Financials Watch – Italian banks to face a struggle to escape

by: Tom Kinmonth

  • NPL issue to linger for a long time, gross NPLs rather static at EUR 349bn
  • SME loans climb to 74% of Bad Debts, total Bad Debt coverage rises to 62%
  • Profitability very low while state, monetary and macro help begin to lessen
  • Coverage ratios improving, yet EUR 39bn still needed across the sector
  • Retail holdings very high, but should drop by EUR 102bn (67%) by end-2019
  • Pressure to build for mid-and-smaller institutions, forcing consolidation
  • A move to Overweight UniCredit Senior mid-tenor, but risks at other banks
  • We prefer AT1’s from core champions versus subordinated Italian bank debt

DISCLAIMER: This report has not been prepared in accordance with the legal requirements designed to promote the independence of investment research, and that it is not subject to any prohibition on dealing ahead. This report is marketing communication and not investment research and is intended for professional and eligible clients only.

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Following on from the dramatic solution to Banco Popular, see here, we turn our gaze to the struggling banking sector in Italy. Initiatives over the last two years have improved the Italian banking health, although the sector still has a huge mountain to climb to escape. The larger banks are gradually returning to strength. However, the medium and smaller banks in Italy remain the fundamental risk in light of a multitude of issues on the horizon.

The Italian macro outlook tough – even before politics is considered

Before we delve into the Italian banks themselves, the backdrop in which the banks will operate is set to be tough. Potential GDP growth in Italy is around zero currently, according to estimates from both the European Commission and the Organisation for Economic Co-Operation and Development  (OECD). The Italian economy, like the rest of the eurozone, receives a huge amount of monetary stimulus yet the conversion to growth has been lacklustre.

The International Monetary Fund (IMF), see box left, has been especially critical of the Italian outlook. The ability the government has to stimulate the economy is now restricted by the need to lower the structural balance deficit in combination with the high and increasing government debt ratio. Fiscal policy will therefore be restrictive as simultaneously monetary policy from the European Central Bank (ECB) will become tighter. Lest we forget the political situation, with election intentions still not known and the power of the senate still strong.

Furthermore, Italy trails behind European peers in many other matters. For example, productivity growth in Italy has been very low since the start of the millennium. Average growth in labour productivity from 2000-2016 was a mere 0.2%, versus 1% for the eurozone. In the years following the eurozone crisis (2013-2016) labour productivity in Italy on average grew by 0.0%, versus 0.8% in the eurozone. Meanwhile, Italy also regularly scores low on global competitiveness and market efficiency rankings. Finally, the demographic makeup of the country will put pressure on the longer-term Italian situation, as the forecast share of citizens who are over 65 is due to substantially increase.

NPLs: No magic wand to solve the besieged system

The clear danger for the Italian banks is the enormous non-performing loan (NPL) portfolios. The situation is improving gradually, but there remains a huge amount to be done. The larger banks in Italy, those which are under the supervision of the ECB, have roughly 76% of the NPLs. Meanwhile, the smaller banks in Italy have comparatively large NPL portfolios (around EUR 61bn) and provisions are smaller than those of their bigger Italian peers.

NPLs as a portion of loans are still very high, although they have decreased to 17.5% of total loans in H1 2016, a drop from 18% at the end of 2014. However, when we look from an absolute level, the NPL picture is not quite so encouraging. Indeed, NPLs have not increased, but unfortunately they have remained stagnant. Actual gross NPLs at the end of 2014 were the same as at the end of 2016, roughly EUR 350bn. However, the coverage of loans is on an upward trend, in H2 2016 coverages for all NPL types increased (some significantly). If we take the entire sector, provisions stood at 62% in regard to Bad Debt at the end of 2016.

The pressure to service these debts and increase provisions is severely impacting profitability.  Recent initiatives, that we discuss later, should slightly assist the banks to address the problem. However, this is a dilemma that is going to drag on for many years. Excluding an unforeseen ‘bad bank’ solution in Italy, it could take until the middle of the next decade to bring down NPL levels to European standards.

Moreover, unlike Spain and Ireland which had real estate bubbles driving NPLs, the Italian situation is far more difficult. Corporate and Small and Medium-Sized Enterprise (SME) loans continue to represent the greatest share of total Bad Debts in Italy, and even rose from 67% of Bad Debts in 2008 to 74% in H1-2016, according to recent PwC calculations. Furthermore, 75% of the total number of NPLs are loans of under EUR 75,000, the IMF noted.

The makeup of these loans deters the much needed external investors to remove the portfolios. Private equity firms have been reluctant to buy NPL loans when; the type of loan, the collateral of the loan and the long bankruptcy laws in Italy are items that work against them. Moreover, the issue is not purely ‘legacy’ as new NPLs are still being created in the system.

Still a high flow of loans going from Performing to Non-Performing

In 2016, the top 20 banks in Italy saw EUR 22bn of loans moving from Performing Loans to Unlikely-to-Pay, and EUR 25bn moving from Unlikely-to-Pay to Bad Loans, according to PwC. The flow back-and-forth between the classifications indicates that this issue is not a pure ‘legacy’ issue.

Indeed, loans are removed from the system however the fundamental structure of the loan system in Italy still has to be addressed. The worry for the banking sector is that present bankruptcy laws will simply cause NPLs to proliferate and be problematic in the future.

Do NPLs portfolio merely affect profitability, and not solvency?

Vitor Constâncio, the ECB’s vice president, recently stated that the NPL problem in Italy should only impact bank profitability. Indeed, NPLs will impact the profitability of banks, however, there are many additional upcoming items on the horizon that will also impact Italian bank profitability. Consequently, our view is that also solvency of the smaller institutions is at risk too.

Plentiful issues await on the horizon

A tirade of upcoming issues await the Italian banks. From an asset side; NPLs, sovereign holdings and IFRS9 regulation will negatively impact the narrative. Meanwhile, a number of state interventions will begin to run-down. Concurrently, European-led capital and funding requirements will begin to now ramp up for the Italian institutions.

The Italian banks also need to deal with the negative side of central bank events.  For instance, sovereign holdings by Italian banks hover over 10% of assets, leading to roughly 20% of Italian government debt being owned by its banks. Therefore, Italian banks will be particularly exposed to domestic sovereign debt widening once the ECB tapering begins. We expect Italian government debt to widen by some 50bps versus the German Bund, which will significantly impact all portfolios where the debt is not carried at amortised cost. Meanwhile, Italy will have to refinance EUR 200bn of TLTRO funding which it has taken, which is by far the highest of any country.

Furthermore, if we assess the impact of European and national capital requirements. The requirements will increase the amount of debt, which in turn increases costs. While demands for increases in equity capital will mean that more profits will have to ultimately return to shareholders. Finally, bank taxes and increased regulatory costs will also play a role in decreasing profitability in the modern banking narrative.

 Italian banks the least prepared for depressed profitability

Indeed, as these capital demands for all institutions across Europe begin to step up under Minimum Requirement for own funds and Eligible Liabilities (MREL), the impact to the small and medium Italian banks could be significant. The return on equity (RoE) for many banks is already very low in Italy, in part a function of the fragmented banking system. As the denominator begins to increase under new capital requirements the pressure will build on the sector. Other nations in Europe have witnessed a recovery in RoE, but Italian banks on the whole still struggle and are positioned the worse when compared to their European peers.

Consolidation to occur in the Italian banking sector

To combat these variety of rising costs, consolidation of the Italian banking sector is inevitable. Three new banking groups are expected to emerge by the end of 2018 from the consolidation of over 300 cooperative banks. Although, at present there are roughly 640 banks operating within Italy, according to the IMF. The sheer number of banks, the coverage shortfalls and the low profitability mean that consolidation will indeed be hard. The large banks cannot mop up the whole sector. In particular the larger banks have been very unwilling to purchase smaller banks, without state assistance to remove the NPLs.

State interventions losing muscle

Also interesting to review is the reducing impact that many recent state-sponsored initiatives will have. For instance, the Italian government debt financed resolution fund to assist the banks will be severely depleted once the Banca Monte dei Paschi di Siena (BMPS) and the Venetian (Veneto Banca and Banca Popolare di Vicenza) situation is solved. The Italian parliament agreed to set aside EUR 20bn to help the banking sector in December 2016. However, this fund could fall to EUR 8.7bn, once the rescue of these banks have occurred. Additionally, the deficit pressure and the high government debt ratio for the Italian government means that it is difficult for them to add sufficiently more to the fund. Even so, the ECB would still have to make sure that each rescue conforms to state-aid rules.

Another initiative, the Atlante fund, is also unlikely to be unable to supply long term assistance when looking at the current cash available. The Atlante fund, see here, in its present form will also be seriously depleted once the rescues of BMPS and the Venetian banks have occurred. Indeed, the rescues could seriously deplete the final EUR 1.7bn that the fund has to offer. More private funds could be raised, however, the larger banks have often stated that they will not contribute more to the fund.

However, on a positive note, the Garanzia Cartolarizzazione Sofferenze (GACS) securitisation scheme, see here can still lightly benefit the Italian banks. The scheme assists the sale of NPL portfolios but only once a bank has suitably provisioned them. However, as the securitisation does have to occur at market prices, the power the scheme to resolve the fundamental NPL dilemma in Italy is limited.

Authorities have been on the side of Italian banks – which should remain

The authorities play a key role in the future of Italian banks, especially as recent regulation allows the authorities to step-in far earlier than previously was permitted. The ECB and European Commission (EC) have actually been rather easy-going on the Italian banks. Their decision to allow government guarantees on senior debt from the non-systematic banks of Veneto Banca and Vicenza was especially pivotal, see here. An event that was in contrast to the dramatic liquidity driven rescue of Banco Popular.

However, we feel the tide is slowly turning, and the European authorities may not be so willing to conclude that Italian banks are viable if they have no access to the capital markets. We also conclude that the benefit that Tier 2 holders have received in the BMPS case, a conversion to equity at 100 nominal, is something that authorities would be unlikely to do going forward.

The BMPS deal seems close to a conclusion, while the size of the Venetian bank rescue should mean that contagion should not be brought to the sector. The Venetian banks should not collapse once the stakeholders find a common ground to protect the sector. At present, it is more a question of who will blink first between authorities, present investors and even with the larger banks. Perhaps not in the Venetian case, but for future problems in the sector, we still feel sentiment still favour protecting traditional senior debt. Although, this naturally means that subordinated debt could indeed suffer larger losses.

The Italian government found a number of exemptions in regard to bank support that allowed them to assist both directly and indirectly over the last year, and this is unlikely to change. For this reason we believe a muddling through scenario for the Italian banking sector is most likely. Although, this does mean that subordinated debt is liable to be sacrificed to achieve stability. To a lesser extent, the fact that many other European countries are performing reasonably well should also help the desire to give assistance to Italy from a European level.

Retail holdings of bank debt should not stop a bail-in

One thing that cannot be ignored is the amount of retail holdings of Italian banks bonds, it is astonishing. Roughly 50 percent of subordinated debt and one-third of senior debt is held by retail investors. The result is that households hold roughly 37% of all Italian bank bonds, a colossal number.

Belatedly, authority pressure is finally reducing the sale of bank debt to retail investors. For example, UniCredit and Intesa Sanpaolo are to wind-down issuance of subordinated debt for retail investors. However, the sheer amount of retail debt outstanding still leaves risk for the sector in the forthcoming years. Fortunately for the system, roughly two-thirds of the retail holdings are to mature by the end of 2019, EUR 101.8bn (67%).

For Italy, we estimate that retail holdings of subordinated debt would be fully compensated in a bail-in, most likely via an exchange for a senior equivalent instrument (as in the BMPS case) or a separated compensation fund (as done with failed Italian lenders in 2015). We conclude that the various initiatives that can be performed to protect retail holdings should therefore, not stop authorities from bailing-in a bank purely because of large retail holdings.

Nevertheless, the retail holdings do reduce (often significantly) the cash benefit that bail-in can achieve for institutions, thus reducing the power of bail-in. The actions over the last year have stopped the public losing money via deposits, but the taxpayer has actually contributed significant amounts of both cash and guarantees (for both bank bonds and NPL portfolios).

 Italian debt views: Positive on UniCredit Senior, wary of Tier 2

Four Italian banks have deals in the investment grade index; Intesa, Mediobanca, UBI Banca and UniCredit. Although ratings agency downgrades of the Italian banking sector to Negative outlook, also signals that new banks are unlikely to be added soon. Italian debt has been incredibly sparse over the last number of years, particularly dampened by ultra-cheap TLTRO financing. As capital requirements come to the fore under MREL, and this TLTRO money begins to be repaid, we expect issuance to now reverse and increase.

We move from Neutral to Overweight on UniCredit senior unsecured mid-duration debt, in particular the UCGIM 2% 23s. The bank is the only Italian global systemically important bank (GSIB) and it will now urgently focus on Senior Non-Preferred issuance. UniCredit will issue roughly EUR 13bn of this debt rank before January 2019. The recent equity raise combined with the sale of Polish subsidiary Bank Pekao, should push the banks CET1 fully loaded level to over 12%. Meanwhile the banks focus on NPL reduction and the diversification outside of Italy (47% revenue comes from Italy) are additional factors that contribute to our positive view on the name.

To finance the position we go Underweight CMZB 0.5% 23s, which trades 39bps inside the UniCredit deal. Crucially, the German bond is also roughly equivalent to Senior Non-Preferred in ranking, versus Senior Preferred for the UniCredit debt. Further details on the German equivalent ranking criteria can be found here.

For debt outside of investment grade, we would be very wary of investing in the mid-sized subordinated bank debt in Italy. If an investment is desired at Italian bank subordinated levels, we prefer to invest in AT1s of country champions from Northern European countries. For example, for the same rating as a subordinated UBI Banca deal, you can achieve the same yield on a three year deal AT1 from Denmark, NYKRE 6.25 C20s. Or if you wish to match the first call date, you can pickup a higher rated and higher yielding AT1 from France, BNP 6.125 C22s.