Mario Draghi: Economic growth outlook, regulatory measures and the
situation of Italian banks
Speech by Mr Mario Draghi, Governor of the Bank of Italy and Chairman of the Financial
Stability Board, at the 17th Associazione Italiana Analisti Finanziari-Associazione Italiana
Operatori Mercati dei Capitali (The Financial Market Association of Italy) (AIAF-ASSIOM
FOREX) Congress, Verona, 26 February 2011.
* * *
The economy
The world economic recovery is continuing, albeit amidst many uncertainties. Global output
grew by 5 per cent on average in 2010; the previous year it had fallen by almost one
percentage point. It is commonly believed that the expansion will continue at almost the
same pace as last year.
In the United States, GDP growth accelerated to almost 3 per cent at the end of 2010; the
increase in consumption became more robust. Growth at similar rates is expected for the
current year. For the emerging economies, the growth estimate is on the order of an average
of 7 per cent this year and next.
In the euro area the German economy is providing the strongest impetus for growth, thanks
to sharp increases in exports and investment in machinery and equipment.
In Italy growth is running at around 1 per cent. The expansion of output is concentrated at
exporters, particularly large firms, with outlets in the emerging economies. Domestic demand
remains weak, especially consumption, which is affected more severely than in other
euroarea economies by uncertain employment prospects and the protracted stagnation of
households' real incomes.
The improvement in the world macroeconomic situation and the overcoming of the financial
disorder engendered by the crisis are nevertheless accompanied by old and new
weaknesses. Sharply divergent growth rates can easily accentuate the volatility of exchange
rates and interest rates, jeopardizing the recovery.
The interconnections between economies make the system vulnerable even to local shocks.
The human dimension and the still uncertain outcome of the popular uprising in Libya are of
concern to the international community. The immediate impact of potential problems for
energy supplies from northern Africa may be mitigated by the abundant unused capacity of
the other producer countries, but the dramatic events we are witnessing may undermine
investment in the oil industry in the area and raise energy prices, with repercussions for
world growth. For the Italian economy, other things being equal, a 20 per cent rise in oil
prices would shave half a percentage point off growth over three years.
Economic policies
Economic policies have less and less room for manoeuvre.
In the last three years the crisis has increased the government budget deficit for the
advanced countries as a group by over 6 percentage points of GDP and the public debt by
almost 25 points to almost 100 per cent of GDP. In the United States and Japan fiscal
consolidation can hardly be put off any longer: the OECD considers that just stabilizing the
debt ratio of these two countries within the next fifteen years would require a correction of the
primary budget balance on the order of 8-9 percentage points of GDP. In Europe we are
already working to reduce the imbalances in the public finances. The strains that affected the
sovereign debt of some of the euro-area countries have focused attention on the risks of
prolonged imbalances.
The euro area's budget deficit is expected to improve sharply this year from 6.3 to 4.6 per
cent of GDP according to the European Commission's latest estimates. The debt ratio is
likely to rise further, but much more slowly than in the last two years.
In Italy the ratio of public debt to GDP, close to 120 per cent, should begin to decline next
year, when the Government intends to bring the deficit down to below 3 per cent of GDP.
In the ten years preceding the crisis, current expenditure, net of interest on the public debt,
grew by 4 per cent per year in nominal terms, far outpacing GDP. Last September's Public
Finance Decision forecasts that its increase will be limited to 1 per cent per year in 2011-12.
This trend must continue beyond 2012 and the composition of primary expenditure must be
geared to growth. There is no other way to reduce the deficit, since the burden of taxes and
social security contributions is already 3 points above the euro-area average. Additional
revenue that comes in as a result of the reduction of tax evasion should be used to ease the
burden on the taxpayers who already pay what is due. It may also be necessary to offset at
the central government level any increases in decentralized taxation caused by fiscal
federalism.
The financial aid that Greece and Ireland received last year from the European Union and
the IMF was conditional on their enacting strict fiscal consolidation plans and incisive
economic and institutional reforms. A major contribution to preventing new sovereign debt
crises should come from the reform of European governance now under discussion, which
aims to strengthen multilateral surveillance of national economic policies. It is important that
semi-automatic rules come into play when deviations from the agreed parameters occur, as
this will drastically reduce the chance of their being evaded. Rescue funds should be used
only in emergencies and, as IMF experience suggests, should be tied to rigorous adjustment
programmes.
Monetary policy faces different situations in different parts of the world.
In the emerging countries, good growth prospects and high yields are attracting abundant
inflows of private capital from abroad. In 2010 these amounted to around $900 billion, equal
to almost 5 per cent of these countries' GDP. At a time when demand is already expanding
rapidly and the financial system is not yet well developed, such inflows can cause high
inflation and financial bubbles. The inflation rates already recorded in these countries - about
6 per cent on average and well over 4 per cent in China - are partly due to the higher cost of
food and energy products, although the acceleration in domestic demand also plays a part,
since it is behind the jump in international commodity prices. These increases, which are
particularly hard on the poorest, could be countered by currency appreciation, which is
necessary in any event in order to reduce global payments imbalances. In the absence of
such appreciation, monetary policies in these countries are becoming more restrictive.
In the advanced economies inflation is dampened for the time being by the ample margins of
spare capacity. In the United States, the Federal Reserve recently confirmed its plan of last
November to increase liquidity by purchasing Treasury paper.
In the euro area, consumer price inflation, driven up by the sharp rises in commodity prices,
in January widely overshot the definition of price stability fixed by the ECB Governing
Council. Core inflation remains low, given the moderate growth in domestic costs and a
cyclical recovery proceeding without any spurts. Inflation expectations over the medium term
remain well-anchored.
However, the appearance of inflationary tensions does require that we carefully assess the
timing and methods for restoring normal monetary conditions and interest rates. Monetary
policy must prevent a deterioration of expectations, in order to keep the stimulus of
international prices from passing through to domestic prices and wages in the longer-term.
Real short-term interest rates that are markedly negative, as they have been over the past
two years, have not improved the growth prospects of the less dynamic economies. As
economic policies reach the end of their expansionary phase, this will not necessarily
endanger growth. In the weakest countries, in particular, the cost of borrowing could benefit
from the narrowing of spreads on government securities following the adjustment of budget
policies and from the containment of risk premiums as inflation expectations are kept under
control.
International financial rules and controls
Considerable progress was made last year in building a more robust international financial
system, better able to withstand crises.
The Basel III regulatory framework was drawn up, with new capital and liquidity requirements
and limits to financial leverage. Its gradual phasing in will prevent it from impeding economic
recovery. The over-the-counter derivatives markets will have a sounder and more
transparent basis, with greater standardization of transactions, the requirement to use central
counterparties for standardized contracts, and full and prompt access to data for the
authorities. We have identified many of the perverse incentives that encouraged excessive
risk-taking - in banks' executive compensation systems, in the role of rating agencies and in
the accounting rules - and begun to rectify them.
But much still remains to be done.
The activity of the Financial Stability Board is now concentrating, in accordance with the
mandate given by the Seoul Summit of the G20, on the moral hazard problem posed by
systemically important financial institutions (SIFIs), those that in the latest crisis and earlier
ones were considered too large, or too complex and interconnected, to be allowed to fail and
that have often received injections of public capital. Knowing that they cannot fail encourages
them to take greater risks, while the markets finance them at lower interest rates than they
apply to intermediaries exposed to the risk of failure.
The ability to wind up these institutions without undermining the markets or using public
money, the certainty that they can absorb larger losses than those that less important
intermediaries can bear, and more extensive and penetrating supervision; these are the
three pillars on which the FSB's recommendations will be based. Within the year the Board
will publish the essential features of national rules for the winding up of SIFIs, a framework
for the restructuring and winding up plans that every SIFI must prepare, and a preliminary
analysis of the questions involved in the international coordination of laws on this matter. It
will then be up to governments and parliaments.
By the middle of this year we plan to have established the parameters for identifying global
SIFIs, to which to start applying more rigorous prudential rules. The criteria will include not
only the size of intermediaries but also the extent to which they are interconnected with
others and their importance in specific segments of the financial market. The necessary
discretion to be left to national authorities in applying the criteria will have to be balanced by
peer reviews starting at the end of 2012.
SIFIs' ability to absorb losses needs to be improved in order to minimize the probability and
systemic impact of a crisis; the measures to this end include capital requirements additional
to those laid down by Basel III. There are various possible techniques: higher ordinary capital
ratios, the participation of some creditors in losses (bail-in) and debt instruments that convert
into common equity on the occurrence of specific events (contingent capital).
Another field for action by the FSB concerns the "shadow banking system". We are preparing
a map of the non-bank activities and intermediaries that, insofar as they create credit and
transform maturities, need rules and supervision similar to those of the regulated banking
system.
The new European supervisory bodies are now operational. The first task, in which the
European Banking Authority will be primarily engaged, is to carry out stress tests on the
leading banks. The tests will have to satisfy four requirements: very severe scenarios; strict
assessment of the results using a common methodology and backed by thorough peer
review; complete transparency; and prompt identification of the remedial measures. The
requirements are essential for the credibility of the exercise and the markets' assessment of
the European banking system.
Harmonization of the prudential rules is the other urgent object to achieve. A set of common
rules - the single rulebook - will help to prevent less strict supervisory rules and practices in
one country from jeopardizing the stability of the European financial system, having
repercussions on the economies of other countries and distorting competition. A first test will
be the implementation in Europe of the Basel III rules. All the countries of Europe have
pledged to transpose those rules into law, in keeping with rigorous principles, already present
in our model of supervision, whose validity was confirmed in the course of the crisis.
The European Systemic Risk Board, charged with signalling areas of risk and making
recommendations, will need to be able to accompany its analyses with effective intervention
measures. It will avail itself of systemic stability risk assessments shared with the
microprudential supervisory authorities.
Italian banks and the Bank of Italy's supervisory action
The money and financial markets are now functioning better, but the return to complete
normality will take time. Banks, particularly European banks, are having difficulty raising
funds in the market. Their balance-sheet assets are exposed to significant risks stemming
from the after-effects of the recession and the strains in the sovereign debt markets, which
give rise to liquidity risk and the possibility of capital losses.
With the financial crisis, the global environment in which Italian banks operate has been
altered. Competition for funding, including competition with sovereign borrowers, has
become fiercer. The structural contraction in the volume of assets in some capital market
segments has brought a permanent decline in income.
In the closing months of 2010 the main Italian banking groups' net liquidity position one
month ahead remained positive, on average, but shrank. In January, however, they made
bond issues worth some €10 billion, or about one fifth of the wholesale funds maturing in
2011. Short-term funding capacity also showed improvement, although the volume of these
placements remains smaller and the duration shorter than before the sovereign debt crisis.
Maintaining adequate reserves of liquidity is vital to safeguarding stability and continuing to
provide finance to the real economy, especially while the market is still vulnerable to sudden
crises of confidence. Prudence must not be sacrificed to profitability.
In 2008, in the thick of the financial crisis, the fall in the earnings of Italian banks due to
writedowns of securities, trading losses and reduced fee income was quite modest compared with
the severe losses suffered by banks elsewhere. But since 2009 the situation has changed.
Italian banks' profits are weighed down by a contraction in net interest income and a
deterioration in loan quality, the consequence of the severe economic recession.
In the first nine months of last year the earnings of the five largest groups declined by 8 per
cent compared with the corresponding period of 2009. Return on equity fell below 4 per cent
on an annual basis. In two years net interest income has fallen from 2.0 to 0.9 per cent of
total assets, owing to the slowdown in lending and the decrease in the mark-down on sight
deposits caused by the low level of interest rates. Value adjustments to loans, though lower
than their 2009 peak, continue to absorb more than half of operating profit. The average
balance-sheet cover ratio for impaired loan assets remains below its long-run level. The
recovery in margins is also slowed by the heightened competition for retail funds.
In recent months a country-risk effect has been added. Today Italian banks, even the most
efficient, are penalized in fund-raising on the wholesale markets. They pay about 70 basis
points more than their German counterparts.
The low profitability of Italian banks reflects not only the sluggishness of the Italian economic
recovery but also their prevalent business model: concentration on lending to retail
customers (households and small businesses); retail fund-raising; low leverage; limited
securities trading on own account; and less maturity transformation than banks in other
countries, owing in part to the predominance of variable-rate loans. This model means our
banks are less exposed to financial market volatility and protected them during the crisis. The
other side of the coin is that it makes them heavily dependent on net interest income and
macroeconomic conditions. It makes their operating costs more rigid.
Resolute action is needed to lower the ratio of costs to total income. In recent years the
largest Italian banks have enhanced their operating efficiency, bringing the cost/income ratio
closer to that of their European competitors: 62 per cent, against an average of 58 per cent
for all EU banks in the first half of 2010. Italian banks must improve further, and decisively,
by rationalizing sales networks, extending and refining the use of technology, simplifying the
structure of production, selling other non-strategic assets, and adapting compensation
policies at all levels.
Curbing costs will permit the recovery in profits needed for the capital strengthening that the
markets and the new capital rules demand. Given the difficulty of raising fresh equity capital,
it is essential to generate sufficient resources internally.
The capital ratios of the top five Italian banking groups are rising overall. At the end of
September the tier 1 ratio stood at 9.0 per cent, while core tier 1 capital came to 7.9 per cent
of risk assets, up from just 5.7 per cent at the end of 2007.
On average Italy's smaller banks already have levels of capitalization in line with the new
regulatory minimums set by Basel III. These banks supply more than half the credit needs of
the country's small and medium-sized enterprises. For the major banks, which use internal
rating models, the Basel II rules for containing the capital charges for loans to smaller
companies stand confirmed.
This year we shall again assess the resilience of Italian intermediaries in the face of highly
adverse conditions, as part of the new series of stress tests of the European banking system.
Thanks to the experience gained to date, the Bank of Italy and intermediaries will be able to
interact fruitfully for the success of this new exercise.
For banks to be prepared when the new capital adequacy rules are fully phased in, capital
strengthening must proceed, above all through retained earnings. We expect that as in 2009
a large part of last year's profits will be allocated to increasing the banks' capital.
Nevertheless, recourse to the capital market would also appear unavoidable as soon as
conditions permit.
Another major structural change in Italian banks' business environment involves consumer
protection, which is considerably stronger today than in the past. In recent years the Bank of
Italy has stepped up its work to improve banks' customer relations. We have acted on
several fronts: new rules, intensified controls, new consumer protection instruments. We
have always favoured the elimination of the distortions that put the Italian banking industry at
a disadvantage vis-à-vis the competition. The Government's recent initiatives concerning the
tax treatment of banks go in this direction and respond to long-standing requests of ours. But
we are just as strongly convinced that the Italian model of banking, given the nature of
banking customers, has a greater need than others for customer relations to be based on
transparency. Any retreat on this front will encounter the Bank of Italy's firm opposition.
Growth
The essential objective remains growth - growth that is equitable and pays heed to the
quality of life. Without growth, financial stability cannot be consolidated in the world, in
Europe, or in our country.
The Monetary Union can overcome the sovereign debt crisis of some of its members if it is
able to reach agreement not only on the ways to ensure fiscal discipline but also on the
structural reforms needed to impart enduring impetus to growth and on the forms of mutual
control over their implementation.
In Italy, growth has been languishing for fifteen years now. We have dwelt on the underlying
causes and the contours of reform action in various venues, on the basis of the analyses that
we have conducted in recent years. Let me recall some of them.
The growth of the whole economy would benefit from a legislative overhaul keyed,
pragmatically, to enhancing the system's efficiency. If legislation is not transparent,
welldesigned and stable, if the administrative burdens are disproportionate to the activities
regulated, in the long run the economy will decline. Despite the progress made, Italy still
stands out in all the international rankings for the burdensomeness of its bureaucratic
obligations, especially those incumbent on firms.
The educational system is decisive. The achievement gap between our students and their
peers in other countries has narrowed but remains wide, and it is particularly large in the
South. The school system must reward academic merit and diligence. It must guarantee a
satisfactory level of education to all students, irrespective of their social background and
geographical origin. Our university system, despite some notable exceptions, is still far from
the standards of quality prevailing in most of the advanced countries. Our research
institutions are unable to attract talented scholars, technicians and managers, Italian and not,
in sufficient numbers. Recognition of merit is one of the central principles of the reform of the
university system just approved. This is a first step in the right direction.
For over a decade the entry wages of young people in the labour market have been stuck
below the levels of the 1980s in real terms. The recession has made the situation more
difficult. The youth unemployment rate verges on 30 per cent. Already high by international
standards, young people's dependency on their parent's wealth and income, a factor of
conspicuous social inequity, has been accentuated. A major contributory factor is the
segmentation of the Italian labour market, where the rule is minimum mobility at one extreme
and maximum precariousness at the other. This is a waste of resources that mortifies young
people and seriously impairs the efficiency of the productive economy.
Our firms' propensity to innovate and their international projection are insufficient to drive
growth, ultimately because too many firms remain small, including successful ones. The
conduct of entrepreneurs also reflects improper incentives not to grow. A tax system with
less evasion and lower rates would be conducive to firms' decision to scale up and to accept
contributions of new equity capital.
As we have seen on several occasions, the North-South gap in Italy depends largely on
national policies and their application at local level.
We can regard the possibility of a reform drive with fair confidence. Italy possesses abundant
resources, has many companies, entrepreneurial ability and a hardworking and thrifty
people. It is a matter of freeing the spirit of entrepreneurs and individuals from many
constraints. This has already begun, but bolder reform measures would improve the
expectations of firms and households and would give a boost to growth.
This year we celebrate the 150th anniversary of the birth of a united Italy. More than one
third of our history has been characterized by the choice - more and more deeply felt with
the passage of time - to be part of Europe in every phase of its integration. We have made
no small contribution, and received no little in return. More than in the past, the strategic
choices that we face as Italians and as Europeans now coincide. To transform this
awareness into action shared by citizens is the noble task of politics in Europe.