Fabio Panetta: The transition towards a more stable financial system
Address by Mr Fabio Panetta, Deputy Governor of the Bank of Italy, at the Conference on
"Strategic choices for the Italian banking industry", organized by the Associazione per lo
Sviluppo degli Studi di Banca e Borsa in collaboration with the Università Cattolica del Sacro
Cuore of Milan, Perugia, 21 March 2015.
* * *
1. Introduction
The powerful stimulus of monetary policy, the depreciation of the currency, and the fall in oil
prices are fueling economic recovery in the euro area. There are still risks in connection with
the crisis in Greece, geopolitical tensions and the cyclical slowdown in the emerging
economies. One of the factors that are impeding investment is the uncertainties surrounding
economic agents'expectations.
The signs are favourable in Italy too, but the strength of the recovery will depend to a great
extent on the proper working of the credit market and the availability of a sufficient volume of
finance for the real economy.
The latest data show an improvement in credit availability. Banks report that they have eased
their lending conditions, the share of firms complaining of lack of finance has diminished, and
the decline in lending to firms has moderated. A decisive contribution to the improvement has
come from the monetary policy action of the Eurosystem, in particular the programme of
quantitative easing.
The normalization of the credit market is not complete, however. The terms of access to
loans are still uneven. The flow of business credit has increased above all for the least risky
borrowers, i.e. the largest and most strongly capitalized corporations. Smaller firms,
especially those whose economic and financial balance is more fragile, continue to have
problems obtaining outside finance.
The performance of the credit market is conditioned by national and international regulatory
changes, which are transforming the market's size, structure and operating model. Moreover,
banks are burdened with a very substantial volume of non-performing loans accumulated in
the course of the protracted recession. The effects in both the short and the longer term
warrant thorough analysis.
2. The financial system and the impact of regulatory reform
The recent regulatory reforms in the financial sector are designed to reduce the probability of
systemic and solo banking crises and to limit their possible repercussions on the economy.
The principal force for change comes from the new capital adequacy provisions. The Basel
III rules raise capital requirements, set a minimum leverage ratio (of capital to assets not
weighted for risk), and establish minimum liquidity requirements. An additional increase in
capitalization has been introduced for "systemically important" banks and, for
macroprudential purposes, for the entire system.1 The regulatory revision is still under way;
rules on total loss absorbing capacity are being finalized, to require global systemically
important banks to maintain an adequate amount of devaluable or convertible instruments in
case of failure.
Another major innovation is the Bank Recovery and Resolution Directive (BRRD). The
Directive, which is being transposed into Italian law, shifts the burden of bank crises from the
public sector to the banks' creditors (shareholders and holders of other liabilities). This marks
the switch from a regime in which big banks were salvaged with public money (bail outs)
from one that involves investors in banks' losses (bail ins).
Some countries have instituted explicit rules to separate credit business from the banks'
proprietary financial and trading activity. The purpose is to eliminate indirect subsidies for
these riskier activities, setting them apart from such socially valuable activities as provision of
credit and payment services.2
The effects on credit - First of all, these reforms produce a force for the contraction of banks'
balance sheets. The tougher capital and liquidity requirements, the higher funding costs that
will stem from the BRRD (which increases the risk of liabilities other than deposits covered
by protection schemes), and any direct limits to operations will decrease the supply of credit.
Market forces are pushing in the same direction: the increase in credit and sovereign risks
has made medium- and long-term wholesale funding more onerous for banks, constituting
one more factor reducing the profitability of credit intermediation.
The banking system forged by these reforms, then, will be characterized by a greater "safety
margin" in terms of both capital and liquidity, but at the same time by lower profitability and a
smaller role in financing the economy. What are the likely consequences of this
transformation, for the Italian economy in particular?
A substantial empirical literature indicates that in equilibrium (that is, once the transition to
the new regime is completed), stronger capitalization of banks will have a positive impact on
the supply of credit.3 During the transition, however, the capital increases required by the
stronger capital adequacy rules tend to adversely affect lending growth. And the same
applies to increased liquidity requirements. Evaluations conducted before the new rules were
introduced support this thesis, even while indicating that the adjustment costs will be
moderate, not so great as to compromise the net long-run benefits.4
On the whole, internationally the adjustment to the new standards is being achieved
essentially through increases in capital and liquidity, with no substantial impact on the
provision of finance to the economy.5 However, the effects of banks' deleveraging differ from
country to country depending on both structural characteristics - such as the degree of
development of the capital markets - and on cyclical factors, such as the stance of monetary
and fiscal policies, the cyclical state of the economy and the financial conditions of firms.
2
"Separation" rules have been enacted in the United States, where the Dodd-Frank Act introduced the "Volcker
rule"; in Britain, where the Banking Act made the proposals of the Vickers Commission into law; in France,
with the Loi de Séparation des Activités Bancaires; and in Germany with the Gesetz zur Abschirmung von
Risiken. Within the European Union discussion on the need for similar measures was initiated by the Liikanen
Report, which was followed by a Commission proposal for a regulation, presented in January 2014 (the
Barnier proposal). The forms of separation differ from country to country. The Volcker rule and the Barnier
proposal prohibit banking groups from engaging in certain types of business (such as proprietary trading),
while the French, German and British laws only require that they be done by separate units within the group.
3
For the United States, see J. Peek and E.S. Rosengren (1995), "The Capital Crunch: neither a Borrower nor a
Lender Be", Journal of Money, Credit and Banking, Vol. 27, No. 3; for Italy, U. Albertazzi and D.J. Marchetti
(2010), "Credit supply, flight to quality and evergreening: an analysis of bank-firm relationships after Lehman",
Bank of Italy Working Papers, No. 756, April.
4
Bank for International Settlements, Assessing the macroeconomic impact of the transition to stronger capital
and liquidity requirements (Final Report), December 2010; An assessment of the long-term economic impact
of stronger capital and liquidity requirements, August 2010.
5
S. G. Cecchetti (2014), "The jury is in", CEPR Policy Insight, No. 76, December.
The leverage of the main US banks has been reduced by 50 per cent since 2007.6 The
possible repercussions of a credit restriction were moderated by firms' recourse to the capital
market and the shadow banking system, as well as by large-scale corporate self-financing.
The transition was facilitated by the increase in the public debt and the exceptional monetary
expansion, which increased the amount of resources available to the private sector.
The banks' deleveraging was significant in Europe as well. At a sample of 43 large banks in
eleven countries, the leverage ratio came down from 26.0 in 2011 to 21.2 in 2014. Two thirds
of the reduction stemmed from capital increases, the other third from a decrease in assets.
However, the context of the balance-sheet adjustment was different from that of the United
States. In Europe the capital market is a less important source of finance for businesses; the
economy consists largely of smaller firms that depend on bank credit. In addition, the
capacity of the public sector to sustain the economy and the banks is limited by ongoing
fiscal consolidation in many countries and by the European budget rules.
In Italy, the difficulty of adapting banks' balance sheets to the new regulatory and market
environment is more acute than in the rest of the euro area, despite lower initial leverage
ratios. Firms' direct recourse to the capital market accounts for an almost negligible share -
around 5 per cent - of total finance to the productive economy. The drawn-out recession has
undercut firms' self-financing, especially for smaller businesses. And the margin for
intervention by the public sector is narrow indeed, notwithstanding the recent measures to
stimulate a rebalancing of firms' financial structure.
Now that signs of economic recovery are emerging in the euro area and in Italy, it is essential
to learn the lessons of the crisis and to avoid pro-cyclical policies. The transition to the new
equilibrium marked by more strongly capitalized banks with greater liquidity must be gradual
and perspicacious. The risks of sudden adjustment must be carefully assessed.
The return to growth and the easing of the interest burden will help to increase firms'
profitability and improve credit quality. Banks need to accommodate rising loan demand
while maintaining strict control of risk, and of credit risk in particular. In this phase a further
stiffening of capital and liquidity requirements could impede the supply of credit, delaying the
economic upturn. Such a course would not only heighten macroeconomic risk but would also
actually increase the risks for the financial system, the exact opposite of the desired
outcome.
Microprudential supervision must engage with macroprudential necessities. The targets must
be set in such a way as to endow the financial system with more than ephemeral strength,
combining the need for bank stability with the need for a recovery in economic activity.
At the same time, we must recognize that European integration, which has been revitalized
by the project for Banking Union, necessarily entails major changes and constraints on
economic agents. The pressure for higher levels of capitalization, which in the current phase
has required a considerable effort on the part of Italian banks, derives largely from market
forces, from a comparison with other European banks.
The impact on crisis management - The BRRD will bring in a new paradigm for the
management of banking crises. The Directive requires the formation of a national Resolution
Authority, which, in collaboration with the European Single Resolution Board (ESRB) in
Brussels, will deal with resolution of "less significant" banks and implement the steps in the
resolution of "significant" banks as decided by the SRB.
Even at times of ordinary bank activity, the so-called "going concern" phase, the new rules on
resolution require completely new activities. The Resolution Authority will simulate the effects
of crises, prepare resolution plans, identify solutions to guarantee the continued performance
of critical functions. The Authority can intervene - observing the principle of proportionality -
to impose changes to banks' operational, legal and organizational structure, in order to
reduce their complexity or to isolate the critical functions with a view to maintaining their
operability. In the case of failure, the Authority will determine how costs are shared and how
the corporate units without systemic importance will be liquidated.
Last year the Bank of Italy provided technical advice to the Government and the Parliament
concerning the transposition of the Directive. This transposition must now be completed with
the designation of Italy's national Resolution Authority.
The effects on bank-customer relations - As I observed earlier, the main effect of the BRRD
will be to limit public intervention in banking crises by requiring creditors to contribute to
resolving the banks' difficulties through devaluation of their assets or conversion of their
financial instruments into shares.
This change will require banks to pay drastically increased attention to correct relations with
customers. Savers must be made fully aware of the risks they run in the event of the bank's
failure. The investments that banks propose to their customers must be perfectly consistent
with the investors' propensity for risk and their financial sophistication. Banks must make
sure that their customer relations officers apply the rules on transparency in substantial and
not merely formal terms.
Substantial efforts have been made in the past to improve the quality and transparency of
communication between banks and customers. The Bank of Italy has laid down forceful rules
and checked compliance in special on-site inspections. Progress has unquestionably been
made. But there is still a great deal of room for improvement, not only in the process of
adaptation to the broad, detailed provisions of the regulations but also in truly partaking in the
spirit of the transparency and correctness regulations.
Even these actions could prove insufficient, however, in the light of the changes introduced
by the BRRD. We shall need to consider requiring that retail customers be directed mainly or
exclusively to the least risky products - that is, those that under the BRRD will benefit from
"depositor reference" in the "pecking order"7 - and reserving other forms of funding to
professional investors.
3. The role of the banks and supervision during the transition
In recent years the Italian banking system has strengthened its capital position. Since 2007
core tier 1 capital has been increased from 7.1 to 11.8 per cent of risk-weighted assets, and
financial leverage has been considerably reduced. The ECB's comprehensive assessment of
bank balance sheets confirms the resilience of the system as a whole in the face of the
exceptionally severe recession afflicting the Italian economy. Nevertheless, changing over to
the new rules will require banks to intensify their efforts. In particular, three issues need to be
addressed by consistent policies on the part of banks and authorities alike. These concern
banks' efficiency, the management of nonperforming loans, and the adaptation of banking
governance to European competition.
Efficiency - Raising the level of efficiency is necessary to increase profitability, which is now
too low to remunerate the capital invested. For a good part of the banking system, efficiency
gains can be attained via mergers. The potential benefits of such operations are substantial,
on both the cost and the revenue side. But they are not automatic: realizing them requires
decisive organizational measures in the rationalization of distribution systems, in risk
management, in the exploitation of technology.
Mergers may require banks to adapt their level of capitalization to their new mode of
operation. Recent experience has shown that international investors are willing to take part in
ambitious, credible plans that can transform today's regional banks into more competitive,
better diversified intermediaries operating on a larger scale and serving the financial needs of
their customers.
The bigger, more efficient banks that will result from mergers can make the inevitable
expansion of the capital market an opportunity to increase their revenues. First of all, the
prolonged period of low interest rates that looms for the European economy will spur
households' search for relatively higher returns, increasing the demand for asset
management services. Moreover, firms' recourse to the market offers substantial
opportunities to provide high-value-added services that absorb relatively little capital and
liquidity.
Banks can meet these needs by capitalizing on their relations with customers and their
knowledge of the economic fabric. This will necessitate the reinforcement of the safeguards
against the conflicts of interest stemming from their joint roles as lender, promoter of market
access, and asset manager.
Non-performing loans - Within the next few years the banks will have to procure from savers
and from the international markets the resources they need to repay the very substantial
loans they have had from the ECB. At the same time they will be called on to sustain the real
economy: lack of a sufficient volume of credit would throttle the recovery.
The attainment of these objectives is impeded by the large volume of non-performing loans
accumulated during the long phase of recession. The dead weight of these impaired assets
reduces the transparency of balance sheets and hinders banks' recourse to international
markets for funding. It also heightens the risk aversion of banks and reduces their willingness
to lend.
The development of a market in non-performing loans is blocked by several factors. First, the
slowness and uncertainty of credit recovery in Italy swells the risk premium that economic
agents demand for investing in these assets, driving their price down below their
"fundamental" value. And Italian banks, which as a group are now well capitalized, are loath
to sell off these non-performing assets at the fire sale prices imposed by this time of
exceptional economic weakness. The situation of our banks, in fact, is quite different from
that of banks in other countries that have been obliged to resort to systemic solutions for the
disposal of non-performing assets. What is more, the simultaneous sale of large volumes of
impaired assets by the entire banking system (or a good part of it) would provoke a collapse
in prices and thereby, as a practical matter, prevent the conclusion of the sales.
If left to market forces alone, the disposal of non-performing loans threatens to be a very
long-drawn-out affair. In this kind of scenario, intervention by the authorities can resolve
problems of coordination between banks and speed up the disposal process, preventing a
"market failure" from ultimately blocking the recovery of the economy. International
experience suggests that reducing the weight of non-performing loans on banks' balance
sheets sustains lending growth and helps to create a virtuous circle of economic growth and
improving credit quality.
The transfer of bad debts would benefit households and firms by increasing the availability of
credit and spurring the economic upswing. It would benefit the banking system by reducing
the balance-sheet incidence of impaired asset items, thus lowering operating costs and the
cost of funding. And it would benefit the public sector, with expanded tax revenues thanks to
the cyclical upturn.
The measures for the transfer of bad credits now under study centre on market-based
solutions. Their precise features will be determined within the next few weeks, in dialogue
with specialized operators and with the banks. The intensity of government involvement may
be of varying degree, and it is the subject of talks with the European institutions to assess the
measures' compliance with the Commission's rules on state aid. The European legal
framework has changed in the last two years, and measures such as those taken in the past
in other countries are no longer practicable. For one thing, those solutions entailed the
massive use of public resources, which in our case would also raise questions of budgetary
propriety.
Significant benefits would also accrue from measures, these too under study, to shorten the
duration of credit recovery proceedings, which is much longer in Italy than on average in
Europe and constitutes one of the main causes for the build-up of non-performing assets
carried on banks' balance sheets.
Last year's amendments to the Civil Code have removed some of the structural causes of
this problem. Hopefully, additional reforms in the near future can shorten or eliminate some
of the terms for foreclosure procedures and streamline asset sale procedures, possibly via
electronic instruments.
Governance - The Bank of Italy has long seen and signalled the need for substantial
progress in banks' governance. Within the limits of our powers, we have acted to strengthen
the cooperative banks and induce them to make changes considered indispensable. We
have asked them, like all the other banks, to upgrade the membership and improve the
functioning of their boards of directors, so as to improve their capacity for governance. We
have introduced rules on executive compensation, based on European regulations. We have
also asked the cooperative banks to encourage shareholders' participation at meetings.
Notwithstanding the new rules, the improvements achieved have not been decisive. Nor
could they have been, given the legislative framework. Our rules could not alter the legal
limits to share ownership, the one-person-one-vote provision, or the constraints on the
voluntary transformation of cooperatives into other corporate forms.
The recent government provisions on cooperative banks permit more thorough monitoring of
directors and administrators; they make the banks more attractive to investors, strengthening
their ability to raise capital on the market. The most capable managers will succeed in
exploiting these opportunities to improve efficiency, move into new markets, and support the
best firms.
Now the need is to reduce the fragmentation that prevails in the system of cooperative and
mutual banks, allowing for forms of integration that preserve these institutions' local roots
and capitalize on individual banks' membership of banking groups. The solutions must be
guided by the essential aim of enabling these banks too to turn readily to the market in order
to raise capital, as well as by the purpose of improving the quality of their management.
The cooperative banking systems of other European countries are much less fragmented
than the Italian system. The prevailing models centre on banking groups, in which the parent
company exercises functions of direction and oversight over the banks in the group and,
where necessary, can recapitalize them by recourse to the capital market. This model does
not denature the cooperative form of the individual banks but allows them to maintain their
characteristic mutuality and their community roots.
Integration of the system of cooperative credit is in the interest of the cooperative banks
themselves, to ensure that cooperative and mutual banks can continue to operate
independently in an environment requiring rapid provision for the needs for recapitalization
and efficient management, and in the light of the narrower margins for intervention at
troubled intermediaries.
4. Conclusion
In recent months the European Central Bank, in keeping with its mandate, has dealt
effectively and flexibly with the pressures towards the fragmentation of the European markets
and with the emerging threat of deflation, preserving the stability of the euro area. Now this
kind of flexibility, without prejudice to the rules we have instituted, is necessary at national
and at European level in order to wed the objective of soundness of banks with the needs of
economic recovery. Where market failures occur, public intervention cannot be ruled out a
priori.
In their own interest the banks, despite the transition to the new set of European and global
regulations and the likely gradual diminution of their role to the advantage of the capital
markets, must enhance their capacity to provide financial support to the real economy. I have
mentioned the priorities of the current phase: regaining efficiency, managing credit risk and
strengthening governance. Mergers can help in attaining these objectives.
The financial system cannot solve such problems of the real economy as poor
competitiveness and low productivity, on which I have not dwelt today. But it does have an
indirect role to play in facilitating the transformation and growth of firms. Banks can play this
role while accompanying the development of the capital market and drawing significant
advantages from it. It is up to firms to continue their action for a better balanced financial
structure, all to the benefit of their ability to stay in the market.