meeting clearly defined eligibility
criteria, with the Bank of Italy bearing the related risks.
To reconcile the objective of increasing banks' access to refinancing with the need to
preserve the solidity of the central bank's balance sheet, the new eligible collateral will be
selected rigorously. In particular, it will include bank loans with a very low probability of
default, not exceeding 1 per cent. As a result of the above changes, once haircuts have been
applied, Italian banks' total eligible assets will increase by another €70-90 billion to a little
under €450 billion. This may permit a progressive reduction in the importance of
government-guaranteed bank bonds, the volume of which is about €60 billion after the
application of haircuts.
The introduction of new collateral eligibility criteria and the ample supply of long-term liquid
funds are helping to restore a uniform transmission of monetary policy in the various
euroarea countries.
The injection of three-year liquidity has already helped to attenuate the tensions on the
money market. Compared with the days preceding the operation, three-month and one-year
Euribor rates have fallen by about 40 and 30 basis points respectively, largely owing to the
reduction in risk premiums. After rising to as high as one percentage point, the differentials
between the overnight rates on the interbank markets of the countries most severely affected
by the tensions and the euroarea average have fallen to zero.
The spreads on credit default swaps for Italian banks have also fallen significantly, although
they remain higher than they were up to the middle of 2011. At the end of January a large
Italian bank returned to the international market with an issue of unsecured bonds that was
favourably received by investors; the yield was not significantly higher than that on Italian
government securities.
3. Banks' profitability and capital strengthening
In 2009 the financial crisis and the recession caused a sharp fall in Italian banks' profits. In
contrast with what happened in the other main European countries, the recovery in 2010 and
2011 was modest and the outlook for this year is not good.
Banks' profit and loss accounts are affected in the first place by the difficulties facing a large
part of Italian industry. In addition to these cyclical problems, Italian banks are faced with
others of a more structural nature related to the relatively limited diversification of their
sources of income and the high level of their costs.
Low profit margins reduce the resources with which to strengthen banks' capital and make it
more difficult to raise funds on the market, thus diminishing the ability of the banking system
to support the economy. Profitability can be increased by improving the quality of the
services supplied, thus permitting revenues to be expanded and diversified. The progress of
technology and the public's growing ability to use it can foster a rationalization of production
processes and distribution networks; significant cost savings can also be achieved by
simplifying corporate governance.
The medium-term objectives for profitability must be revised taking into account the
far-reaching changes that have occurred in recent years. Profit levels such as those seen in
some parts of the international banking industry before the crisis are not compatible with the
stability of the financial system. More efficient and stable banks can raise capital more
cheaply.
Basel III requires banks to operate with more and higher quality capital than in the past; in
periods of rapid credit expansion it requires them to build countercyclical capital buffers; it
sets a limit on their leverage ratio; and it introduces new liquidity ratios, so as to make banks'
balance sheets more resistant in the short term and better balanced in the medium term.
Additional capital requirements are now planned for banks that could pose a threat to global
systemic stability if they were in difficulty; effective and credible resolution mechanisms in the
event of a crisis, including clear provisions on burden sharing, are likely to avoid costs being
charged to the public or reduce them to a minimum.
The new regulatory framework confirms the favourable treatment of loans to small and
medium-sized enterprises already established by Basel II. In many cases such firms have
opportunities to grow. Lending to well-capitalized firms deemed to be able to exploit
economies of scale or scope carries lower capital charges for banks that use internal rating
systems, so that loans can be granted at relatively low interest rates. In the years leading up
to the crisis we saw just how damaging a race to the bottom between financial systems in
both regulation and supervision can be. Therefore, when Basel III is transposed and
implemented in the EU and in the other G20 countries, its objective of creating a level playing
field for all banks must be fully respected.
We have asked Italy's leading banks to strengthen their capital considerably in recent years.
They have complied, even in difficult times, mainly by raising funds, to a value of almost
€20 billion, on private capital markets.
Much ground has been covered in just a few years. The core tier 1 ratio of the five largest
banking groups has reached an average of 9.5 per cent of risk-weighted assets, compared
with 5.7 per cent at the end of 2007, on the eve of the crisis. The gap, now narrower, that
remains between the capitalization of our leading banks and the average capitalization of
their main foreign competitors partly reflects differences in the way risk-weighted assets are
calculated in the various systems.
Work to reduce these differences, which we strongly support, is now under way at
international level and will include peer review mechanisms. In Europe, the adoption of the
single rulebook will be a step in the same direction.
When evaluating banks' capital adequacy we also take account of their overall leverage.
From this point of view, Italy's banking system is extremely sound. The ratio of total
balance-sheet assets to tier 1 capital of our leading banks is less than 20, against an
average of 33 for the principal European banking groups.
The Recommendation on banks' capital issued by the European Banking Authority on
8 December as part of a broad package of measures approved by the European Council at
the end of October aims to enhance the system's ability to withstand the high sovereign risk
tensions and potential additional shocks. It does not change the current prudential and
accounting rules; it does not discourage investment in sovereigns as the capital buffer
against sovereign risk relates to exposures at the end of September. The
EBA's Recommendation calls for a strengthening of capital, not a reduction of assets.
The measure was decided in exceptional circumstances, necessitating a difficult trade-off
between dispelling, firmly and promptly, any market doubts about the soundness of
European banks and avoiding pro-cyclical effects. The EBA and the national authorities have
repeatedly emphasized that the Recommendation is a temporary measure and will not be
repeated. The EBA has decided to postpone the next stress test exercise on the European
banking system to 2013.
The optimal sequence for the measures taken by the European Council would have been to
strengthen the EFSF and make it fully operational and to activate the system of European
public guarantees for new medium- and long-term bank liabilities before or at the same time
as the EBA issued its Recommendation. Had Europe's intervention capacity been reinforced
immediately, this would have reduced uncertainty over the course of the sovereign debt crisis
in Europe and thus improved both the valuation of sovereign bonds and the banks' ability to
raise funds on the market.
The EBA has agreed to re-examine the need for a sovereign buffer once the EFSF is up and
running and sovereign bond prices are picking up.
The Italian banks that took part in the EBA exercise can strengthen their capital base as
required without reducing their lending to the economy. One leading bank has already
successfully completed a large capital increase, which alone will cover nearly all its capital
requirements and make good almost half of the Italian banks' overall capital shortfall. The
capital strengthening must proceed, however. We expect the banks' forthcoming decisions
regarding their dividend policy and executive compensation to take account of this. The Bank
of Italy is about to issue guidelines to the banks in this regard.
It is important that the banks prepare for the introduction of Basel III, which will be phased in
between next year and 2019. Experience of recent years has shown that it is within the
banking system's capacity to achieve a reasonable strengthening of the capital base.
4. Banking competition and customer protection
In a legal order that recognizes the entrepreneurial nature of banking, competition is the most
effective means of protecting savings and safeguarding customers, to the benefit of the
system's stability. In addition to prudential supervision, the Bank of Italy is entrusted with
tasks and responsibilities concerning transparency and correctness in bank-customer
relations as regards banking products. In recent years we have significantly stepped up our
commitment on this front.
In the face of inefficiencies, it is necessary to shun the temptation to impose price caps or
prohibitions on banks; however commendable the intent, these would merely scratch the
surface of the problems, determining non-optimal pricing policies, impeding innovation and in
some cases even reducing competition. Competition develops if the market is transparent,
supply is diversified and switching costs are low - all necessary and mutually reinforcing
factors.
This is the thrust of the measures introduced by law in recent years: cost-free withdrawal
from all contracts of indeterminate duration with banks, hence including current accounts;
portability of real-estate mortgage loans; simplified procedures for transferring mortgages.
The rules laid down by the Bank of Italy in exercising its powers of customer protection have
the same thrust. We have demanded greater clarity and comparability of the information
provided by banks, especially on the costs of their products. Measures have been introduced
to make the costs of loans and current account overdrafts more transparent and comparable.
Banks have been warned on more than one occasion that they must comply with the
substance of these rules, and enforcement action has followed.
Among the latest legislative measures, the prohibition on simultaneously holding corporate
office in competitor firms is intended to prevent the risk of collusive conduct in boards of
directors; the measures that favour the use of electronic payment instruments aim at
reducing the use of cash, as in the other European countries; the terms and conditions
applying to loans and breaches of overdraft ceilings will be more transparent. The Bank of
Italy is in full accord with the spirit of these measures and is prepared to do its part for their
implementation by rapidly overcoming any doubts of interpretation regarding the exact scope
of some prohibitions.
* * *
The Eurosystem will continue to counter the malfunctioning of the markets and provide
support to bank liquidity and lending. But to bring government securities prices back to levels
consistent with the fundamentals of the euro-area economies, thereby eradicating the chief
cause of the difficulties of the banking system, it is essential that national policies continue to
be directed to stability and growth, which are not conflicting objectives, and that the reforms
of European economic governance be implemented swiftly.
The abundant liquidity made available by the Eurosystem in December and with the
upcoming end-of-month operation, though not a cure in itself, is nevertheless crucial in the
present phase. It has averted the imminent risk of an acute funding crisis with repercussions
on credit and severely destabilizing consequences; it makes it possible to maintain a high
level of financing for the economy.
Banks will have to demonstrate that they are able to perform their credit allocation function
well, under conditions of sound and prudent management, with keen discernment. Their very
raison d'être demands it; it is essential that the economy not be starved of credit, allowed to
waste away, dragging down the prospects of the banking system with it. At the same time, it
is necessary to intensify the efforts to strengthen balance sheets and eliminate the structural
problems that weigh on the efficiency and profitability of the Italian banking system.
We firmly believe that we both can and must have confidence in the ability of our banks to
rise to this challenge; and we are equally confident that an economic policy aimed at financial
stability and directed to promoting an environment conducive to balanced growth will allow
greater opportunities for investment and a rapid return to creating new permanent jobs.