Mario Draghi: Monetary policy and the banking system
Address by Mr Mario Draghi, Governor of the Bank of Italy, at the Annual Meeting of the
Italian Banking Association, Rome, 11 July 2007.
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I wish to thank the Italian Banking Association for extending its traditional invitation to the
Governor of the Bank of Italy to take the floor on the occasion of your Annual Meeting. And I
should like to convey my special greetings to President Corrado Faissola, who is presiding
over the gathering for the first time.
Economic and monetary developments
The euro-area economy will continue to expand in line with its potential growth rate. The
rapid increase in exports should be accompanied by lively internal demand. Industrial
production is now at a five-year peak, as is the indicator of business confidence, and
consumer confidence continues to improve. In the second quarter of 2007 GDP growth was
about 2 per cent on an annual basis. The EuroCOIN coincident indicator calculated by the
Bank of Italy has declined slightly since the start of the year but remains at a high level.
The Governing Council of the European Central Bank, clearly perceiving the signs of
expanding economic activity, has been making its monetary policy progressively less
accommodating since the end of 2005. This prompt intervention, in advance of actual
pressure on prices, has kept inflation expectations anchored to a stable scenario.
Lending conditions for households and firms remain favourable.
The money supply and credit in the euro area are still expanding rapidly. M3 growth remains
near the highest rates recorded since the start of monetary union. The most liquid
components, cash and current accounts, have decelerated. Bank credit to firms is growing at
a strong pace, while lending to households has slowed slightly. The deceleration in mortgage
lending for house purchase reflects the slackening of property prices and rising interest rates.
Since January the rate of inflation has been just under 2 per cent. It may exceed that value
temporarily in the months to come as a result of the recent rise in energy prices.
The euro has contributed substantially to Italian and European economic growth. Since its
introduction, thanks to the Eurosystem's monetary policy, inflation expectations have
remained low and stable, even in the face of sharply rising energy prices. The credibility of
the monetary policy stance has kept interest rates significantly lower than in previous
decades in every phase of the economic cycle, not just in Italy but in the other euro-area
countries. The predictability of monetary policy has helped reduce the volatility of the
financial markets.
At the launch of the monetary union there were fears that certain structural features would
make the Italian economy more vulnerable than others to variations in the official rates.
Monetary policy produces its effects on the economy above all by influencing the cost
differential between firms' external and internal finance. Its impact is therefore amplified by
information asymmetry concerning the state of the borrower, or by the impossibility for firms
of replacing bank loans with market instruments such as bond issues. A situation that is
especially common in Italy, where small firms depending on bank credit are prevalent and
where private capital markets are still less highly developed than in other large industrial
countries. The effect is heightened if the loan market consists mainly of short-term,
variablerate loans.
Studies conducted by the Eurosystem using a broad range of econometric techniques have
nevertheless found that, albeit with modest differences, the economies of all the euro-area
countries have so far responded in similar fashion to changes in interest rates. In recent
years the exceptionally low level of risk premiums and of interest rates, the abundance of
finance in the form of both loans and other financial instruments, and the large volume of
firms' internally generated funds may have softened the effects of structural disparities, which
could re-emerge in the presence of less favourable economic and financial conditions.
At the same time, however, the structure of the Italian economy is becoming more robust.
The consolidation of the credit system has given birth to large banks capable of operating on
a range of markets. The improved efficiency of intermediaries and the considerable
lengthening of corporate debt maturities have removed earlier weaknesses. The
extraordinary development of the euro bond market and the recent opening of the Italian
stock exchange to international alliances will also help a system that had lost the market for
corporate bonds and where firms' recourse to the equity market is still limited. Further
progress on these fronts is essential if we are to fully exploit the advantages of participating
in the Monetary Union.
Financial innovation and monetary policy
The diffusion of financial innovations, the creation of new products and new intermediaries,
and the changing structure of the financial markets alter the importance of the various
channels of monetary policy transmission and affect the analysis of money and credit
aggregates and their role in monetary management.
The role of the banking system in transmitting monetary policy impulses has been
diminishing in importance. If the recent changes in the structure of the financial markets
prove to be permanent, banks will increasingly be agents that originate loan assets which
they then combine and transfer in part to the market. Loan securitizations are booming. In
2006 they were equal to more than one fifth of the increase in lending in the euro area and in
Italy. Credit derivatives, though still small in volume, are growing explosively. The transfer of
assets to non-bank investors such as pension funds and hedge funds gives banks an
alternative channel for procuring liquidity. The transfer of risk by means of derivative
instruments can reduce the supervisory capital requirement for a given volume of lending. A
study by the Bank of Italy and the ECB on eight years of data from 3,000 intermediaries in
the euro area has shown that the banks that make the greatest use of securitization
decrease their lending less than others in response to rises in the official interest rates.
Other transmission channels are gaining in importance. Innovation has made financial
markets more liquid, efficient and complete. The speed with which official rate changes are
reflected on a broad range of financial instruments, and hence on saving and investment
decisions, has increased. The markets respond to expected moves by the central bank even
before its actual moves.
The promptness with which markets react to new information increases the risks of instability
inherent in unclear communication by central banks. Monetary policy decisions that diverge
from the expectations of the market already embodied in financial asset prices can have
devastating effects on liquidity and prices in extreme cases. In recent years central banks
have augmented the predictability of monetary policy, making objectives and strategies clear
and explicit.
Central banks take expectations into account, but they do not lose sight of the fundamentals.
To avoid surprising the markets is preferable but not always possible. It remains essential for
price stability that the authorities' actions orient the market, not the other way around.
The changes in financial structure also affect the information content of the monetary
aggregates. Until not many years ago virtually all euro-area M3 consisted of transaction
instruments of households and firms, whose behaviour as holders of money was stable
enough. In recent years there has been considerable growth both of the portion held by
nonbank intermediaries, including investment funds and loan securitization vehicles, and of the
portion consisting of negotiable instruments, holdings of which are largely determined by
portfolio choices rather than consumer spending.
Nevertheless, the money supply is still an essential element in central banks' assessment of
price stability. To extract the full information content, a broad set of aggregates and
indicators should be analyzed. The analytical tools need to be adapted, an objective shared
by all the central banks of the Eurosystem. The Bank of Italy is developing techniques for the
analysis of a set of monetary indicators that includes all the components of money and credit.
The transformation of the banking system
In the year since your Association's last annual meeting, three major bank mergers, two of
them involving cooperative banks, have been concluded with approval by shareholder
meetings. A fourth, passed by the boards of the banks involved, awaits shareholder
approval.
The Italian banking system has become more robust in terms of the size of institutions.
Today the two largest groups both have a significant presence abroad; the conditions exist
for competing on a European scale. The other mergers have created banks that are among
the largest in Italy.
The consolidation of banks is just the starting point. Reorganization can only be said to have
been successfully carried through when the gains in efficiency envisaged by the business
plans are achieved. The market expects savings from the unification of technological
platforms, the integration of distribution channels, the increase in labour productivity. Having
a greater number of national-scale banks will increase competition. In order for increased
size to engender greater competitiveness, integration synergies must be exploited in full.
Past experience shows how complicated it is to integrate different organizations,
technologies, networks and corporate cultures. There is a serious risk of heel-dragging and
slowness to adapt. A high degree of unity on the part of management and the greatest
possible reserve in external communication are of the essence. There is no time to lose.
The quality of corporate governance is crucial to the success of integration. Choices must be
guided by clear objectives and a rational division of responsibilities. The Bank of Italy is
active, attentive. We shall continue to examine the solutions adopted and the way corporate
bodies operate, ensuring their proper functioning for purposes of sound and prudent
management and intervening whenever necessary. Specific rules on the governance of
banks will be issued.
It is essential that the new groups organize their system of internal controls as a matter of
urgency. The complexity of integration and the rapid expansion of innovative products
heighten operational, legal and reputational risks. Clear accountability and the ability of top
management to keep control of the key processes are prerequisites for stability even more
than efficiency.
All the banks involved in the mergers had developed advanced methods of risk
measurement to be submitted for supervisory approval as an instrument for calculating
capital requirements. In some cases the project will have to be revised to take account of the
new situation. In no case is a deterioration of risk control, even a transitory one, permissible.
The consolidation of the banking industry will facilitate the reorganization of the asset
management industry and the realization of the scale economies that could result if
integration synergies are exploited in this field too. Consideration should be given to
measures to guarantee the complete independence of the directors of asset management
companies. It is commendable that the majorities of the boards of the two largest
bankowned asset management companies consist of independent directors.
Italian banks have large market shares in the countries of eastern Europe, where lending is
expanding rapidly. The loans go above all to households for the purchase of houses, whose
prices have risen rapidly. In Slovakia, Poland, Bulgaria and Hungary, where Italian banks'
market share is around one fifth, lending is increasing by more than 20 per cent per year on
average. These countries' external current account deficits are large and persistent. Last
year Bulgaria ran a deficit of 16 per cent of GDP. Bank loans, which are mostly indexed to
the euro or other foreign currencies, carry lower interest rates than those in domestic
currencies. In the short run they are attractive to borrowers but expose them to a severe
exchange rate risk, with potential financial and reputational repercussions on the banks.
I have repeatedly called attention to the need to complete the reform of the governance of
Italy's cooperative banks. The aim, which I believe is generally shared, is to release the
extraordinary potential of these institutions, make sure their corporate bodies are
satisfactorily representative, not to question their cooperative mission. To those who want to
maintain the present equilibria, I shall not cease to recall the benefits - especially for the
largest cooperative banks listed on the stock exchange - of a reform that removes the
anomalies of a legal framework tailored to small, local banks. We must ask whether
decisionmaking mechanisms in which small minorities have a decisive voice in strategic choices are
consistent with the rules of the market.
Banking supervision in Europe
The concentration of banking systems, the removal of barriers between markets and the
transnational nature of the largest groups have given banking supervision a European
dimension. These developments have demanded a rethinking of the instruments of
supervision that has already had important consequences but is still under way.
Harmonization of the rules on banking supervision has reached an advanced stage. There is
agreement on the fundamental choices and extensive cooperation among the supervisory
authorities, in the first place within the Committee of European Banking Supervisors. For
transnational groups supervisory panels are at work, formed by the authorities of all the
countries in which a group is present and coordinated by the authority responsible for
consolidated supervision. The Bank of Italy chairs the panels for UniCredit and Intesa
Sanpaolo and participates in many others. The exchange of information and experience is
continual, the climate of cooperation excellent.
It is necessary to extend harmonization gradually from supervisory rules to supervisory
practices: more effective action, equal conditions of competition, a lighter burden on banks,
especially those present in different countries, are the objectives. Further harmonization of
the rules on own funds and risk concentration appears urgent. It will also be necessary to
design common criteria for stress tests and work for the adoption of a homogeneous
prudential statistical reporting format.
In the coordination fora the authorities have conducted simulations to prepare for the crisis of
a large bank. One learns a great deal from these exercises, and it would be a good thing if
they were held more often. Principles and procedures for the allocation of tasks and
responsibilities are being defined; the process must be completed rapidly. A strengthening of
the role of the CEBS will speed up convergence of supervisory practices and simplify
cooperation between authorities. Thought also needs to be given to the possibility of
emphasizing the position of the coordinating authority in supervisory panels by giving it the
role of lead supervisor, with greater powers on the group's subsidiaries for purposes of
preventing and managing crises.
However, the remaining differences between countries in deposit insurance, insolvency
procedures and the rules on the transfer of assets between units of the same group could
seriously complicate the management of a crisis. Eliminating or attenuating these differences
must be placed on the legislative agenda at national and European level.
Banks, firms and innovative products
Bank's dealings with firms now embrace not only the provision of loans and payment
services, but also the supply of innovative financial services, including risk management
products. These can increase the efficiency of the system and be a growth opportunity for
banks, provided the customer is given complete information, the seller fully understands the
product and the bank's top management, whose duty it is to appreciate these products in all
their complexity, is clearly aware.
Banks provide an important service to firms if they assist them in selecting instruments suited
to their characteristics. The purpose must be the hedging of risk, not anything else. To
encourage customers to assume financial risks rather than hedge them increases
counterparty risk, with large possible losses; it creates legal and reputational risks that can
undermine the bank's prospects for growth and even call its stability into question.
This is before our eyes in a case now being clarified. An inspection that the Bank of Italy
began at a bank in January of this year found that it had sold business customers complex
derivative products, highly exposed to an increase in interest rates. Owing to market
developments, these derivatives have caused a sudden surge in the indebtedness of the
customers who had bought them. The result was an increase in the bank's exposure to
counterparty risk as well as to legal and reputational risks. The Bank of Italy intervened; it is
following the case with the utmost attention.
Proper conduct, transparency and adequate organization are essential to every bank that
alongside its traditional credit operations sells complex products. There must be a clear line
of decision-making connecting top management to operating decisions and to customers'
demands.
Transparency, proper conduct and the protection of bank customers
The Bank of Italy's supervisory provisions on compliance have been approved and will
shortly be published. They lay down general principles, granting banks discretion in selecting
the most effective organizational arrangements. Banks' governing bodies decide the overall
design of the compliance function and monitor its actual operation.
In all customer relations, transparent and correct information increases the public's range of
choices, fosters competition and prevents legal disputes. Lawmakers and regulators have
become more responsive than in the past to the need to ensure correct relations; banks
themselves are rapidly becoming aware that the point is not only to defend and enhance the
reputation of the industry, but also to gain an important tool of competition.
As I have said on other occasions, it is appropriate for regulators to intervene where
economic agents and the market are unable by themselves to ensure adequate standards.
Self-regulation, if based on agents' clear determination to pursue its underlying objectives,
can be more effective than mandatory rules in many cases. The most powerful tool for
pursuing the interest of consumers remains competition, which can function well, however,
only if transparent terms and conditions are ensured and the obstacles to customer mobility
eliminated. This requires rules at various levels; statutory provisions, administrative
regulations, self-regulation and competition are complementary instruments.
I therefore take note with favour of the action plan ABI has just adopted to improve relations
with customers. The intent to capitalize on cooperation with consumer associations and the
authorities is commendable, the declared objectives endorsable: to enhance the
transparency and simplicity of relations with customers, to assist customers before and after
the sale of financial products, to strengthen their confidence, to eliminate residual barriers to
mobility. It is in the system's interest that customers see concrete progress soon.
Self-regulation must benefit competition. The cooperative relationship between the banking
system and the Antitrust Authority is positive.
In recent times Parliament has intervened on various aspects of the bank-customer
relationship, in particular by ordering the abolition of costs for closing current accounts and
introducing the customer's right to extinguish a mortgage loan without a penalty. The Bank of
Italy looks with favour on the purposes of these measures, even if it has raised doubts on
certain technical aspects and suggested leaving room for secondary legislation and
selfregulation. For current accounts, the new rules have given rise to problems of interpretation,
and progress has been insufficient: complete portability of accounts is not yet guaranteed.
For fixed-rate mortgages, the ban on penalties for early repayment may lead to banks setting
higher rates: early repayment is an implicit option in favour of the debtor and thus has a
financial cost.
Parliament is examining a bill that will prohibit the maximum overdraft fee, a practice not
easily defensible and in fact one that some banks have already dropped in a logic of
competition. An amendment approved during the bill's passage through Parliament will, in
line with views expressed by the Bank of Italy, allow banks to apply fees for open credit lines,
a common practice in other banking systems.
The MiFID Directive on Markets in Financial Instruments, which will enter into force in
November, will also affect relations between customers and intermediaries. Its more precise
description of information requirements, differentiated according to the nature of the
customer and the service, will enhance the transparency of the instruments offered.
Customers will be in a position to benefit from a larger dataset and make more informed
decisions. Fulfilment of the obligation to offer best execution, extended to include factors
other than the price, will be entrusted to suitable organizational solutions identified by
intermediaries. The Bank of Italy, with the other authorities, is engaged in defining a flexible
regulatory arrangement consistent with the need to limit the costs for intermediaries and with
the objective of enhancing the attractiveness of the Italian financial marketplace. We have
organized training courses for the staff of some of our branches to assist banks in adapting
to the new rules.
Protection of the parties to bank contracts requires swift-acting, effective and economical
dispute resolution instruments. The law now asks intermediaries to subscribe to non-judicial
mechanisms. The Bank of Italy, which will have to submit a proposal to the Credit Committee
for the regulation of the matter, is about to begin a consultation with intermediaries and
customers. The proposal will be based on the experience gained in Italy and elsewhere and
on a specific European recommendation; it will ensure that the adjudicating bodies are not
only independent but also clearly perceived to be so. The Bank is ready to contribute by
taking part in the appointment of disputes resolution panels and providing technical
secretariat services. The success of the initiative requires both involvement of the
associations of consumers of financial services and convinced participation by the
associations of intermediaries, which will also make it possible to draw on the experience of
the Banking Ombudsman.
No rule on transparency and protection is truly effective if customers lack the means for
making informed decisions. With the growing complexity of supply, ensuring the financial
education of consumers of banking services has become a matter of crucial importance. The
Bank of Italy cooperates with other institutions in projects of financial education, has begun to
develop a dedicated section of its own website and, with the Ministry of Education, has
launched initiatives targeted at schools. But much remains to be done.
The Bank of Italy is committed to preventing and combating money laundering. The planned
incorporation of the Italian Foreign Exchange Office into the Bank and the transposition of
the new European Anti-Money-Laundering Directive will create the conditions for further
progress. The independence of the Financial Intelligence Unit will be confirmed. The rules
will be made more incisive, controls increased and new forms of intervention introduced.
Loans to households
Household debt has risen from 31 to 48 per cent of disposable income since the end of the
1990s. Compared with the situation in the other main industrial countries, both the amount of
household debt and the burden of instalments and interest payments are still limited. The
debt is largely concentrated with high-income households, which normally are better able to
absorb additional costs due to rising interest rates, but its rapid expansion is involving
everbroader strata of the population.
Financial innovation, more flexible rules and increasing competitive pressures have
multiplied the forms of financing available, especially for house purchases. Until not long ago
mortgages rarely exceeded 15 years in duration or 50 per cent of the purchase price. Today
more than one third of mortgages last more than 25 years and the cover ratio is considerably
higher. Access to consumer credit has also become easier. The market in lending to
households has expanded and matured.
Further progress must be made, however. Both for home mortgages and for consumer
credit, the interest rates charged by banks in Italy are higher than the euro-area averages for
similar transactions. The recent change in monetary conditions has led to a shift in the
demand for mortgages from variable to fixed rate loans; for the latter, the increase in interest
rates has exceeded the European average. The new rules on covered bonds will enable
banks to expand the range of funding instruments to finance long-term loans and reduce
their costs; this will have to be reflected in more favourable conditions for customers.
Data harmonized at European level show that Italian banks' annual percentage rate of
charge on consumer credit is still about one percentage point higher than the euro-area
average, even though the gap has narrowed in the last few months. Not all of the difference
is due to risk factors or to the still limited development of the consumer credit market in Italy.
Not even the entry of foreign intermediaries, which now account for more than one third of
such lending, has proved a sufficient stimulus to competition. This must be strengthened,
especially in distribution channels.
According to data gathered pursuant to the law on usury, the interest rates charged by
financial companies are higher still. Furthermore, especially where small amounts are
involved, rates vary widely even for transactions of the same type, such as personal loans,
loans secured by wages and instalment purchases of consumer goods. This probably
indicates insufficiently transparent contractual conditions and a pronounced segmentation of
the market.
The attention banks pay to customers and to their own reputation must be greatest when
their contact with the customer is made through outside collaborators. It is necessary to
check that each link in the chain leading to bank products charges commensurate fees, to
assist in the fight against usury, and to act promptly in cases of suspected unauthorized
banking or financial activity.
The instruments are not lacking. Brokers' terms and conditions are subject to transparency
requirements. A bank employee who steers someone to an unauthorized person for banking
or financial transactions commits a specific crime. Certain characteristics of current account
transactions that suggest usury have been made known by the Italian Foreign Exchange
Office.
The Council of the European Union has reached agreement on a new directive on consumer
credit, which will be examined by the European Parliament in the autumn. If approved, the
directive will enhance consumer protection by providing for forms of transparency and
assistance and new rights. It is in the nature of "maximum harmonization" and will therefore
facilitate intermediaries that want to operate in more than one country, thereby stimulating
competition. The Government has the commendable intention of anticipating the main points
of the directive with ad hoc legislation and introducing, for loan and financial brokers, more
detailed regulation and more effective controls, to be entrusted in part to organizations
created by trade associations.
Payments: lowering costs, improving quality
Competition between banks will also be based increasingly on their ability to offer efficient
payment services. There is room for improvement in payment completion time, costs and
security. Completing a payment by cheque still takes an average of seven days; a legislative
amendment facilitating digital transmission of the images would make a significant reduction
possible. The creation of the Single Euro Payments Area will provide the occasion for
modernizing instruments and infrastructure at national level as well and will be conducive to
the specialization of intermediaries and to innovation.
The Payment Services Directive has harmonized the European legal framework,
strengthened the protection of users and opened the market to new agents competing with
banks. But Italy is still considerably behind in the use of electronic payments. Although the
diffusion of POS terminals and payment cards is not less than in the rest of Europe, the
number of transactions per capita with these instruments is far below the average. The
excessive use of cash lowers the efficiency and security of transactions, increases the cost
per transaction and hinders the reduction of the prices of payment services. ABI's
commitment in favour of a rapid development of electronic payments is commendable.
The results of the survey on the costs of bank current accounts that the Bank of Italy has
already begun will be available in the autumn.
The stock exchange
I cannot conclude these remarks without mentioning the developments involving the stock
exchange.
A year ago on this occasion, I recalled at some length the essential role that the stock market
plays in fostering the growth of the economy. I noted the strong boost to efficiency deriving
from the integration of European and world exchanges and the drive to consolidate stock
exchanges, including on a federal basis. Just a month has passed since my Concluding
Remarks to the annual meeting of the Bank of Italy where I again underscored the growth
opportunities that are emerging for exchanges that open to international cooperation and the
risks for those that stay on the sidelines.
Borsa Italiana has taken steps to capitalize on its strengths - operational efficiency, local
roots and its strong presence in some markets - and to reap the benefits of integration in a
market of global dimensions. This opening is definitely a positive development. As in other
fields, the Bank of Italy points to what it considers the right route. It does not seek to
determine any institution's traveling companions. It notes that the road ahead is still very long
and urges that it be traveled resolutely.