Italy's five largest banks, UniCredit SpA, Intesa Sanpaolo SpA, Unione di Banche Italiane SpA, Banca Monte dei Paschi di Siena SpA and Banco BPM SpA made solid progress with disposals of bad loans between the beginning of 2018 and the end of the third quarter of 2019.

But after a notably good run, Italian banks could face significant challenges in the next phase of their nonperforming loan reduction efforts, including another downturn in the Italian economy and the prospect of steep discounts on loan sales.

Good momentum

Monte dei Paschi saw a particularly sharp drop in toxic debt over the period, with NPLs falling to €14.52 billion in the third quarter of 2019, compared with €42.59 billion at the end of the first quarter of 2018.

The Siena-based lender, which was rescued from the brink of collapse in a €5.4 billion state-backed bailout in 2017, is on the cusp of another large reduction in bad loans — subject to the approval of the European Commission. The Italian government has been in negotiations with the EC over a proposal to spin off approximately €10 billion of the bank's bad debts into a separate vehicle that would be merged with state loan manager AMCO (previously known as Società Per La Gestione Di Attività - S.G.A. SpA). CEO Marco Morelli told analysts during a call for the bank's third-quarter earnings in November he was expecting a decision from the EC "within weeks" regarding the plan.

UniCredit also made strides with its balance sheet cleanup, with NPLs totaling €28.76 billion at the end of the third quarter of 2019, against €44.54 billion at the end of the first quarter of 2018. The bank offloaded several portfolios since July, including a €1.1 billion book to SPF Investment Management LP and a €730 million Italian portfolio to a securitization vehicle managed by illimity Bank SpA. Both portfolios comprised primarily loans to small and medium-sized enterprises.

In October, UniCredit sold a €6.06 billion portfolio of mainly home mortgages to securitization vehicle Prisma. They were securitized under the Italian government's GACS scheme, guarantees the least risky portion of debt. GACS has been hailed by analysts as a useful tool in helping banks work through toxic debt efficiently.

Mirko Sanna, an Italian-based director in S&P Global Ratings' banks team, said Italian lenders had "surpassed expectations" with NPL reductions over the past year.

Benign credit conditions and a debt market that is "more developed than expected" have gone in banks' favor, he said.

In the Italian banking market as a whole, the stock of gross NPLs almost halved between the end of 2015 and the end of the second quarter of 2019, falling to €165 billion from €341 billion, according to S&P Global Ratings. Despite the progress, NPL ratios are still an area of concern.

"Most banks still have gross and net NPL ratios well above the 5.0% and 2.5% benchmarks endorsed by the European Commission," the rating agency said in a Nov. 12 note. Monte dei Paschi's NPL ratio of 16.5% at end-September remained the highest among Italy's five biggest lenders.

More action needed

Italian banks need to do more to clean up their balance sheets in the next year, before the economy turns again, warned Angela Gallo, a lecturer in finance at Cass Business School, City, University of London.

Italy’s economy fell into a technical recession in the final three months of 2018, when GDP contracted by 0.2%, following a 0.1% drop in the previous quarter. However, it returned to positive territory in the first quarter of 2019 with 0.2% growth.

The economy is widely predicted to be sluggish for the 2019 full year and 2020. In September, Italy’s new government revised growth predictions down to 0.1% and 0.4% for 2019 and 2020 respectively, down on previous estimates.

"The next recession is most probably coming. If that happens again, then NPLs will automatically increase," Gallo said. Italian banks have on their side a good level of demand from investors for both loan portfolios and securitized debt, she added.

Securitized debt may appeal more to investors than large portfolio sales, Gallo said. "It's easier to find investors for securitizations than it is for a large bank to buy up a big portfolio — unless, of course, the bank is doing such a transaction for strategic reasons," she said.

Securitization also has the benefit of tranching, meaning that investors can pick and choose the level of risk that suits them, she added.

While Italian banks are under pressure to push ahead with NPL sales, these deals should not happen "at all costs," Gallo said. If a bank is struggling to sell debt for a reasonable price, it may be better for the bank to hold on to it.

Research from distressed loan specialist Banca IFIS showed market transactions of bad debt in 2018 totaled €17 billion, compared to an original value of €66 billion. Consumer debt had the biggest write down, with an estimated average price of just 5% of original value.