Ignazio Visco: Overview of Italy's economy and banking system
Address by Mr Ignazio Visco, Governor of the Bank of Italy, at the Annual Meeting of the
Italian Banking Association, Rome, 10 July 2013.
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The economic climate and outlook
In the first half of 2013 Italy's GDP again diminished, largely owing to the fall in domestic
Economic
demand; exports also declined. Our forecasts, which will be published in the
Bulletin in a week's time, put the contraction of GDP this year at close to two per cent.
Economic activity is expected to begin to expand at a moderate pace from the end of the
year, with overall growth of more than half a percentage point in 2014. In the short term,
domestic demand will have to be buoyed by the timely payment of general government
commercial debts.
The level of uncertainty is high. The timing and strength of the recovery are subject to the
risk of a slowdown in the global economy, in particular in the emerging economies, together
with the risks inherent in financial market developments. Italy's large public debt and weak
growth prospects, as well as the uncertainties over European governance, make risk
premiums on government securities highly sensitive to swings in market confidence, as has
been shown recently by the wide fluctuations in interest rate spreads relative to German
Bunds. A deterioration would further narrow the scope for fiscal policy measures and would
have repercussions on banks' funding and hence on the availability and cost of credit to firms
and households.
We cannot risk losing investors' confidence, which is fragile and exposed to the changeable
evaluations of analysts. Budgetary policies must continue to be responsible; the reforms
already decided and those still to be implemented should be set within a comprehensive
design and the aims clearly defined.
Monetary policy will sustain the recovery. On 4 July the ECB Governing Council announced
that monetary conditions would continue to be accommodative for as long as necessary. It
adopted innovative communication procedures, specifying that it expects official rates to be
kept at or below their current levels for an extended period of time given the subdued outlook
for inflation, the weakness of economic activity and modest monetary growth in the euro
area.
The Italian banking system has been under severe strain from the financial crisis, the
doubledip recession and sovereign debt tensions. The banks' income-producing capacity has been
reduced; in the absence of an adequate response it would be further undermined by the
persistence of the crisis or the occurrence of new adverse shocks.
Credit
The contraction of lending to firms intensified in the first half of this year, to an annual pace of
over 5 per cent in the three months ending in May. The decline in lending to households was
less severe, amounting to 1.6 per cent. The average interest rate on new business and
house purchase loans remained the same as at the start of the year, at just over 3.5 per
cent. The spread over the euro-area average did not change significantly, hovering around
three quarters of a percentage point.
The cyclical downswing is squeezing credit demand. It is aggravating debtors' repayment
difficulties: in the first quarter the new bad debt ratio for business loans was around 4.5 per
cent, which was high in historical terms; other impaired loans are also increasing sharply.
Heightened risk is weighing on banks' credit supply policies, discouraging lending and driving
up interest rates. This can be seen in the surveys conducted with banks and firms alike. The
strains will continue over the next few months; past experience indicates that the
deterioration in loan quality tends to continue beyond the start of a cyclical upturn.
Above all, the difficulties affect small firms, which have less opportunity to access the capital
markets. The Government's recent changes to the workings of the Guarantee Fund for small
and medium-sized enterprises are a step in the right direction. The implementing provisions
should allow firms with good growth prospects to apply to the Fund, even in the face of a
temporary recession-induced deterioration in their accounts. The guarantees should be
made conditional on the effective granting of loans, with more favourable terms provided for
banks showing better overall credit growth. The availability of guarantees must translate into
an actual improvement in credit terms, enabling firms themselves to apply directly to the
Fund.
On 1 July the Italian Banking Association and the country's trade associations signed a new
agreement allowing firms in difficulty to obtain a temporary suspension of repayments of
medium- and long-term loans and an extension of loan maturities, and to be granted new
loans if they increase their capital. The Bank of Italy will make sure that the moratorium
provides support for deserving firms without concealing the actual riskiness of the loans. Past
experience in this regard has been positive.
Italian banks must guard themselves against the risk of a worsening of their funding
conditions. The supply of assets eligible for use in Eurosystem refinancing operations is now
very substantial thanks in part to a large volume of public guarantees on bank bonds, which
will mature in the next few years, however. Going forward, the supply must be maintained by
increasing the share of eligible assets, among other things by adding new types. Great care
must be taken to ensure that loan granting procedures meet the requirements for
Eurosystem refinancing. In the coming weeks we will call on the banks for an examination of
the steps to be taken.
In several cases Italian banks not only provide finance, they also participate directly in the
capital of firms. This can lead to a more accurate assessment of a firm's growth prospects
and a better evaluation of its financial needs. However, a participating interest can
sometimes distort lending decisions; as the size of shareholdings and loans increases, there
is the risk of collusion or of actions designed to delay the surfacing of difficulties.
The banks' governing bodies must properly safeguard against these risks: to maintain loan
quality and keep banking profitable, in the banks' own interest; to protect the value of the
savings entrusted to them, in the interest of their customers; and above all to ensure the
efficient allocation of savings and boost the competitiveness of the productive economy.
In January the legislation on related-party transactions came into force. It aims to protect
banks from potential conflicts of interest with closely connected parties; it provides a
necessary counterweight to the European rules easing the restrictions on the links between
banks and industry. The limits on exposure to each related party are calculated in relation
both to the amount of credit granted and to the size of the bank's shareholding in the
company. The decision-making process on these matters must be transparent and correct
and the outcome suitably motivated.
The banks must be scrupulous in applying the new rules. The Bank of Italy will evaluate the
effectiveness of the measures they adopt; when necessary, it will intervene, possibly by
setting stricter limits and conditions for related-party transactions.
The difficulties besetting the credit system highlight once again firms' overdependence on
bank lending. By international standards Italian firms are undercapitalized, make very limited
use of the capital market, and tend to limit scrutiny by investors.
The credit market tensions will persist in the months to come. Bank loans cannot be the sole
source of external finance, as they are at present for most firms. The financing of investment
must also tap new resources as well. It is in the banks' interest to encourage this process by
seeking to maintain a balance between loans and deposits, sharing the risks of financing
customers with the markets, and carefully avoiding potential conflicts of interest.
Above all, it is necessary for firms to increase their equity. The tax deductibility of new equity
capital invested in a company, which was introduced in 2011 under the rules on the
Allowance for Corporate Equity (ACE), could be increased, in order to eliminate the
remaining tax advantage of debt. The financial soundness of firms and their ability to finance
medium- and long-term investments would benefit significantly.
Asset quality and capital
International analysts' fears about the soundness of Italian banks' balance sheets should not
be underestimated, even though they are not always well justified. The policies undertaken to
curb costs, improve risk management and strengthen banks' capital base must continue. Our
ongoing intervention concerning the adequacy of provisioning for non-performing loans aims
to ensure a satisfactory level of risk coverage; it will enable the banks to preserve investor
confidence and attract low-cost external financing. It is essential in order to guarantee a
satisfactory flow of credit to households and firms.
The stock of impaired assets, which reached 14 per cent of total loans in March, remains
high in part owing to the slowness of credit recovery procedures. Another factor is the
exceptionally long time it takes for loan write-downs to become tax deductible. By
international standards, the representation of loan quality on balance sheets reflects a
prudent definition of impaired assets.
In the mid-1990s, when the ratio of bad debts to loans was higher than it is now, the
reduction in the stock of impaired loans was favoured by the development of a market in
these assets, with the participation of foreign investors. Initiatives of this sort could be
successful today, provided that transparency is guaranteed and that the mechanisms of risk
transfer from banks to investors are fully consistent with prudential rules and accounting
standards, permitting the definitive cancellation from banks' balance sheets of the impaired
assets transferred.
Over the last few difficult years the Italian banking system has strengthened its capital base
considerably. Banks' ability to withstand adverse shocks has improved. The increase in
highquality capital needed to satisfy the capital adequacy requirements envisaged by the Basel III
rules that will be phased in by 2019, which was €35 billion at the end of 2010, dropped below
€9 billion last December; already today most of the largest intermediaries would meet the
new prudential requirements.
Still, capital strengthening must continue. While this may automatically reduce the return on
capital, at the same time it favours its stability. By increasing banks' ability to withstand
adverse shocks it boosts investor confidence and lowers the cost of external funding.
Exposure to the public sector has increased significantly since the beginning of 2012.
Contributory factors included the high risk of loans, the objective of expanding the supply of
collateral eligible for refinancing operations with the central bank, and the high yields on
government securities. Widespread among banks, these purchases were concentrated in
securities with an original maturity of three years or less and were mostly recorded in the
banking book. Economic recovery and a return to normal conditions in the credit market will
enable fund allocation policies to return to what they were before the crisis and permit an
expansion of lending to households and firms.
Banks' stability is also founded on appropriate risk management and control systems:
organizational shortcomings prevent the correct allocation of capital, encourage the unwitting
assumption of risks, render the institution vulnerable to violations of internal norms and
procedures, and expose intermediaries to potentially severe reputational damage.
In recent days the Bank of Italy has issued new supervisory provisions on banks' internal
control systems. The new rules require that governing bodies be fully involved in the design
of risk management and control systems, the determination of "tolerated risk" and the
approval of key decisions, such as offering new products, undertaking new business or
entering new markets. They also underscore the need to ensure the independence and
authority of the control functions. The banks will be granted sufficient time to adapt and must
inform the supervisory authorities of the measures they intend to adopt.
Profitability and governance
The events of recent years have depressed banks' profitability and their ability to generate
the resources needed to increase capital and thereby support the financing of the economy.
In the banking industry, which is labour-intensive, wage levels and dynamics must be made
fully consistent with the objective of preserving banks' stability. Careful consideration must be
given to measures, possibly temporary, aimed at significantly reducing staff costs in relation
to revenues. There must be full awareness of the constraints stemming from the difficulties
that the banking system currently faces, a change of pace to deal with contingent difficulties
for intermediaries, including with a view to safeguarding employment. The effort to adapt
productive factors and distribution channels to the opportunities offered by new technology
must be stepped up.
In recent years banks have become aware of the importance of corporate governance.
Ahead of global regulatory developments, the Bank of Italy has issued rules on governance
and stiffened them over time. It has urged the adoption of best practices and intervened
repeatedly with corrective actions.
Progress in this direction must continue. A number of unresolved problems remain to be
tackled. I addressed two - the role of the banking foundations and the governance of
cooperative banks - in my concluding remarks last May. Here I would like to offer some
further considerations.
In most cases the presence of the foundations among banks' shareholders has fostered
stability. During the crisis, in the absence of other large investors, some of them underwrote
very substantial capital increases.
At this point foundations should be encouraged to diversify their investment portfolios, so as
to loosen their sometimes excessive dependence on the performance of their reference bank
and prevent interference in banks' governance and business choices. This would be
conducive to the inclusion of new investors in the banks' shareholder base.
Analyses of banks' bylaws, shareholder pacts and shareholders' behaviour at general
meetings have shown that some foundations tend to interpret shareholders' prerogatives
very extensively indeed. This has produced excesses, at times impeding the necessary
turnover within the governing bodies and causing directors to be chosen according to criteria
other than professional qualifications.
Episodes of this sort have an adverse effect on banks' performance, limiting their ability to
finance the economy. Measures to prevent their recurrence must be taken as soon as
possible.
The Charter adopted by the association of savings banks and foundations in 2012 calls for
transparency in the criteria and procedures for appointing the members of foundations'
decision-making bodies. It establishes waiting periods and incompatibility conditions with
respect to previously held political positions. It sets experience and independence
requirements for the top officers of foundations and also of the banks in which they hold
stakes. These indications must be made fully effective. They must also be strengthened by
prohibiting passage from top positions in foundations to those in banks.
The ban on controlling stakes to which the largest foundations are subject must be fully
observed, if necessary by redefining control in such a way as to cover its exercise on a de
facto basis or jointly with other shareholders. Adequate measures for enforcement of the ban
must be instituted. Incompatibility with other positions and stricter requirements for bank
directors also need to be provided for.
The imminent application of the fourth revision of the capital adequacy directive offers the
occasion for reinforcing the standards of experience, independence and reputation for banks'
corporate officers and enabling the supervisory authorities to intervene, when the situation so
requires, including by removal from office. The application of the rules on transactions with
related parties, which I mentioned earlier, will also help to guarantee the independence of the
banks against undue interference and influence.
The cooperative banks, in recent years, have experienced a healthy process of membership
renewal. The increase in widespread share ownership and the greater presence of
institutional investors have strengthened their capital. These changes now require a review
of the cooperatives' governance arrangements, which were originally conceived for small,
local banks and are not suited to today's large institutions with a substantial national
presence and a broad membership base or stock exchange listing.
For the largest of these banks the rigid application of some of the rules typical of
cooperatives - one person one vote, share ownership ceilings, approval clauses for new
members - may have negative effects on the quality of governance and the capacity for
capital strengthening. In the absence of adequate counterweights, a fragmented and
dispersed shareholder base is likely to result in low attendance at meetings and a lack of
incentive to monitor the performance of the directors.
Within our powers, we have intervened in respect of cooperative banks' bylaws to encourage
an increase in the number of proxies that may be conferred on a member, to limit the
fragmentation of holdings and to remove the obstacles to institutional investors' presentation
of candidates when governing bodies are renewed. Important as they may be, however,
these actions cannot resolve the structural governance problems of the cooperative banks,
especially the largest ones.
It is necessary to embark on a course of gradual but incisive reform. Considering, among
other things, the prospect of banking union and the changeover to a single supervisory
mechanism, the more noticeable and unjustified are the differences vis-à-vis the other large
banks, the more sudden could be the call for change.
The revision of governance structures can be pursued in two directions. First, shareholders'
control of management's activity must be enhanced and the injection of capital by new
members encouraged. The transparency and effectiveness of management must be ensured
by increasing shareholders' awareness of risk-taking, by combating potential conflicts of
interest. Expectations of sure profits and, for unlisted cooperative banks, of easy disposal of
shares must not be engendered. Institutional investors, whose presence confers stability
thanks to their long investment horizon, must be given adequate representation in the bodies
charged with supervisory functions. Sound and prudent management demands that the
presence of current and former employees in the shareholding structure should not influence
management policies and decisions.
Second, there should be no hesitation to change the bank's legal form. International
authorities and investors concur that the limited share company is the model most consistent
with the characteristics of large banks, encouraging contributions of capital and fostering
transparency of ownership structures and governance. The larger cooperative banks must
open up to this transformation, easing the way by setting realistically achievable quorums for
their general meetings.
The revision of governance is essential to ensuring informed risk management, a correct
allocation of credit to the economy and an efficacious management of conflicts of interest. By
removing the obstacles to capital strengthening, it will reassure investors as to the banks'
ability to cope with the difficult macroeconomic context and growing competition.
The banking union
The work to create a single supervisor in the euro-area, consisting of the ECB and the
national authorities is proceeding expeditiously. Starting out from the national authorities'
store of technical knowledge, the new institution will have to ensure a supranational vision
based on best practices in supervisory methodologies, modelling and assessment of banking
risks. The transition to the single supervisory mechanism will give stability to the euro area,
helping to counter the trend towards the segmentation of the financial markets along national
lines, which we have seen during the crisis. It will facilitate comparisons between the banks
and systems of the different countries.
On 20 June the Eurogroup reached an agreement on the possibility of using the resources of
the European Stability Mechanism (ESM) to recapitalize banks directly under certain
stringent conditions for a maximum of up to €60 billion. This will be conditional on the launch
of the single supervisory mechanism, which in turn will have to be preceded by a balance
sheet assessment of the banks subject to centralized supervision at European level and, in
particular, by an asset quality review.
In the following days the Ecofin Council reached a general agreement on the rules for the
recovery and resolution of banks in crisis. The procedures whereby creditors are to share the
costs of a banking crisis were decided, with entry into force scheduled for 2018. These
so-called bail-in mechanisms are consistent with the recommendations of the Financial
Stability Board aimed at curbing opportunistic behaviour and limiting the costs of bank crises
for taxpayers.
The agreement specified the bank liabilities covered by a creditor bail- in and the order in
which they will be called on to participate. At national level, a minimum share of liabilities
able to ensure sufficient loss-absorbing capacity will be established for each bank. In
addition, it was decided to set up national resolution funds financed by the banks
themselves; within ten years these funds must have an endowment equal to 0.8 per cent of
the deposits covered by the respective deposit guarantee schemes. Only if a number of
conditions are met and if there are severe risks for the system's financial stability may public
funds also be used.
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Recourse to the resolution fund allowed when the bail-in process makes available
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resources equal to at least 8 per cent of the bank's liabilities enables account to be taken of
national specificities, such as the widespread use of retail bond funding in Italy. The work to
establish the fund must proceed rapidly, with appropriate negotiations with national and
Community authorities. The transition phase must be completed well before the time limit of
ten years indicated in the agreement, while assessing the scope for synergies with the
entities already in place. When the fund is fully operational, the availability of adequate
resources will allow the cost of crises to be divided between the bank's creditors and the
banking system as a whole, with advantages for the cost of banks' funding.
The agreements reached are an important step towards banking union but they do not break
the vicious circle between the conditions of sovereigns and banks or eliminate the
fragmentation of financial markets along national lines.
A European resolution mechanism must be created as soon as possible, based on a single
resolution authority and pooled resources, able to cope with systemic crises and prevent
contagion. The possibility of using ESM funds to recapitalize banks directly has in practice
been postponed for many months, since it depends on the entry into operation of the single
European supervisor. There remains the possibility of using such funds indirectly, by means
of ESM loans to member states, but recapitalizing banks in this way bears on the public debt
of the countries concerned.
The asset quality review of euro-area banks that will be carried out in the coming months will
make heavy demands on the participating countries' supervisory authorities. It will have to be
based on common rules and methodologies and valuation methods that are uniform across
countries. We are confident of the outcome of this exercise, aimed at eliminating doubts
about banks' solidity. In Italy analyses of this kind are routinely part of both on- and off-site
supervision. The inspections carried out recently at twenty intermediaries made it possible to
assess the adequacy of their loan loss provisions and to request corrective action where
necessary. The same action is now being taken at other intermediaries. The methods used
provide an example of how such analyses can be conducted.
Any capital shortfall that emerges for some European intermediaries will be met in the first
place with private-sector resources. Prompted by supervisory authorities, banks will have to
take appropriate action to meet their needs, such as restricting the distribution of dividends or
disposing of non-strategic assets. The definition of an adequate financial back-stop, to be
established ex ante, will be necessary to prevent deleveraging.
The asset quality review will be followed, in 2014, by stress tests conducted by the European
Banking Authority and the ECB to assess banks' ability to withstand low-probability extreme
shocks. The similar exercises performed by the IMF under its Financial Sector Assessment
Program (FSAP) show that, all told, the capital of the Italian banking system is well above the
regulatory minimum and meets the capital requirements established for the Basel III phase-in
period. However, given the low level of profits, in extreme circumstances capital buffers could
be rapidly depleted. These results confirm the need to carry on the process of capital
strengthening.
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The Italian economy remains in a difficult transition phase. To pass through it successfully
requires a universal effort. The banking system must play its part. There cannot be a lasting
recovery in the absence of sufficient financial support for firms.
To counter the effects of the recession on their accounts, banks must press ahead with
measures to improve their profitability and strengthen their capital. To ensure an adequate
flow of funds to the real economy, they must take account of their clients' growth prospects.
Intermediaries must be fully aware of the positive effects of this on the Italian economy and
of the advantages for themselves.