XXXI Adolfo Beria di Argentine Symposium
La banca nel nuovo ordinamento europeo: luci e ombre
Ideas for the future of
Italy's financial system
Salvatore Rossi
Senior Deputy Governor of the Bank of Italy and
President of IVASS
Courmayeur, 23 September 2017
CONTENTS
Italy's banks in the new European system
The problems besetting the 'business of banking' today
The transition of the Italian financial system
The rules are changing
Technology and its uses are changing
The system's transition
Italy's banks in the new European system
Italy's economy was already weak when the 2007-08 global
financial crisis struck. Its productive system was structurally incapable of
delivering innovation, efficiency and genuine development; its financial
system was overly reliant on banks. The old dinosaur that was its
banking system had already begun to stir back to life, but many banks
lagged behind as a result of ingrained bad habits in governance and
management. These weaknesses fed on each other and were decried at
conferences and publicly condemned. Given that they were also deeply
rooted in the country and its history, at least its recent history, a solution
appeared remote.
If you get a raging temperature when already under the weather,
you run a serious risk, as Italy did in these years. The country is only
now coming round and while not yet decisive, the signs are
encouraging.
What happened outside our borders in recent years - worldwide
efforts to draw up new regulations for finance, banking union in Europe
1
and its first faltering steps - will be analysed by future historians.
Europe's banking union is here and we must ensure it functions
smoothly, starting with the Single Supervisory System (SSM) and the
Single Resolution Mechanism (SRM) established in Frankfurt and
Brussels. I will return to this point shortly.
From a legal perspective, banking union formally rests on
numerous and complex legislative acts, which I will refer to using their
English acronyms. For the euro area only, there are the two SSMR and
SRMR Regulations establishing the new bodies tasked with supervision
and banking resolution, dating from 2013 and 2014 respectively; for the
European Union as a whole, we have CRD IV (the Capital
Requirements Directive), followed by the CRR (Capital Requirements
Regulation), both from 2013; finally, there is the BRRD (Banking
Recovery and Resolution Directive), from 2014, and the DGSD (Deposit
Guarantee Schemes Directive), also dated 2014. Several of these acts
are still being revised and refined.
On the question of banking resolution, a vital component in the
overall project for banking union, the European Commission's July 2013
Communication updated its own earlier interpretation of the rules on
State aid in the banking sector. Taken together, the BRRD, DGSD and
this Communication have played an important role in the case of the
failing Italian banks that were wound up, placed under resolution or sold
to other banks.
Banking union makes sense if markets and investors believe that
Europe's banks are European first and foremost, and only then Italian,
German or French. It follows that if a bank is in difficulty, it must be a
matter for Europe, not just for the country in which that bank is
headquartered. This implies the sharing of risks, both at private and
public level, a concept that many countries have yet to accept. For
several good reasons, I might add. However, one point must be clear:
banks run many risks that have to do with how they are managed, but
they also share with the State in which they are established - and
whose government bonds they hold in their portfolios - what is
commonly termed sovereign risk. In the euro area today this is a
reflection not only of idiosyncratic factors in that State, but also of the
possibility - which the markets continue to entertain, though much less
than in 2011 - of a euro break-up and the redenomination of credits into
renascent national currencies. This element of risk must be eliminated
by driving the message home at every opportunity: whatever happens,
the euro will endure.
Proceeding with banking union necessarily implies sharing
banking risks: all countries must work to make this a reality.
The problems besetting the 'business of banking' today
What problems do Italian banks face today, now that the fall-out
from the crisis, specifically the ratio of non-performing loans, is slowly
diminishing? Essentially, our banks generate too little profit, even
excluding the cost of bad loans. To understand why, it helps to look at
what has happened internationally.
Over the last five years the return on capital and reserves,
namely the return on equity (or ROE), of our banks has been virtually
nil, while in the euro area ROE has been just under 2 per cent and in
the United Kingdom it has hit 3; in the United States it has reached as
much as 9 per cent.
Italian banks have not only had to make enormous write-downs
of non-performing loans on their balance sheets, they have also had
to bear higher costs than in other countries. Up to now, traditional
lending, especially when concentrated around smaller customers, has
obliged banks to allocate a large amount of human resources per unit
of revenue; moreover, for our major banks labour productivity,
expressed as the value added per employee, is modest, averaging
€124,000 over the last five years, compared with €170,000 for a
sample of large European groups with similar business models.
The low interest rate environment, created the world over by
monetary policies, has squeezed interest margins and reduced profits.
Although this is a global phenomenon, Italian banks have suffered
more than those of other countries owing to their traditional business
model: for several years their ROE has been much lower than the
cost of capital, which does not make it easy for them to find new
funding on capital markets.
As we see, Italy's entire financial structure is in difficulty. Despite
the progress made in recent years, we still have companies that are
poorly capitalized (as well as too small on average) and a bloated
banking sector within the financial system.
And yet the overall size of Italy's financial sector is no greater than
that of other advanced countries. On the contrary! At the end of last
year, the financial debt of the private sector (excluding banks and other
financial entities) was below 120 per cent of GDP, compared with
around 160 per cent in the euro area, the United Kingdom and the
United States.
But, for our companies, equity finance accounts for only 46 per
cent of their total liabilities, compared with an average of 53 per cent in
the euro area. Moreover, they turn mainly to banks rather than to
financial markets or non-banking intermediaries: bank loans represent
more than 60 per cent of firms' financial debts, while the euro-area
average is not even 40 per cent and in the United States and the United
Kingdom it is one third.
As a result, Italian banks, even the largest ones, have specialized
in retail lending to firms. They are therefore more exposed to adverse
cyclical conditions.
The transition of the Italian financial system
The rules are changing
The response of governments and supervisory authorities to the
global financial crisis has focused on two key concepts: 'more capital in
banks' and 'no more taxpayer-funded bail-outs'. This is not all: action
has been taken on liquidity, securitizations and off-balance-sheet
transactions. Limits on leverage have also been recognized as
necessary supplements to risk-based capital requirements. Even stricter
rules have been envisaged for systemically important financial
institutions. Instead, less attention has been paid, at least so far, to two
extremely important non-banking topics: the shadow banking system
and over-the-counter derivatives transactions.
Has the pendulum swung too far towards rules for banks? Many
institutions have naturally begun to think so. The Basel Committee on
Banking Supervision is where the world's supervisory authorities are
now debating this question, during the negotiations on the proposed
Basel III reform package, which should reinforce and refine banking
supervision rules. I have three observations to make, in line with the
stance adopted by the Bank of Italy.
First observation. A period of adjustment for the reforms will be
needed to produce a stable legal framework, otherwise uncertainty will
increase, as will risks and the costs of banking. We must allow the rules
to settle into place and then look at their effects on business conduct
and models. The burdens, especially for smaller banks, need to be
reduced where possible, though how this is to be done is a subject for
discussion.
Second observation. The desire for a period of stability is not to be
confused with an easing of the rules, and the USA is currently wrestling
with this problem. The Fed has defended the reforms it made in
response to the global financial crisis by showing how they have
strengthened the banking system without limiting economic growth.
However, the new administration has yet to define its negotiation
strategy. This uncertainty, which can occasionally be seen in the
position taken by American representatives in some international
forums, deprives the entire international community of important
leadership.
Third observation. Work is ongoing in the euro area on regulatory
and institutional reforms. This is a good thing as banking union is still
incomplete. Yet in Europe, we also need to consolidate what has
already been achieved, starting with the SSM and the SRM, the two
organizations responsible for the supervision and resolution of euro-area
banks. Practices need to be harmonized by taking the best from each
national system without prejudice. Progress is under way, including a
contribution from Italy, and must be continued.
Rules can contribute to forging the business model for all banks. If
the rules change, banks must take this into account when deciding on
their identity and strategy. We hope that the uncertainties in the global
and European regulatory framework will be dispelled as soon as
possible, because banks, especially in Italy, must reinvent and redefine
themselves; and do so also in the light of new technologies.
Technology and its uses are changing
FinTech is the new buzzword at the centre of any debate on the
future of banking. FinTech companies make use of existing technology,
and of new technology as it becomes available, to offer financial
products to their customers that up to a few years ago could only be
purchased through a bank. This business is expanding rapidly in the
markets for loans, payment services, and financial advice and has
managed to attract substantial funding from venture capital and private
equity firms: last year such firms invested more than $13 billion in
FinTech. This is still a trifling amount compared with the trillions of
dollars involved in global finance, but its growth is exponential.
Until very recently, the banks benefited from being the main
gateway to the financial world for most of the population. By providing a
simple but fundamental product like the current account, they were able
to reach a vast client base and make profits. Today, FinTech companies
are trying to unpack the bundle of financial services offered by the
banks, leaving the latter with only the least profitable ones.
FinTech uses innovative data analysis techniques (artificial
intelligence and machine learning) to process efficiently the information
that individuals and companies put online, sometimes unknowingly (big
data). Using this data, algorithms calculate the creditworthiness of those
applying for a loan and the result is available, on digital platforms not
requiring a bank to act as intermediary, to the savers who directly
disburse the financing. The method seems particularly profitable when
an individual or a small company is asking for a loan: in this case,
according to the advocates of FinTech, an algorithm based on big data
is far more efficient than an office peopled by bank clerks.
FinTech companies are radically changing the relationship
between clients and financial service providers, even in terms of
usability. They mainly meet the needs of younger people, enabling
them to conduct financial transactions at any hour of the day or night
using their mobile devices.
This poses a serious threat to traditional banks. The only factor
that keeps borrowers and lenders tied to a traditional bank is trust,
based on familiarity with other human beings behind a counter or even
based purely on a brand. This is an imponderable factor, one that is
difficult to predict. Certainly, the banks will have to give much more
importance to the digital distribution channels and radically alter the way
that client data are analysed and stored. Substantial investment in
technology and human capital will be necessary.
Another option for traditional banks is to acquire one or more
FinTech companies, as seems to be happening with payment services.
Smaller banks could team up with FinTech companies and outsource
some of their own business, as has happened in many English-speaking
countries.
FinTech also raises questions and problems for those with a public
responsibility as financial regulators and supervisors. There is a risk, for
instance, of enlarging the boundaries of shadow banking, that is
financial entities that elude any kind of supervision. Progress cannot be
stopped, but it should be pointed in the right direction in the public
interest. We are already considering the best approach to take.
The system's transition
The financial crisis, the global reaction that widened and hardened
the perimeter of banking regulation, the tumultuous developments in
technology and in the market and, in the case of Italy, the long-standing
problems in the structure of the economy require that our financial
system be transformed. The changes are already under way, and the
system is in a state of transition.
Throughout the euro area, the banking system has progressively
consolidated since the crisis. At the end of last year, the number of
banks was just over 5,000, a drop of 25 per cent compared with eight
years ago, while the number of residents per bank branch has grown by
more than 30 per cent. In Italy, the first figure is in line with the euro-
area average, while the second is lower (19 per cent), but nonetheless
considerable.
Similarly, the productive capacity of Italy's banking industry is no
more excessive than that of the euro area. At the end of last year, the
number of residents per bank in Italy was about 100,000, much higher
than the average of 67,000 in the euro area and 48,000 in Germany,
even if the number of residents per bank branch was lower: about 2,000
compared with 2,300 in the euro area and 2,600 in Germany.
However, the future does not so much hinge on the number of
banks and bank branches, as on the composition of the financial system
and the types of activities that banks undertake.
I mentioned earlier that our financial system perceives firms as
being overly indebted, especially towards banks but without them having
benefited in terms of profitability. In order to increase the profitability of
the Italian banking system and make it sounder, counterintuitive events
are necessary: firms must increase their capital and diversify their
sources of financing in order to reduce the role played by banks in the
financial system.
Signs of this are already apparent. The moderate expansion in
bank lending to firms in recent years, despite its recent recovery, is also
a result of this process. From 2012, firms' leverage (the ratio of debt to
debt plus equity) has fallen, the share of bonds in total financial debt has
increased and the share of bank lending has diminished in equal
measure. Changes in the composition of financing sources, initially
limited to large industrial groups already active in the bond market, are
now being seen among smaller firms as well.
Over the past few months individual savings plans (PIR funds)
have been introduced, i.e. instruments offering tax breaks and designed
to channel investment directly towards Italian firms. The experiment has
thus far been a success, attracting a net amount of approximately €5
billion. Special Purpose Acquisition Companies (SPAC) are another
relatively new addition to the market, with growing success: in essence
they are small private equity funds that gather resources from a limited
number of investors solely on the basis of the personal reputation of the
promoters. The resources are used to purchase equity in a target
company, to be acquired within a set time limit after the vehicle has
been established. SPACs are listed companies and serve to accelerate
the listing of the target company.
***
It is not enough for Italy to change the composition of its financial
structure. Banks must advance their business model by accepting and
facilitating a narrowing of their traditional role.
In the long run, regulatory and technological changes make the
Italian model of banking that prevailed in the ten years prior to the
global financial crisis no longer sustainable. However, the transition to a
new model is far from being free of obstacles and risks. For example,
the immediate repercussions on employment of a rebalancing of the
financial structure that lowers the share of the banking sector must be
considered carefully, and tools to upgrade the skills of redundant staff
must be set up - as we have already begun doing.
There is no one solution. Each bank is a unique case and
generalization must be avoided. Some banks might increase the supply
of bond or share placement services to small and medium-sized
enterprises, leveraging the wealth of information gathered over time: in
short, this would translate into less direct credit but greater support and
the provision of collateral for firms seeking access to financial markets.
Other banks might remain totally retail-oriented but enhance their use of
digital tools, boosting their online channels and expanding the
transactions and services available through them.
Such decisions are up to the banks. Analysts and supervisors can
only try to glimpse the trends and prospects that, interspersed with risks,
lie in the mist that always clouds the future. Of one thing we can be
certain: the financial and banking systems cannot remain as they are if
we want our country to return to a path of growth as it has done in the
past.