Major Factors

Rationale

S&P Global Ratings classifies the banking sector of the Republic of Italy (unsolicited rating, BBB/Negative/A-2) in BICRA group '5', along with India, Peru, and Malta. Other peer countries include Brazil and Portugal (group '6'), and Ireland, Poland, and Spain (group '4').

Chart 1

Our bank criteria use our BICRA economic risk and industry risk scores to determine a bank's anchor, the starting point in assigning an issuer credit rating. The anchor for banks operating only in Italy is 'bbb-'.

Italian banks continue to face higher economic risk than most of their peers, in our view. While most banks have largely absorbed the effect of past recessions and tightened their underwriting standards, some still have meaningful legacy NPEs; an additional burden in a deteriorating economic environment. Moreover, the substantial amount of time needed for creditors in Italy to recover collateral and settle lawsuits--due to the less effective insolvency and foreclosure procedures and judicial system--remain a weakness compared with most advanced economies. In such a context, the sharp contraction in economic activity in 2020 amid the coronavirus outbreak is likely to affect a large number of small and midsize enterprises (SMEs) to which the Italian banks are particularly exposed, in our opinion. We anticipate credit losses to double in 2020 and 2021, up from about 70 basis points (bps) reported in 2019, before normalizing again in 2022, when we expect Italy's GDP to be have returned to 2019 levels.

Industry risks for Italian banks are also higher than for banks in peer countries, in our opinion. Italian banks' access to affordable unsecured wholesale funding remains constrained from by uncertainties about the sovereign's creditworthiness and economic prospects. Still, near- to medium-term refinancing risk has abated, given the abundant liquidity provided by the European Central Bank (ECB), the large deposit funding base, and the banking sector's very low external position, with only 5% of reliance on wholesale funding. Failing business volume and margins combined with structural problems, such as high cost bases and fragmentation, will constrain Italian banks' capacity to absorb the likely rise in credit losses over the next couple of years, in our opinion.

Supportive factors for the Italian banking system are Italy's traditional focus on retail and commercial lending, and our view that its regulatory standards are aligned with international best practices, mainly thanks to the ECB's direct supervision of more than 80% of the banking sector.

BICRA Overview

Economic And Industry Risk Trends

Our economic risk trend is now negative, reflecting the potential long-term implications that the ongoing recession might have on the Italian economy, household wealth, and various corporate sectors, particularly if the rebound in 2021 is not as robust as we are currently anticipating. We expect Italy's GDP to contract by 10% in 2020, before to growing by 6.4% in 2021, and 3.2% in 2022. The government's flexibility to further adjust its policy to sustain economic growth remains also constrained compared with other countries by its high levels of debt, likely to exceed 140% of GDP in 2021.

On the other hand, our industry risk trend is stable. The €750 billion Pandemic Emergency Purchase Program launched by the ECB paired the abundant liquidity provided to the banks to significantly ease near-term refinancing risk for both the Italian Sovereign and financial institutions. Indeed, banks' access to affordable unsecured capital market sources is likely to remain constrained due to current market sentiment. Given the relatively contained need to tap the capital market, the effect on Italian bank's cost of financing or ability to comply with regulatory requirement on MREL should be, on the most part, manageable.

Economic Risk  |  6

After Germany, Italy is the most open economy in the group of the seven largest world economies (G7), with exports totaling 32% of Italian GDP. Italy remains the seventh-largest exporter in the world and is a diversified and wealthy economy, with no single export category exceeding 4.5% of the total. The economy's openness, and its sizable current account surplus, make it sensitive to global developments including this year's synchronized global recession. Italy's limited policy flexibility and some structural constraints undermine its economic resilience, in our view.

Economic resilience:

Economic structure and stability.  Poor competitiveness remains a major hurdle for the Italian economy, which has suffered from a misalignment between stagnating productivity and rising wages in the last decade. Structural constraints, including low labor participation rates and tightly regulated services markets, alongside modest foreign investment inflows, paired to unsupportive demographic factors might continue to undermine the country's long-term growth prospects compared with those of its peers.

Macroeconomic policy flexibility.   Given its high public sector debt burden, the government has little scope, in our view, to use an anticyclical fiscal policy to support economic growth, particularly in a downturn. We estimate Italy's government debt to GDP will rise over the coming years to 140% of GDP in 2022.

That said, we consider that the ECB's highly accommodative monetary policy has eased the pressure on funding costs for the Italian banking system and borrowing costs for domestic corporations and households.

Political risk.  The global pandemic has thrown the Italian economy--the world's eighth largest--into a severe---albeit temporary--recession. The Conte government's response so far has been to launch extraordinary fiscal stimulus measures of around 2.8%/GDP (reflecting additional policies included in the Supplementary DEF Budget on April 21) on top of already existing automatic stabilizers. What is notable is that the government's efforts to support the real economy in the face of an unprecedented standstill of economic activity have notably boosted the PD/M5S coalition's approval rating, and in particular that of Prime Minister Giuseppe Conte. Given the uncertainties around the timing and trajectory of Italy's economic recovery, popular support for the current government is likely to be fluid and contingent on any European measures (such as the launch of a joint financed Recovery Fund) to share the cost of Europe's post-pandemic recovery. At present, we do not expect early elections any time during 2020, and continue to foresee the government benefiting from its mandate to reopen the economy.

Table 1

Economic imbalances: NPEs and credit losses to start rising again in 2020

We expect credit losses of 140bps-150bps in 2020, and 120bps-130bps in 2021, therefore at least doubling compared with the 68bps-70bps reported in 2019. This will stem from a rapid increase of NPEs we see occurring by the end of this year, primarily from SMEs. We anticipate those losses to remain overall lower than what the sector experienced at the peak of double dip recession occurred between 2009 and 2015.

Correction phase.  After largely absorbing the impact of the previous recession on their balance sheet, the Italian banking sector is likely to enter a new correction phase. Italian banks are more vulnerable to deteriorating economic conditions compared with other systems in Europe because of the high exposure to the SME sector. The expected harsh recession in 2020 is likely to harm small businesses in particular, and their default rates are likely to rise sharply in the coming months. Additionally, we note some Italian financial institutions entered into this challenging period with more meaningful legacy issues than most of their domestic and international peers. As of December 2019, for example, we note that the stock of NPEs net of provisions still represented 40% of Italian banks' core Tier 1 capital on average, compared with the 5%-20% we see in higher rated banking sectors.

Although Italy has not experienced the level of real estate bubbles of other countries in past years, we observe that prices have fallen by more than 20%-25% in most areas of the country. We anticipate further contraction in 2020 and 2021, reflecting the subdued economic conditions, despite affordability metrics appearing more supportive of housing demand than in most peer countries.

Some mitigating factors could eventually reduce the amount of losses in the expected downturn. More specifically, we believe domestic companies are now in a stronger position than they have been in the past, and thus more able to withstand weaker growth and financial stress, after having reduced their debt and lengthened maturities, while largely benefitting from very low financing costs. Most Italian banks have tightened their underwriting standards in recent years, improving their loan and client diversification, as well as reducing exposures to riskier customers. Furthermore, Italian government and European authorities have been so far more proactive in introducing measures to support affected enterprises and individuals.

Current account and external debt position.   We consider the Italian banking sector's external vulnerability to be limited. This is because the public sector accounts for most of Italy's net external debt, while domestic households and the corporate sector have strong asset positions. Net external debt in Italy accounted for around 40% of GDP in 2018, lower than in other European countries like Spain, at 70%; Portugal, at 60%; and France, at 52%.

The Italian private sector's high propensity to save means that Italy is set to become a net external creditor by 2021. Italy's international investment position remains positive, and we expect it to improve further. We expect Italy will continue to operate current account surpluses in the range of 2%-3% of GDP over 2020-2022. We see this as confirmation that the economy continues to be competitive internationally.

Table 2

Credit risk in the economy: Exposure to a slow foreclosure and recovery process

We consider that Italian banks face high credit risk because of the length of time required to settle a lawsuit in Italy, and the banks' large exposures to risky SMEs, which are particularly vulnerable in downturns. As a result of these factors, the banking sector has a high level of NPEs even in good times, and was subject to the rapid deterioration of its asset quality during downturns, and requires a longer time than other European banking systems to work out the stock of NPEs accumulated afterward, in our view. Although, we believe the low leverage of the household sector partly tempers this risk.

Private-sector debt capacity and leverage.   With an estimated GDP per capita of $33,100 as of December 2019, we view Italy as a relatively wealthy country. After a one-off drastic decline in 2020, we expect it to reverse to similar levels from 2021. Its leverage, defined as private sector domestic credit to GDP, is the lowest among Italy's major European and U.S. peers, at around 100%-110% of GDP. We anticipate that corporate debt levels could rapidly increase in 2020, given the government actions to widely provide banks with guarantees to credit lines granted to enterprises and further liquidity lines banks are providing to viable clients to withstand near-term difficulties. These measures are, however, temporary.

Household indebtedness, instead, is likely to remain low, at approximately 39%-41% over the next couple of years, about half the eurozone average. Households' financial wealth is about twice GDP, representing a significant support to their creditworthiness in case of difficulties, in our view.

Country-specific characteristics.  We consider Italian banks' loan books to be riskier than other European banks because of their larger exposures to corporates and SMEs (about 50% of loans) and lower share of residential mortgages (23% of loans), while the rest is made up mainly of financial corporations, consumer finance, and other household loans. Moreover, in our view, Italy's corporate credit risk across the whole credit cycle is higher than that of other major Western European countries due to the predominance of SMEs. Those companies have generally been riskier than large companies for a variety of reasons, of which the most common are their smaller size, greater focus on internal demand, and exposure to competition from emerging markets. That said, the corporate sector has shown significant progress in the past couple of years, namely through increasing capitalization, lower leverage, and better efficiency. These factors have clearly mitigated the risks related to the higher than peers' structural exposures for banks.

Table 3

Base-case credit losses

Based on our current economic forecast, we are assuming credit losses to double in 2020 versus 2019, to 140bps-150bps, and remain high in 2021, at 120bps-130bps, before then falling to around 80bps in 2022. Even assuming the peak level losses at the time of the last decade double dip recession, the credit losses would remain below 200 basis points, because of the lower exposures to small medium enterprises.

In our forecast, we are considering that the guarantee of the sovereign will at least cushion additional losses that we might derive from extra stock of loans. Still, it is possible and likely that the guarantee will also reduce losses on existing lines. The guarantees are temporary. Accounting wise, real figures might be different in terms of recognition given the temporary relaxation of some of the requirements in 2020, but we are comfortable that three years cumulative losses of 350bps-380bps are relative prudent assumptions. IFRS 9 will likely lead to more prudent recognition and provisioning, while the calendar provision should erase any capital incentives to delay provisioning. This would correspond to around €50 billion-€55 billion of credit losses in three years on private sector loans, of which around €10 billion-€15 billion relate to existing NPEs, and the remainder on the new net NPE addition. Still, credit losses might increase further if economic contraction is sharper than we expect or recovery is delayed.

Table 4

Industry Risk  |  5

We assess industry risk for the Italian banking system based on our view of three factors: institutional framework, competitive dynamics, and systemwide funding.

Institutional framework: Regulation and supervision now aligned to international standards

The ECB has full responsibility for supervision, under the Single Supervisory Mechanism, of the 11 largest Italian banks, representing around 80% of the banking sector's total assets.

Banking regulation and supervision.  We believe that regulatory standards in Italy have now aligned with international best practices under a European common regulatory framework. This will also increase transparency and competition and further reinforce principles of sound and prudent bank management. In particular, compared with the Bank of Italy, the ECB has stronger early intervention power, including the ability to replace managers without needing any special administration procedures. Furthermore, the full implementation of the EU Bank Recovery and Resolution Directive introduced new resolution tools, such as the selective transfer of asset and liabilities or establishment of bridge banks.

In addition, the ECB has taken a more proactive and stringent stance and regulation on NPE management and provisions. We also view positively the ECB's efforts to strengthen frameworks for the management and reporting of NPEs, which were one of the market's main concerns about Italian banks. In particular, measures to help European banks work out existing NPEs and prevent the future build-up of new ones include the minimum levels of provisioning, in terms of own capital deductions, for exposures that banks keep on their balance sheets for too long, introduced in 2018. (For more detail, see "Several Eurozone Peripheral Banks Are Racing To Resolve Problem Loans," Feb. 13, 2019). Those so-called calendar provisions on newly generated nonperforming loans were also incorporated into the ECB legislation since April 2019.

Regulatory track record.   In our view, Italy's past regulatory success in preventing individual banks' crises has been modest. Several institutions needed to be bailed out by the government or required the intervention of the Italian Deposit Guarantee Scheme due to financial distress. We believe that for most of those banks, inadequate risk management and internal process and weak governance have exacerbated the impact of the recession on their asset quality.

We see evidence that, in some notable cases--namely Monte dei Paschi, Veneto Banca, Vicenza, Banca Carige, and Popolare di Bari--the Bank of Italy has not taken a proactive stance to prevent some of these problems from occurring again, nor has it acted decisively and effectively to avoid further financial deterioration when those weaknesses became apparent.

To prevent the impact of major failures of weak banking institutions to the financial sector, the Italian government decided to step in and support the banking sector.

Until now, the Italian government has injected around €6 billion for Monte Paschi (including €1.5 billion of compensation for retail subordinated bondholders) and provided Intesa Sanpaolo SpA with €5 billion, to take some of the assets of Vicenza and Veneto Banca. The government has also provided over €20 billion of guarantees for Monte Paschi, Vicenza, and Veneto Banca, which represented contingent liabilities for the government. Banca Carige also benefited of such guarantees.

On Dec. 15, 2019, the Italian government also announced its intention to inject up to €900 million into government-related entity MedioCredito Centrale, with the likely objective of bailing out troubled Southern Italy-based bank Popolare di Bari.

As a result of the bail-out of Monte Paschi and the liquidation of Veneto Banca and Vicenza, shareholders and institutional holders of subordinated liabilities were subject to burden-sharing. Government support, though, was sufficient to protect senior bondholders and depositors, preserve financial stability, and mitigate the financial impact on the remaining banks in Italy. Italian banks as a whole have also contributed around €14 billion-€15 billion to provide support or cover losses regarding troubled domestic institutions since 2015. We believe this could happen again in the near future, if other small-to-midsize institutions were to fall into financial trouble and need to complete sizable capital strengthening actions to preserve solvency.

Governance and transparency.   We expect corporate governance to improve. The level of disclosure, particularly for risks, has improved over the past decade, and is now on a par with that of Italy's European peers. Since 2005, Italian banks have published financial statements according to International Financial Reporting Standards, a practice that has been adopted across the EU. The largest banks, mostly listed on Italy's stock exchange, release both year-end and quarterly accounts.

Competitive dynamics:

While banks benefit from their traditional banking model, an absence of market distortion, and limited competition from foreign institutions, we continue to see some overcapacity in the banking sector due to fragmentation. This weighs on Italian banks' efficiency and earnings generation, as do persistently low interest rates.

We anticipate the economic crisis could further impair the Italian financial system's modest earning capacity and amplify risks on business model sustainability for a number of banks, especially the smaller and undiversified ones. In our opinion, the relatively high cost base compared with the amount of revenue banks can generate, constrains their ability to cushion rising business and credit losses. As of December 2019, Italian banks' average cost to income ratio still exceeded 65%, although this is in line with the average in Europe.

Risk appetite.   Italian banks are typically focused on plain vanilla retail and commercial business models. Investment banking and merchant banking make a much smaller contribution than in the U.K. or French banking systems, for example. Moreover, Italian banks have generally limited their recourse to untested and innovative risky products. They have only infrequently used securitization to shift risks off the balance sheet. As such, we believe most of the NPEs accumulation reported in previous years was mainly driven by the effect of the double dip recession and, in some notable cases, paired with poor management and aggressive strategy.

Industry stability.  The Italian banking sector remains dominated by the traditional banks that continue to benefit from long-standing relationships with their customers. The sector experienced significant

changes and restructuring to deal with the consequences of the double-dip recession occurred between 2009 and 2014. As a result, we observed increasing concentration, with 12 banking groups now controlling about 80% of assets. Still, this was not sufficient to solve most of the issues the sector faces.

Most Italian banks are consequently unable to reach satisfactory return, in our opinion. This stems from high margin pressure due to some overcapacity in the system and persistently low interest rates. Despite cost-cutting measures, banks have been just able to cushion the loss of revenue. The COVID-19 crisis will likely amplify the pressure on revenue, while rising credit losses are likely to absorb a larger proportion of the several weaker banks' operating income than the stronger domestic banks and most peers in Europe, over the next three years. In this context, performance among banks varies significantly.

We therefore expect most Italian banks to increasingly focus on cost-cutting, as their recent business plans show. Over time, we believe the development of digital banking and introduction of open banking in Italy could further pressure the profitability of those weaker institutions that are unable to cope with the investment required to enable these developments. Given the conservatism of the Italian population, the effect of this might take more time to become apparent than for other countries.

The above factors could result in further consolidation in the system.

Market distortions.  After the bail-out of Monte Paschi (in which the government now owns a 68% stake), the government's presence in the banking sector has increased to around 8% of total assets. We view this ownership as purely temporary and precautionary, and believe that banks receiving support will continue to operate on commercial terms, as required by European State aid rules.

Table 5

Systemwide funding: Structurally high retail funding base and ECB support stability

We believe the Italian banking sector remains exposed to a period of constrained or more expensive access to wholesale unsecured funding sources. COVID-19 will likely add further uncertainties.

Unless protracted for a very long period of time, however, those constraints are unlikely to have meaningful repercussions on the Italian banks' funding structure and costs. As of December 2019, the Italian banks reported the historically low average cost of funding. This primarily stems from deposits largely covering most of the banks' lending, while the sector's reliance on wholesale funding is low, at less than 5% of total.

The ECB's accommodating measures continue to help Italian Banks to contain their cost of funding, as well. As such, we expect Italian banks to take advantage of the upcoming new series of targeted longer-term financing operations, which started in September 2019, for another three years. Italian banks are the largest borrowers of ECB facilities, amounting to around €240 billion as of September 2019.

In addition, despite its relatively lower creditworthiness compared with most peers' countries, the Italian Sovereign has demonstrated a good track record in providing timely guarantees to senior notes issued by troubled institutions preventing them from facing liquidity issues.

Core customer deposits.   Italian banks' funding position benefits significantly from their strong presence in retail and commercial markets. One of the key strengths underlying their credit profiles is that they primarily fund themselves through retail financing. As of March 2020, domestic core customer deposits (including bonds placed with retail clients) financed around 90% of systemwide customer loans. This ratio is higher than peers', and in our view, reflects the pivotal role that Italian banks play in intermediating domestic financial flows between households and the corporate segments. Consequently, Italian banks' recourse to wholesale domestic funding has always been relatively contained. The ratio has improved since 2011, when sovereign debt tensions in Southern Europe began, highlighting Italian banks' still-strong domestic franchise.

External funding.   Net external debt adds limited risk to the Italian banking sector, in our view. Net of ECB funding, debt represented less than 5% of systemwide loans on Dec. 31, 2019, down from 13% at year-end 2010, below that of most developed banking sectors globally. The decrease was primarily because banks have had reduced access to external wholesale funding sources, both short- and long-term, since June 2011. On a gross basis, most of the reduction in external funding is associated with the sharp jump in funding from the ECB. Foreign banks and investors have also reduced cross-border lending, as still-high TARGET2 imbalances demonstrate. These imbalances mirror Italian banks' persistently high net borrowings from the ECB, constrained access to funding markets, and elevated, if decreasing, funding costs.

Domestic debt-capital markets.   We consider the Italian domestic capital market to be smaller than European peers', partly because the domestic corporate sector makes limited use of debt securities as a source of financing. At the same time, Italian banks have a large and liquid domestic market for securities with maturities longer than one year. The Italian government has higher annual public borrowing needs than its peers. It has effectively competed against banks to secure funding from investors, particularly since 2012, when taxation on bonds issued by private entities was raised above that on government bonds.

Government role.   While Higher-rated sovereigns in Europe appear in a stronger position to provide liquidity support to their banks, we observe that the Italian government's recent track record has been relatively strong. We expect that the ECB will maintain its liquidity support for domestic banks, as in other eurozone banking systems. Italian banks have also used ECB funds to increase their holdings of domestic government bonds. Their combined exposure to these securities stood at €333 billion, or about twice their total common equity Tier 1 capital, as of Sept. 30, 2019. This reinforces the link between banks' and sovereign creditworthiness, in our opinion.

Table 6

Peer BICRA Scores

Our BICRA assessment on Italy (group 5) is comparatively worse than for most of the other large Western European economies, such as Germany or France, and other European peers such Spain and Ireland that came out from substantial banking crisis. Our current assessment of Italy compares with Poland and Slovenia in Europe, and countries like India, among the larger global economies.

Compared with Ireland and Spain, economic conditions in Italy have been less favorable in recent years, supporting a faster correction of past imbalances, while for the future we expect both countries to come out from the COVID-19 recession a touch faster than Italy. We also see that the judicial system is slower in Italy, making the timely recovery of NPEs more difficult for banks.

Spanish banks benefit from higher efficiency ratios and lower tax burdens that structurally support their profitability prospect compared with Italian banks.

Italy's BICRA compares well with that of Portugal, mainly reflecting our view that Italian banks face lower industry risks. Compared with Portugal, Italy has significantly lower banking sector external debt.

Table 7

Government Support

In our recent "Continued Bank Bail-Outs Stretch The Credibility Of Europe’s Resolution Framework", published on Feb. 26, 2020, we elaborate on how ineffective the resolution regime has been so far and how we could reconsider the Government support in the ratings if we were to conclude that the bail-out of banks is the new normal and not the exception to the rule. At present we continue to consider the government support as unpredictable in Italy, and consequently we do assign notches of extraordinary support to systemic important banks.

Table 8

Related Criteria And Research

Related Criteria

• Criteria | Financial Institutions | Banks: Banking Industry Country Risk Assessment Methodology And Assumptions, Nov. 9, 2011

Related Research

• Outlooks On Most Italian Banks Now Negative On Deepening COVID-19 Downside Risks, April 29, 2020
• Italy 'BBB/A-2' Ratings Affirmed; Outlook Negative, April 24, 2020
• Europe Braces For A Deeper Recession In 2020, April 20, 2020
• European Banks' First-Quarter Results: Many COVID-19 Questions, Few Conclusive Answers, April 1, 2020
• The Coronavirus Pandemic Is Set To Test The Resiliency Of Italy's Banks, March 13, 2020
• COVID-19 Countermeasures May Contain Damage To Europe's Financial Institutions For Now, March 13, 2020
• Italian Banks Not Adapting To The Digital World Quickly Will Be Left Behind, Feb. 17, 2020