Fabio Panetta: Banks, finance, growth
Remarks by Mr Fabio Panetta, Deputy Director General of the Bank of Italy, at a colloquium
entitled "Beyond the crisis: What lies in store for Italian banks?", by Associazione per lo
Sviluppo degli Studi di Banca e Borsa in collaboration with Università Cattolica del Sacro
Cuore of Milan, Perugia, 23 March 2013.
* * *
The Italian economy is going through a very difficult period, in which structural
weaknesses have been compounded by adverse cyclical conditions. In the last five years,
we have had to deal with the financial crisis, instability in the sovereign debt market and a
severe double-dip recession. Since the start of the crisis, GDP has fallen by 7 per cent and
600,000 jobs have been lost.
Thanks to sound initial conditions, the Italian banking system has been able to
withstand the succession of real and financial shocks, benefiting from prudent supervision,
which has reassured international investors as to the quality of banks' balance sheets and
averted the destabilizing surge that has hit other European financial systems.
Nonetheless, Italian banks could not avoid the indirect repercussions of the crisis: the
recession affected loan quality; the deterioration of sovereign debt ratings dried up the
sources and increased the cost of funding; profitability fell dramatically. This affected the
supply of credit, which has tightened in recent months. The latest data, for January, indicate
a twelve-month contraction in lending to firms of around 3 per cent.
The exceptional measures taken by the Eurosystem in 2011 and 2012 stopped the
liquidity crisis from turning into a credit crunch, with ruinous consequences for the real
economy. Tensions are now concentrated on loan quality: bad loans account for 6.9 per cent
of total lending, while all deteriorated credit amounts to 12.8 per cent (3.3 per cent and
8.4 per cent, respectively, net of value adjustments). The impact on earnings is substantial:
in the three years 2009-11 write-downs and loan losses absorbed 60 per cent of operating
profit on average.
The economic cycle forces banks to take high lending risks, which must be covered by
their reserve assets. The Bank of Italy is checking, including by means of on-site controls,
the adequacy of the value adjustments made by a great number of large and medium-sized
banking groups and, where necessary, requiring corrective action. The preservation of a
satisfactory level of provisioning allows banks to maintain investor confidence and attract
low-cost external funding. This is essential to continue to guarantee an adequate flow of
credit to households and firms.
In order to avoid procyclical effects, in connection with this action the Bank of Italy has
asked banks to increase internally-generated resources by cutting costs, selling non-strategic
assets, and adopting dividend policies consistent with their individual income and
balancesheet position. The criteria for the remuneration of directors and executives must also be
consistent with the aim of capital strengthening, giving a clear indication of company
strategy.
Beyond the short term, the recovery of banks' profitability and the strengthening of their
capacity to serve the real economy will require profound changes to their business model. In
the following pages I will examine two topics of particular importance for the Italian banking
system.
The first regards the need to encourage firms to access the capital markets directly.
Conditions are now favourable for both banks and firms to work for this objective to their
profit.
The second regards the need to shift more decisively, through technology, the
traditional distribution channels towards more advanced systems, achieving a substantial
reduction in operating costs.
* * *
In the last few weeks uncertainties over prospective developments in the Italian
economy have resurfaced. The quite moderate recovery forecast for late this year is now
threatened by the unpredictability of the domestic political situation and the resurgence of
financial turmoil in the euro area, which could undermine confidence and investment.
In order to preserve the prospective recovery, action to support business activity is
necessary. If taken promptly, the measures now under discussion for the payment of general
government debts to suppliers will be of considerable help.
However, there cannot be an enduring recovery without adequate financial support.
Banks are called on to make an essential contribution: to continue providing the credit
needed to sustain economic activity; to accompany firms with good growth prospects in
raising funds on the market; to serve, once more, as a focal point for revitalizing the Italian
economy.
The structure of the financial system and the financing of firms
The Italian banking system is comparatively small with respect to the real economy. Its
total assets amount to 2.7 times GDP, significantly less than in the other major countries
except for the United States (Figure 1). Nevertheless, the banks play a pre-eminent role in
the financing of firms. Bank loans made up over two thirds of Italian firms' financial debt,
compared with about a third in France, Britain and the United States and half in Germany.
Italy is the only major country in which this share has increased since the onset of the crisis
(Figure 2).
By contrast, the Italian capital market plays a limited role in financing enterprises.
Firms' equity endowment in Italy is not unlike that in other countries. Financial leverage,1 at
about 50 per cent, is broadly on a par with that of firms in Japan, Germany and the United
Kingdom and higher than in the US and France.
But about four fifths of shares are held and traded outside the official markets. Stock
exchange listing is circumscribed to a few large firms. Considering non-financial corporations
only, in 2012 Italy counted 230 listed firms, compared with about 700 in France and
Germany. The median firm in Italy had a market capitalization of about €90 million, twice as
much as in those two countries. The total market value of Italy's non-financial corporations is
less than 20 per cent of GDP, compared with 75 per cent in France and 45 per cent in
Germany (Figure 3).
Bond financing is also limited, outstanding issues now amounting to less than
8 per cent of firms' total financial debt (Figure 4). Just a few Italian corporations make bond
issues on the capital market (an average of ten a year over the past decade). Here, again,
Italy lags significantly behind, and in recent years the gap has widened (Figure 5).2 The same
pattern holds for other instruments of direct or indirect recourse to the market, such as asset
securitizations.
This type of financial system - bank-dependent, lacking well-developed equity and
bond markets, incapable in practice of offering the productive economy any resources other
than bank credit - is especially disadvantageous in the present cyclical phase. It penalizes
firms, especially the smaller ones, because it prevents them from coping with the tightening
of credit supply by replacing bank loans with other instruments. And it penalizes banks as
well, saddling them with very high costs and risks. What is more, the strains in credit supply
aggravate the difficulties of firms and feed back onto the banks' own balance sheets through
heightened credit risk and defaults.
The scant presence of Italian firms in the capital markets is a well-known problem,
rooted in the structural weaknesses of the economy. First of all, it reflects the response to the
incentives of firms themselves. They are, in fact, reluctant to open themselves to outsiders.
Expansion and access to the markets entail potentially significant transparency costs owing
to increased visibility (to the tax authorities, to regulators, to minority shareholders), an
excessive tax burden, a plethora of inefficiently applied rules and regulations, and the poor
flexibility of the goods and labour markets.3
One consequence of the small average size of Italian firms is low demand for such
financial services as listing assistance, securities issues, and syndicated loan placement.
These are services that are used heavily by large corporations but very little by small firms,
which are inherently less transparent, have few shareholders and are generally not present
in the capital markets. In the past, repeated efforts have been made to draw Italian firms to
the stock market by reducing the cost of listing, offering tax breaks for listing or share issues,
and instituting stock exchange segments dedicated to small and innovative businesses.
Action has been taken to raise disclosure standards, enhance the liquidity of securities and
improve the quality of governance. The results have been disappointing.
At times, banks too have imagined that they could profit from the underdevelopment of
the markets. Firms' dependence on credit reduces their bargaining power, enabling banks to
impose better terms for lending. The limited empirical evidence on this point suggests that
listed firms and firms that issue bonds on capital markets pay lower interest rates. These
findings apply also to large corporations, which are the least likely to be "captured" by their
banks.4
Growth of the markets: a possible change
An under-developed capital market and the productive system's reliance on bank
lending have thus been the short-sighted response of Italian firms and banks to incentives.
Accordingly, they have been a typical feature of our financial system. The financial crisis, the
sovereign debt tensions, and the economic recession are changing those incentives,
however, and may initiate a shift in the methods of financing Italian business.
On the one hand banks are being forced to reduce the overall size of their balance
sheets in response to both cyclical and structural factors, such as the new capital and
liquidity regulations, market pressures to reduce leverage, the high cost of funding, large
credit risk, and low profitability. The credit supply tensions that have arisen on several
occasions in recent months are a reflection of these factors. On the other hand firms have
seen their scope for self-financing diminish and the volume of overdue payments from
general government sky-rocket. In such a situation, even healthy businesses need to be able
to count on the availability of sufficient external sources of financing.
This dangerous stalemate - the combined effect of a reduced supply of credit and the
productive system's increased dependence on external finance - can be overcome by
enlarging direct recourse to the markets, with considerable benefits for firms and banks alike.
In the present phase of the cycle, the benefits for firms of being able to access
otherwise unavailable funds outweigh the costs of disclosure. The advantages of diversified
sources of funding, greater negotiating power in raising bank loans, and the reputational gain
that comes with access to the markets are another inducement towards openness and
transparency.
Expanding the sources of funding requires a major commitment by businesses to
increase the transparency of their financial statements, take concrete steps to open up to
outside parties, and strengthen their capital base as a sign of confidence in the company's
soundness. It is unrealistic to suppose that today's markets would be willing to support
opaque or under-capitalized projects.
The potential benefits are considerable for banks as well. To begin, chaperoning
businesses in the market would allow banks to avoid the deterioration in credit risks that
rationing their clientele might otherwise entail and to increase income from business
services, which remains under-developed. By providing the consulting services that are
crucial for firms' direct funding and that imply low capital and liquidity absorption, the banks
could strengthen, not weaken, their relationships with firms, as well as their role in a more
articulated financial system.
For greater recourse to the market to be possible banks must enter into long-term
relationships with firms and improve their ability to evaluate the latter's economic and
financial prospects. The task is not an easy one, and in the past it was not carried out in full.
Steps must be taken to improve staff training and increase their ability to help firms
access the markets, and to prevent conflicts of interest within the banks stemming from their
combined role in granting credit, promoting market access and (directly or indirectly)
managing household savings. Fears that the banking system plans to transfer the cost of
past lending errors to the market must be dispelled. Even the riskiest borrowers can be
helped to access the market if potential financiers can rely on the transparency they need to
make informed decisions. Unless these conditions are fulfilled, banks' reputations and their
clients' confidence will be undermined.
Banks and firms are not the only ones responsible for developing the Italian capital
market. To achieve this objective the whole economic and financial system must undergo
changes to stimulate long-term investors such as pension funds, provide incentives for
investment in venture capital, and eliminate the fiscal and administrative constraints that
discourage firms from growing in size.
Banks and firms have a crucial role to play, however. It is up to them to pave the way
for change.
Technology and banks' distribution costs
Italian banks' profitability has fallen significantly during the crisis. Between 2006 and
2011 their annual profit declined by more than 30 per cent as a result of a steep drop in
income together with a slight rise in costs (Figure 6). The deterioration was concentrated
among the largest groups, which saw their annual profit decline by 46 per cent as they
recorded a reduction in operating costs (down by 9 per cent) but an even sharper contraction
in gross income (Figure 7). The other banks registered a slight rise in profits (up by
1.6 per cent), despite an increase of 17 per cent in costs. Profitability remained low in 2012
as well.
The current levels of profitability are insufficient to remunerate capital adequately. In
the absence of incisive action, they threaten to weaken banks' capitalization, their capacity to
finance the recovery of the real economy.
In the 1990s the rebound in bank profitability came about principally through an
expansion of income, with only modest interventions on costs (Figure 8).5 In the present
circumstances, an increase in revenues appears unlikely considering the stagnation in
lending, narrow profit margins, the downward trend of asset management and the
penalization of trading activity implicit in the new capital rules. Overall, the Italian banking
system seems to have an excess of capacity, which drives down the overall volume of
business. In the short term, therefore, raising profitability requires energetic action on the
cost side, with an unflinching review of the combination of production factors and distribution
channels.
While the demand for banking services has grown slowly in the last twenty years, the
number of bank branches has nearly doubled. Gauged against the euro-area average, it is
excessive in relation both to total bank assets (€111 million per branch in Italy against
€170 million in the euro area) and to the volume of loans (€59 million against €67 million).6
Until the start of the financial crisis, the increase in the number of branches went
together with an expansion of virtual distribution channels (Figure 9), rapidly growing
investment in information and communication technology (ICT) (Figure 10) and stable staff
size. The crisis has only attenuated these trends. The use of technology and remote
distribution has thus largely overlapped, not replaced, the utilization of labour and the
traditional branch network. The cost-income ratio has not come down; on the contrary, up to
2011 it increased.
Massive recourse to ICT can reverse these trends through synergistic use of the
different distribution channels (branches, telephone, call centres, ATMs and the Internet),
according to the practices followed by the intermediaries that have become international
success stories.
Remote channels can be used for the distribution of highly standardized,
low-valueadded transaction-based services, such as liquidity management and consumer finance
products, especially to the more technologically or financially advanced customers. This
would permit the drastic pruning of the traditional distribution network and would free up the
resources needed to strengthen the remaining branches, focusing their activity on more
complex or advisory-intensive products, such as corporate banking, mortgage lending and
wealth management, that can generate more value added and reinforce customers'
preference for one-stop shopping. Recent analyses suggest that the result could be a
reduction in costs of as much as 30 per cent in the medium term.7
A transformation along these lines is no easy task. It will require changes to banks'
organization and operating arrangements in order to acquire the necessary technological
knowledge, ensure integration among the different distribution channels and train staff to
perform new tasks.
The business plans of the main listed banking groups do not always appear to be
consistent with the above-mentioned objectives. In a number of cases, efficiency gains and
productivity increments are based on restructuring of the territorial network and containing
the number of staff, without envisaging progress towards multi-channel distribution. For the
few groups that publish complete information on the subject, investment in ICT is limited in
amount and allocated mainly to optimizing existing information systems rather than
developing virtual channels. In many cases the resources devoted to staff training are
modest as well.
Large-scale use of remote channels requires, above all, full confidence on the part of
customers. Its absence precludes, for example, the distance marketing of high-unit-value
products such as mortgages and retirement savings products. In recent years significant
efforts have been made to improve the quality and transparency of communications between
banks and customers. The Bank of Italy has laid down rigorous rules, checking compliance in
part through inspections at bank branches. Progress has been made, no doubt, but there is
still considerable room for improvement, not only in the process of compliance with the large
and diversified body of rules but also in actually partaking of the spirit that animates the
regulations on transparency and correct conduct.
Going forward
Greater recourse to the market by firms and cost cutting are in banks' interest; they are
essential for the financing of the real economy. However, they are not the only measures
needed to adapt intermediaries' business model to the changes brought about by the
financial crisis.
Looking ahead, we must ask what will be the impact of the radical changes that have
occurred in the regulatory framework, the financial system and the behaviour of investors.
The events of recent years have clearly (though sometimes tardily) revealed the elusive
nature of economies of scale and scope in banking,8 giving renewed impetus to the debate
on the optimal size of intermediaries and the range of activities that can be performed
simultaneously by any one banking group.
The rules adopted or under discussion in the main countries, designed to separate
traditional credit business from investment banking,9 are likely to lead to a radical change in
the operating structure of the largest groups. Their application deserves to be carefully
assessed.
Faced with growing recourse to the markets and globalization, it will be necessary to
find innovative ways to establish lasting credit relationships with customers, to follow firms in
their international expansion and support their success in outlet markets, and to strengthen
the supply of products and services to households at conditions that are advantageous for
both savers and banks in an environment of low interest rates.
To provide answers to these and other questions, it is essential that there be a
continuous exchange between authorities, practitioners and scholars to compare theoretical
precepts and institutional knowledge with experience in the field. It is to be hoped that this
meeting will make a significant contribution to this search for understanding.
Figures
Figure 1
FINANCIAL ASSETS OF THE BANKING SYSTEM (MFIs)
IN RELATION TO GDP
12.0
10.0
8.0
Germany
6.0
France
Italy
United Kingdom
4.0
United States
2.0
0.0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Sources: Bank of Italy and Istat for Italy; Eurostat and ECB for the euro-area countries; Central Statistical Office and Bank
of England for the United Kingdom; Federal Reserve System and Bureau of Economic Analysis for the United States.
Figure 2
RATIO OF NON-FINANCIAL CORPORATIONS' BANK DEBT
TO THEIR FINANCIAL DEBT (1)
Percentages
75
70
65
60
55
50 2006
2012
45
40
35
30
25
Italy France Germany United Kingdom United States (2)
Sources: Bank of Italy for Italy; Eurostat and ECB for the euro-area countries; Bank of England for the United Kingdom; Federal Reserve
System for the United States.
(1) Bank debt comprises only the loans disbursed by the banks resident in each country.
(2) 2011 data.
STOCK MARKET CAPITALIZATION OF NON-FINANCIAL CORPORATIONS
As a percentage of GDP
100
90
80
70
60
2007
50
2012
40
30
20
10
0
Italy France Germany United Kingdom United States
Source: Based on Datastream data.
Figure 4
RATIO OF NON-FINANCIAL CORPORATIONS' BOND ISSUES
TO THEIR FINANCIAL DEBT
Percentages
50
45
40
35
2006
30
2012
25
20
15
10
5
0
Italy France Germany United Kingdom United States
Sources: Bank of Italy for Italy; Eurostat and ECB for the euro-area countries; Bank of England for the United Kingdom; Federal Reserve
System for the United States.
NON-FINANCIAL GROUPS: RECOURSE TO THE INTERNATIONAL BOND MARKET
BY COUNTRY OF RESIDENCE OF THE PARENT COMPANY
Gross issues Number of groups issuing bonds
Yearly data, billions of euros Semi-annual data
100
250
90
80
200
70
60 150
50
100
40
30
50
20
10
0
0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
1_2005 2_2005 1_2006 2_2006 1_2007 2_2007 1_2008 2_2008 1_2009 2_2009 1_2010 2_2010 1_2011 2_2011 1_2012 2_2012
Germany Spain Germany Spain France
France Italy
Italy United Kingdom
United Kingdom
Source: Based on Dealogic data.
Figure 6
BANK INCOME AND COSTS: CONTRIBUTIONS TO GROWTH 2006-11
Gross income (-13.55%) Operating costs (+ 1.60%)
4
2
0
-2
Administrative expenses
-4
Other staff costs
-6
Wages and salaries
-8
Fee income and other revenues
-10
Net trading income
-12
Net interest income
GROWTH RATES OF GROSS INCOME AND OPERATING COSTS
BY SIZE OF BANK 2006-11
5 largest groups large small minor
30
20
10
0
Gross income
Operating costs
-10
-20
-30
-40
Source: Bank of Italy, supervisory reports.
Figure 8
BANK INCOME AND COSTS: MEDIUM-TERM DYNAMICS
Index numbers (2000=100) of the series at constant prices (left-hand scale)
and percentages (right-hand scale)
120 80
110 75
100 70
90 65
Cost-income ratio (%)
80 60
70 55
Gross income
60 50
Operating costs
50 45
DISTRIBUTION CHANNELS
Percentage of households' current accounts (left-hand scale) and units (right-hand scale)
50 35000
40 28000
Branches
(righthand scale)
30 21000
Households with
20 14000
remote banking
transaction
capabilities
Households with
10 7000
phone banking
transaction
capabilities
0 0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Source: Bank of Italy, supervisory reports.
Figure 10
BANKING INDUSTRY FACTORS OF PRODUCTION
Thousands of units (left-hand scale) and millions of 2005 euros (right-hand scale)
360 1150
345 925
Staff
330 700
IT investments
deflated using
the BEA index
315 475
300 250
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Source: Bank of Italy, supervisory reports.