February 06, 2019

IMF published its staff report and selected issues report under the 2018 Article IV consultation with Italy. Directors welcomed the progress in reducing non-performing loans (NPLs), increasing provisions, and building capital buffers. They emphasized the need for further strengthening of the banking system, continued reduction in costs and NPLs, and strengthening of bank governance.

The staff report highlighted that the financial sector in Italy has stepped in to buy government securities, reinforcing the sovereign-bank link. The banking system bought about EUR 45 billion since April 2018. The rise in sovereign spreads has adversely impacted banks’ capital and insurance companies’ solvency ratios. The report further noted that banks’ asset quality has improved notably over the past year. However, gross NPLs fell from 16.5% of loans in 2015 to about 10% in mid-2018, mainly through sales. This is a notable reduction by any standard, though NPLs remain well above the 3.6% average of the main EU banks. New NPL formation has fallen to the pre-crisis levels. Provisioning coverage rose to 55%, which is 9% above the average of the main EU banks. The report mentioned that intensive supervisory oversight of NPL reduction should continue in the significant banks (that is, the banks supervised directly by the Single Supervisory Mechanism or SSM), which are seeking to further reduce NPLs to 7% of loans by end-2020. It should be extended fully to smaller banks with high NPLs to ensure that their strategies and targets are ambitious and credible. 

In mid-2018, banks reported a common equity tier 1 (CET1) ratio of 13.2%, which is 0.6 percentage points less than at the end of 2017 and 1.3 percentage points below the average of the main EU banks. Furthermore, tail risks are re-emerging with the recent rise in sovereign yields. Sustained high yields would potentially reduce banks’ capital further, raise funding costs, and increase liquidity pressures. They would complicate plans to raise substantial volumes of the minimum requirements for own funds and eligible liabilities (MREL), which are all the more important, as most banks may find it difficult to grow sufficient loss-absorbing capital buffers through retained earnings. Moreover, the SSM’s thematic review of profitability drivers and business models of the major euro area banks identified no systemic issues for Italian banks, but found considerable opportunities for individual banks to improve their business models and processes. Following from these findings, assertive supervisory oversight is recommended to ensure banks proactively identify and address capital-depleting business lines. Supervisory benchmarking and guidance to banks would promote more effective and consistent use of risk-based pricing, cost allocation, and scenario analysis frameworks.

Additionally, the report notes that consolidation of smaller banks should not be delayed further. About 270 cooperative banks are expected to consolidate into three new banking groups, two of which would be supervised directly by SSM and subject to an asset quality review in 2019. Dealing with weak banks remains a challenge. Two medium-size banks were required to raise fresh capital in 2018. Tackling the problem banks continues to burden the system, with swift recapitalization of problem banks or the timely and effective use of the resolution framework being essential to avoid weaknesses from threatening financial stability and excessively burdening the taxpayers. Ensuring adequate bail-in-able instruments is also a challenge. Under this backdrop, a large volume of fresh bail-in-able debt is needed and banks will be required to increase MREL buffers in the coming years. Introducing safeguards is recommended to ensure this new MREL is effective, including by limiting the proportions of MREL allowed to be held by retail investors and rigorous public enforcement of Markets in Financial Instruments Directive (MiFID) rules. The selected issues report focuses on reforming the social welfare system in the country and on lowering taxes on labor.

 

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Keywords: Europe, Italy, Banking, Insurance, Securities, Article IV, NPLs, Financial Stability, SSM, MREL, IMF

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