Algirdas Brochard // 21 September 2017

Within the European Union, the problem of non-performing loans (NPLs) is predominantly an Italian issue. Whilst Italian authorities have successfully passed a few different legislative reforms to facilitate the resolution of this crisis, more remains to be done, notably in the development of secondary markets for NPLs.

The latest available figures are clear: according to the European Commission, the Italian banking system, which is the third largest in the Eurozone, hold a quarter of all EU’s NPLs. If loans that are unlikely to pay and past due are also included, the total of non-performing exposures (NPEs) amounts to €331bn, or 19.5% of total loans in the Italian banking system. The average for the rest of the Eurozone is below 6%.

An important amount of NPEs on banks’ balance sheet is a major source of concern as it lowers their profitability; it reduces the amount of available capital; and it increases their cost of funding, monitoring and servicing costs. Banks have to provision for the expected losses on these non-performing assets. The lower the expected recovery rate, the higher the coverage ratio – the amount of capital that banks have to hold to provision for these losses.

In the Italian banking system, the average coverage ratio for bad loans, the worst non-performing assets, is 62.3%, with an expected recovery rate of just 37.7%. By comparison, German banks are able to achieve a recovery rate of 58%.

As the Bank of Italy observes, the older a position is when it closes, the lower the recovery rate. Lengthy foreclosure procedures are therefore contributing to these low recovery rates. The Italian Ministry of Justice estimates that corporate insolvency processes take on average 7.5 years – in a country where 73% of bad loans originate from the corporate sector, largely comprised of SMEs that often have less than ten employees.

The Italian authorities have passed reforms to accelerate the insolvency procedures in 2005, 2007, 2009, 2012, 2015 and 2016, the latest of which has introduced welcomed out-of-court enforcement for secured loans granted to enterprises. The Italian insolvency procedures remain nonetheless extremely complex, with Italian banks indicating that this, as well as court backlogs, were the chief impediments to effective credit recovery. It should also be noted that some of the latest measures approved concern only new NPLs.

For the European regulator, the ECB, the priority is now to reduce the level of NPLs on banks’ balance sheets. As such, Eurozone banks with high levels of NPLs had until 31 March 2017 to submit their plans to reduce NPLs levels to the ECB.

To help banks dispose of NPLs, several measures have been put in place by the industry itself as well as by the Italian authorities. In April 2016, the largest Italian banks and other financial institutions created a fund called Atlante, which can support Italian bank’s capital increases and act as a buyer of last resort for junior tranches of NPLs. For senior tranches, the Italian authorities introduced a guarantee scheme called GACS. This scheme enables banks to buy a government guarantee for investment-grade NPLs that have been transferred to an entity separate from the bank – a special purpose vehicle (SPV). The aim of the GACS is to facilitate the sale of securitised NPLs to markets.

There remains, however, one important barrier to the further offloading of NPLs onto markets: the very different valuations that banks and potential investors place on NPLs. As an example, BNP estimates that the net value of the portfolio of NPLs is 41% of the value written on banks’ balance sheet. On the contrary, asset-management companies that specialise in NPLs and other investors value them, respectively, at 34% and 21% of their gross book value. This large difference is explained by the fact that investors value loans by discounting future cash flows from asset recovery (with larger haircuts required the longer the average time for foreclosure) whilst banks impute interest payments. Accordingly, the IMF predicts that shorter foreclosure times would help reduce the pricing gap, easing the pressure on banks’ capital.

Regardless of whether or not NPLs are offloaded onto the market, Italian servicers will continue to play a more important role in managing NPLs. Managing and recovering NPLs requires significant resources and investment. Specialised services can manage NPLs on behalf of investors, but also on behalf of banks. Today, around 40% of Italian banks’ bad loans are managed by these specialised players and PwC estimates this percentage to reach up to 60% by 2021.

Resolving non-performing exposures remains a pressing challenge for the Italian banking system. Because of their high NPLs levels, Italian banks have to hold more capital than their European counterparts – capital requirements for Italian banks could further increase with IFRS9, an international financial reporting standard which will require banks to accrue provision based on expected losses starting on 1 January 2018. Holding more capital, in turn, increases the cost at which banks can provide financing, in a country where corporate financing is overwhelmingly dependent on banks. So far, the result has been constrained investment, something which significantly hampers the Italian slow economic recovery.

Consequently, there is a necessity to act quickly: as Italian banks continue to extend credit, additional NPLs are likely to be forthcoming. To solve the Italian NPLs crisis, four important measures need to be taken.

First, the Italian authorities need to define a powerful pro-growth agenda to accelerate the Italian recovery as an increase in real GDP would drive asset prices up. In addition to this, as Italian banks devote a large part of their assets to lending to SMEs, their profitability would highly benefit from better economic conditions. As the Financial Times reckons, thanks to stronger economic growth and greater investor interest, the total volume of Italian banks’ bad debt shrank by €18bn in July. This is the largest decrease since the Bank of Italy started to record data 20 years ago. However, this positive situation may soon deteriorate again if the government falls short of providing clarity about its longer-term economic agenda.

Second, consolidation in the banking sector is required. Consolidation would help drive down banks’ costs as smaller banks will continue to struggle to be profitable and competitive on a global scale. To give an order of magnitude, at the end of 2016, the five largest Italian banks had assets amounting to €2.3tn or 58% of total assets in the Italian banking system. By comparison, the five largest French banks had assets amounting to €7.2tn, or 86% of total assets in the French banking system.

Third, on a more ambitious note, the ECB could allocate some resources away from the purchases of Italian state debt and start buying senior tranches of Italian NPLs. This measure would improve the position of Italian banks directly and they could, as a result, provide cheaper funding to borrowers, thus sustaining the broader Italian recovery.

Finally, to reduce the pricing gap, the Italian authorities need to continue their reforms to reduce foreclosure times. In exchange for Italian guarantees to accelerate reforms, a special EU funding scheme could also be put in place to help reduce this gap. This scheme would help reduce bank’s losses and encourage them to offload more NPLs onto markets.