Italian banks have entered 2023 facing the familiar prospect of difficult macroeconomic conditions, but they do so from a relatively unusual position of financial strength. If that suggests that the year will be a balancing act, it is one that S&P Global Ratings expects Italy's financial system and its banks can manage.

A few factors underpin that confidence. One is our assumption that the spread between Italian government yields and those of other eurozone countries will not materially increase for a protracted period of time, which is also one the factors supporting our stable sovereign outlook on Italy. Two, we believe that Italy's economic contraction in 2023 will remain mild to moderate and followed by a recovery in 2024. And three, we are confident that Italian banks, on average, entered the year with historically stronger balance sheets, solid capital bases, well-balanced funding profiles, and record-low nonperforming exposures of about 1.7% (net of provisions).

Managing The Downturn

Our base case scenario assumes that Italy's GDP will contract by 0.1% in 2023, before rebounding 1.4% in 2024. That should prove relatively manageable for most institutions, not least because the imbalances that traditionally weakened Italy's financial system have been rectified. We also note that the corporate and household sectors are stronger than during previous economic downturns, partly because they rebounded faster than expected from the effects of the pandemic. Given those strengths, we anticipate net inflows of nonperforming exposures (NPEs) will prove manageable, even as they rise from historically low levels (see chart 1).

Chart 1

We also expect the positive effect of higher interest rates on banks' net interest income (NII) will more than offset the potential impact of the mild recession on credit loss provisions -- which we forecast will be between 90 basis points (bps) and 100 bps.

Relatively (Not Worryingly) Exposed To Asset Quality Deterioration

Italian banks may be in an historically strong position, compared with their own checkered past, but they still remain more exposed to asset quality deterioration than their European peers. More than half of Italian domestic customer loans are to corporates and riskier small and midsize medium enterprises (SME), a higher proportion than in most other European countries (see chart 2), even if the difference is less than in the past.

These loans to SMEs matter because smaller companies are typically more prone to default than other credit portfolios. Indeed, we expect most new Italian bank NPEs to come from already weakened SMEs. In our base case scenario of a mild recession in 2023, we expect default rates on Italian banks' credit books to gradually increase in the coming quarters.

Chart 2

Increasing NPEs are evidently unwelcome, but they need not be cause for undue alarm. Indeed, credit quality deterioration at Italian banks should remain manageable throughout 2023. That view is based on a handful of factors including:

• Italian banks' deleveraging and costly cleanup of their weakest exposures in recent years, which has left loan books significantly less risky than ahead of previous recessions.
• Parallel efforts by Italian corporations and SMEs to improve their finances and reduce leverage.
• A recent history of limited loan origination, which has reduced the likelihood that imbalances have built-up on banks' loan books.
• Government support over the past two years, which has created a pool of about €300 billion of loans to SMEs and corporations that is guaranteed by the Italian sovereign. These guarantees helped SMEs survive the pandemic related recession and provide banks with meaningful protection against deteriorating credit quality.

None of that guarantees that default rates won't rise significantly. We believe, however, that would occur only if weaker economic conditions and related uncertainties continued beyond 2023, which is not our central scenario.

We further believe that there is less potential for pressure on Italian banks' credit quality due to the limited tail risk from already defaulted loans, many of which have been sold since 2016 as part of a massive reduction in NPEs (see chart 3) held by banks. The low level of legacy defaulted loans at Italian banks means that future credit losses will come predominantly from new flows of NPEs.

Chart 3

Italian banks' NPE reduction and provisioning efforts reduced their average value, net of specific provisions, to about 1.7% of total customer loans as of September 2022, which was close to the European average (see chart 4).

Chart 4

Contrary to our earlier expectations, new flows of NPEs remained at historically low levels in 2022. This was despite the lifting, at the end of 2021, of the government's loan moratorium, which was introduced at the beginning of the pandemic to support customers directly affected by COVID-19 related restrictions. Stage 2 loans are now about 14% of Italian banks' total customer loans, above both the pre-pandemic level of 10% and the European Banking Association (EBA) average, also 10%.

The Outlook For Credit Losses

We expect credit losses will peak in 2023 at about 100-120 bps, close to their level in 2020, before falling to about 80-90 bps in 2024 (see chart 5). Our forecast does not distinguish between credit losses recorded in a bank's profit and loss statement and losses related to the effect of calendar provisioning on regulatory capital ratios. We partially incorporate the effects of government guarantees, such as the Fondo Centrale di Garanzia for SMEs and the Italian export SACE Guarantee for larger corporations. That's because we don't currently have enough visibility about how banks can use them and how the recovery process will work. We acknowledge that these guarantees could provide additional and meaningful cushions against future credit losses, particularly given that more than 25% of loans to corporations are now guaranteed by the sovereign--at an average guaranteed amount in excess of 80% of the nominal value. Furthermore, while the option to extend new guarantees on loans expired at the end of 2022, existing guarantees will remain valid for six years to 15 years, depending on the type of guarantee used.

Chart 5

A More Dynamic Approach To NPE Management

We expect Italian banks will choose to proactively manage any increase in NPEs in 2023, continuing a trend that emerged in recent years to replace an earlier passive approach. We note, in particular, that the introduction of calendar provisioning (a regulatory requirement dictating that provisions should cover nonperforming exposures within a predetermined timeframe) means that bank capital no longer benefits from keeping older NPEs on the balance sheet. This has prompted banks to preemptively recognize and manage customers facing difficulties. At the same time, banks also have greater flexibility to rid themselves of NPE in Italy's advanced and well established secondary debt market.

A more proactive management approach could enable banks to maintain NPE ratios close to their current levels, despite our forecast increase. For that to happen banks will, however, have to frontload credit losses, which can then be sold. It is also not yet clear whether GACS (the Italian government guarantees on senior tranches of NPE securitization) will be reinstated. GACS has played an important role in facilitating a number of large NPE deals in Italy.

Net Interest Income Growth Provides Support

We expect net interest income (NII) will increase 15%-20% in 2023, adding to a 5%-10% expansion in 2022. That gain should prove sufficient to offset our forecast increase in credit losses.

The NII increase is largely due to the peculiarities of Italian bank's deposits and lending. As of November 2022, 90% of Italian banks' customer deposits were granular sight deposits spread over millions of clients. These deposits (and particularly household savings) are typically much less sensitive to interest rates movements than other sources of funding, meaning banks have been able to pass on little of the cumulative 250 bps of interest rate hikes completed by the ECB in 2022. Italian bank's lending, meanwhile, is dominated by floating rate loans, particularly to corporate and SMEs, that have closely tracked the rate increase. The upshot has been a fast growing spread between lending and deposit rates (see chart 6 and 7).

Chart 6

Chart 7

Our forecast increase in NII over 2023 is lower than the average guidance provided by Italian banks, many of which are predicting a greater than 20% gain. That is partly due to our assumption that customer deposit rates will eventually reprice faster than many banks indicated, due to increasing competition, although we are yet to see any evidence of that happening. Our forecast also takes into account costlier wholesale financing, and expectations of a further impact on NII from the loss of favorable targeted longer-term refinancing operations (TLTRO III). That financing had a net positive effect on NII of 7%-10% prior recent changes to its terms.

We also expect inflation's effects on bank operating expenses will become more apparent in 2023, compared to 2022 (see chart 8). Banks should continue to benefit from recent (and ongoing) cuts to staffing and branch numbers, though future employee cost growth will depend on the outcome of collective agreement talks, which are due to begin in the coming months.

Chart 8

Under our base case scenario of a mild recession, Italian banks' profitability in 2023 should remain in line with that of 2022. Last year's result benefited from rates hike in the final two quarters of 2022, though results at larger banks were also affected by one-off provisions against potential losses relating to Russian and Ukrainian exposures. We expect average return on equity, net of extraordinary items, to hover around 6% in 2023, though individual bank's performances will continue to vary.

Our economists have also modeled a more severe economic downturn scenario, including a 1.1% decline in GDP over 2023 and a more gradual recovery. In this scenario, profitability in 2023 and 2024 could decline meaningfully compared with 2022. Nonetheless, we expect most banks would avoid losses because the increase in NII (from portfolio repricing at higher rates) would partially offset some of the increased credit provisions and reduction in other non-interest income. Some weaker institutions, and particularly those that haven't finalized loan book restructuring, could experience financial stress under a more severe downturn.

An End To Cheap And Stable Funding

Italian banks entered 2023 with solid liquidity and funding metrics. That was primarily due to their strong retail funding footprints, but also reflected years of accommodative ECB monetary policy, and particularly Italian bank's significant take up of TLTRO III (€430 billion as of September 2022).

The ECB's decision, taken in 2022, to normalize monetary policy means Italian banks will now have to reimburse TLTRO III funds, about half of which will mature by June 2023, with the rest falling due over 2024. We think banks are unlikely to reimburse a meaningful amount of debt in advance due to current market uncertainties. And despite the current lack of financial benefits due to the ECB's recent changes to the remuneration systems, we believe the TLTRO III might continue to prove a source of non-volatile funding for banks.

We also note that, as of November 2022, Italian banks had deposited much of their excess liquidity(around €324 billion) at the Bank of Italy. That likely represents just over 75% of Italian bank's ECB borrowing.

Our calculations suggest that a hypothetical full reimbursement of the TLTRO III, without further mitigating actions by banks, would leave some banks' with tighter net stable funding position (see chart 9). It was thus not surprising to note that a recent Bank of Italy survey suggested Italian banks plan to replace around half of the TLTRO III debt with alternative funding sources in order to maintain significant buffers to regulatory minimum net stable funding ratios. That new funding is likely to come from a combination of market-based and customer-related sources and include a mix of debt repayment and refinancing.

Despite likely difficult market conditions in 2023, we anticipate that most Italian banks will be able to reimburse the TLTRO while preserving balanced funding and enhanced liquidity. At the same time, some weaker institutions might see a significant erosion of their margins as they increase reliance on costlier funding sources.

Chart 9

We expect banks will primarily turn to the collateralized funding market to raise new funds, while also increasing issuance of covered bonds. The result will likely be an increase in bonds placed with customers, at least compared with recent years.

The repayment of TLTRO III will also free significant amounts of high quality assets (predominantly Italian government securities) that were pledged by banks in order to qualify for TLTRO III funding. The release of those assets should benefit banks' liquidity positions.

Chart 10

Rising Unsecured Bond Prices

Italian banks may find that tougher market conditions limit their ability to issue unsecured bonds at affordable prices. This matters because the banks will need to use unsecured bonds to fill the gap in their regulatory minimum requirement for own funds and eligible liabilities (MREL). The aggregate shortfall of Italian bank's eligible liabilities within their MREL exceeded €5 billion, as of September 2022 (see chart 11), with most of that accounted for by the subordinated requirement.

Time is not on the banks' side. Most will have to fill gaps in their MREL before January 2024 (see chart 12). Nonetheless the benefits of higher rates on the banks' NII should offset much of the increased cost of new bond issuance.

Chart 11

Chart 12

Evenly Balanced Ratings

We consider that the ratings on Italian banks currently balance their resilience with the risks from structural and cyclical headwinds we expect in 2023.

That could change, of course. The key determinant of the banks' creditworthiness is likely to be the magnitude of asset quality deterioration, which could worsen more than we expect, particularly if weak economic conditions last beyond 2023. But we see reason for optimism in the bank's stand-alone strength, and particularly their freedom from the burden of legacy NPEs.

We also note that bank creditworthiness is strongly linked with the sovereign due to bank's significant holdings of Italian government securities and the strong correlation between the state's ability to refinance its debt and banks' access to affordable sources of non-core deposit funding.

Related Research

• Global Banks: Our Credit Loss Forecasts, December 13, 2022
• Global Bank Country-By-Country 2023 Outlook: Greater Divergence Ahead, November 17, 2022
• European Banks’ Residential Mortgage Losses Should Remain Contained Even As Economies Slow, November 15, 2022
• European Banks: The Agile Will Come Out Stronger, Nov. 9, 2022
• The New Normal For Eurozone Banks: Strong Funding Franchises Are Back In Vogue, July, 7, 2022

Writer: Paul Whitfield.