Banks Caught In A Vicious Cycle
BMI View: Caught in a vicious cycle of deteriorating asset quality, higher capital requirements and tighter credit standards, and with no economic recovery in sight, we retain our negative outlook towards the Italian banking sector. While current liquidity provisions have kept the sector on life support, rising NPLs are slowly pushing banks towards crisis point, and with economic growth still a distant prospect, we see little chance of the sector recovering without external assistance.
The Italian banking system is mired in an extremely precarious predicament. Faced with a period of extended recession, rising regulatory capital requirements and deteriorating asset quality, banks have tightened credit standards and reined in lending, particularly to small-to-medium sized enterprises (SMEs) , where credit risk is highest. As a result of losing access to credit lines, bankruptcy rates among Italian firms have soared, feeding into higher unemployment and weakening the banking sector's household and business loan books . This in turn has forced banks to increase loan-loss provisioning, reducing the amount of available credit for lending and triggering further tightening of credit standards. In light of the fact we do not expect to see any resemblance of a recovery in Italian economic activity until 2015, we find it hard to envisage a scenario for the sector that does not involve further public sector intervention.
|Italian Businesses Starved Of Credit|
|Italy - Loans To Firms, % chg y-o-y|
Italian banks have benefitted from ECB's efforts to stabilise market conditions for banks within the euro area. Indeed, were it not for the ECB's long-term refinancing operation (LTRO), which provided financing for euro area banks and eased the strains on the interbank market, the Italian banking sector would undoubtedly be in a far worse condition. As the chart above shows, eurosystem refinancing has been a major contributor in plugging the funding gap since early 2012, although bank funding has also been helped by a robust deposit growth. Despite an improved liquidity position, concerns over borrower risk continue to restrain lending, and appears unlikely to improve significantly without capital injections into the system.
|Micro/SME's Account For A Fifth Of Loan Book|
|Italy - Aggregate Loan Book, % Total|
Without external assistance, the health of the Italian banking sector will continue to deteriorate, helping to exacerbate the recession as capital starved businesses continue to collapse. Indeed, the overall health of Italian businesses remains a major risk both to the banking sector and wider economy. Italy's SME sector - the largest in the EU by number of firms - is dominated by 3.6mn micro firms with less than 10 employees. Like most small firms, Italian SMEs rely heavily on debt for financing (especially for working capital) , almost exclusively in the form of bank loans rather than capital instruments. With bank financing becoming increasingly scarce, financial conditions for SMEs have worsened substantially, with 7.1% of companies more than two months overdue on commercial payments in Q412, up from 6.0% in Q411.
|Eurosystem Liquidity Has Proved Vital|
|Italy - Growth In Bank Funding: percentage point chg y-o-y|
As the chart above shows, lending to firms has been contracting since the start of 2012. While loan growth to small firms fell faster initially, loans to medium- and large-sized firms are now contracting at a similar pace, shrinking by 5.3% y-o-y in February 2013 against 6.0% y-o-y for small firms. The bank s reluctance to lend to small businesses is understandable. The financial condition of domestic firms is poor and worsening: the share of financial debt held by firms with a ratio of interest expense to gross operating profit of more than 50% is estimated by the Bank of Italy to have reached 48.2%. Bank of Italy econometric testing indicates that over the threshold of 50 %, there is a noticeable reduction in investment, profitability and self-financing, implying business debt levels are not far off from creating a material drag on growth.
With the government battling a sizeable fiscal deficit, the authorities have few policy tools at their disposal to assist struggling businesses . On the contrary, the government has almost certainly exacerbated the situation through its freezing of payments to government suppliers, which totalled EUR90bn in 2011. The authorities have made some effort to redress the situation, with EUR10bn in financing being offered by the Cassa Depositi e Prestiti to SMEs, although similar SME lending schemes in the UK and EU have experienced limited success in stimulating business lending to date . Additionally, the financing is only available to companies in certain strategic sectors or companies with annual net revenues over EUR300mn and an average of 250 employees. Exceptions may be extended to slightly smaller companies, but broadly speaking these funds will remain inaccessible for the majority of Italy's SMEs. Perhaps more significantly , the government intend s to unfreeze the first tranche of commercial debt payments owed , which should help to improve the liquidity position of these businesses. Nonetheless, neither of these policies are likely to substantially improve SME lending over the next 24 months.
|Debt Burden Is Becoming A Drag On Growth|
|Italy - Share of financial debt held by firms with a ratio of interest expense to gross operating profit of more than 50 per cent, %|
Worse still, Italy's SMEs account for 12.2mn job s in the country , and with some 53,000 companies going out of business in 2012, the condition of small firms is worsening the financial health of Italian households too. Unemployment continues to rise, reaching 12.0% in April 2013, and joblessness remains especially bad among youths, reaching a 36-year high of 40.5% in the same period. As a result, we expect to see the trend of rising repayment difficulties continue over the coming years; substandard loans rose to 4.1% by end-2012, from 3.4% in 2011. The overall non-performing loan (NPL) ratio for Italian banks shot up by 22 % in April to EUR133bn, the highest level since 1998, at roughly 13% of total loans.
|NPLs Are Exaggerated By Conservative Methodology|
|Italy - Non Performing Loans (unadjusted and adjusted for collateral), % total|
One caveat to this view is that while Italy's NPL ratio appears to be substantially higher than other European banks, there are two mitigating factors . First, Italian banks follow a stricter criteria for NPL definition which identifies impaired positions exclusively on the creditworthiness of the borrower, regardless of collateral or guarantees. Most European banks by contrast would not classify a loan as non-performing if, due to collateral or guarantees available, they do not expect to book losses in the future. Second, the credit recovery process in Italy is particularly slow, which exacerbates the length of time that NPLs remain on bank balance sheets. Bank of Italy calculations suggested that adjusted for fair comparison, the NPL ratio would be around 30% lower than official levels.
Nevertheless, it is clear that the sector remains caught in a vicious cycle of tightening credit and de teriorating asset quality. Core 1 capital ratios are relatively weak across the sector, especially amongst mid-size lenders, although Italy's largest banks fare better. I n light of the high probability of continued asset quality deterioration, there is considerable doubt that the capital buffers of many Italian banks would be sufficient to pass ECB stress testing , bolstering our view that the Italian banking sector will require further capital injections. While current liquidity provisions have kept the sector on life support, rising NPLs are slowly pushing banks towards crisis point, and with economic growth still a distant prospect, we see little chance of the sector recovering without external assistance.