On The Unsustainable Losses Of The Italian Banking System
While not in the throes of a real estate crash, Italian banks are seeing a sharp deterioration in the quality of their assets. And while Italy's bond spreads head back to pre-crisis lows, as BofAML's Alberto Cordara notes, the ongoing pace and depth of asset quality deterioration further erodes the banks' ability to help Italy on the way back to growth. Critically, the lack of demand for banks' NPLs suggests that asset valuations may be overstated, thereby posing doubts on the real solvency status of Italian banks (i.e. they are not being totally truthful about their balance sheet assets); which explicitly means more capital is needed and soon. The rate of acceleration in newly impaired loans is staggering as it appears the current recession, driven by falling internal demand, is more insidious than the export-led crisis in 2009. And no matter how the Italian banks try to differentiate their bad loan composition, it is an ugly picture. The Italian House Price Index (IPAB) decreased 4.6% yoy as a result of tightening credit conditions, new property taxes and a difficult macro environment; and is unlikely to provide any assistance any time soon. Based on losses and capital, ISP appears best positioned, and BMPS worst - and do not expect a new LTRO to help as this is "not a normal economic downswing."
Our analysis shows that ISP has the highest equity buffer and is the only bank that could withstand a write-down of its current exposure without falling below the 7% B3 common equity ratio. Meanwhile, BMPS looks to be in a comparatively worse state.
When looking at the aggregate balance sheet of Italian banks it appears that the LTRO was predominantly used to replace the run-off of pre-existing short-term funding facilities and fund the purchase of government bonds. The shift in the asset portfolio at Italian banks spurred by the LTRO means that banks’ profitability is drifting further away from commercial lending and deposit-gathering activities.
A sustainable business model cannot be based indefinitely on central bank support. However, the current framework of low rates and rampant credit losses suggest to us that additional liquidity measures are desirable.
Italy's industrial base has one important particularity: 95% of companies have under nine employees. In fact the average is four. They are micro companies and have such, their balance sheet is modest and so is their ability to withstand prolonged contraction in demand (external or domestic depending on the line of business). The chart below shows the development in profits in the last ten years and how far we are relative to the average of 2002-2012 (we choose this period to include a meaningful period ahead of the 2008 crisis).
Italy has a second important peculiarity. It has significant household financial wealth and an aging population, including a high average age of entrepreneurs. This implies that on the margin more entrepreneurs are likely to decide to scale back operations as expected profitability has diminished due to weak turnover, high red tape and growing fiscal burden. On the margin, opting for early retirement looks like an increasingly appealing option. Be it because of severe balance sheet pressures or because of less attractive future returns, the economy is losing productive capacity at a disturbingly high pace.
Normalisation is not in sight: need of continued support So far, additional liquidity provided by the ECB has not resulted in a reactivation of the lending cycle but it has enabled banks to sustain revenues (NII, trading) through the purchase of sovereign bonds. We think banks may need strong support measures for longer than the LTRO term (early 2015) in order to absorb further credit losses. Alternatively, the system could undergo an immediate extensive clean-up, but this might require further capital injections at the weakest banks.
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