This year, most banks we rate in Italy are likely to again report sound pre-provision income well in excess of credit losses, despite a slowdown of the domestic economy. Such strong operating performance creates buffers against unexpected events in S&P Global Ratings' opinion, although most Italian banks have announced generous distributions to shareholders.

Rated Italian banks are among financial institutions that have benefitted from rising interest rates since midyear 2022. Their profitability most likely peaked in 2023, when the return on equity averaged about 14%, the highest reported in two decades. This was thanks to a rare combination of higher net interest income of more than 50% of the 2021 level, a benign economic environment, and contained credit losses.

Economic conditions in Italy started deteriorating in the second half of last year and will likely remain relatively weak. In our base-case scenario, GDP will expand by just 0.6% in 2024 after 0.7% growth in 2023. Nevertheless, we consider Italian banks to be better able to withstand downturns than they were in the past decade. This is primarily because of more effective credit risk management and control, significantly stronger corporate borrowers, and banks' larger capital bases. Most of our ratings on Italian banks have stable outlooks. Two positive outlooks are on entities that have completed a restructuring and improved their business and financial profiles toward those of higher-rated peers.

Pre-Provision Income To Remain An Ample Cushion

Albeit edging down slightly compared to 2023, net interest income will remain, on average, 50%-55% higher than during the pandemic (see chart 1). In our view, for most banks, net interest income will likely peak in the first quarter of 2024 as the full effect on loans from the rising Euro Interbank Offered Rate (EURIBOR; a common benchmark for pricing floating-rate loans) is reached. The passthrough of higher interest rates to retail customer deposits will likely remain gradual, almost doubling to 30% of the rates increase by the end of the year but staying contained.

The overall contraction of loans and deposits will eventually reduce net interest income from the second half of the year. That said, most banks have already taken steps to stabilize their net interest income via hedging strategies and by replicating portfolios. Most expect the European Central Bank (ECB) to start cutting interest rates later this year, however.

Based on recent profit guidance, some banks appear more optimistic than us about the evolution of net interest income in 2024 and 2025. We believe the profitability gaps between banks will become wider as the ECB's third targeted longer-term financing operations (TLTRO III) expire. Banks with further funding needs will likely report a sharper contraction of income. We expect net interest income to decline somewhat in 2025 as a result of falling interest rates, low loan volumes, and more expensive funding sources.

We also expect operating expenses to increase by 2%-3% in 2024, as the initial effect of renewed labor contracts filters through profit and loss accounts. The average salary increase will be about 9% but spread over time. Moreover, banks are still benefiting from previous layoffs, early retirement plans, and synergies. Overall, we expect average pre-provision income for the banking sector to reduce only modestly, but with meaningful differences among banks.

Chart 1

Strong Asset Quality Could Dip

Although default rates remain low, and below our expectations so far this year, they are likely to rise in the coming quarters (see chart 2). The effect of high inflation, higher interest rates, and tightening financing conditions will inevitably lead to some asset quality deterioration in Italy and elsewhere, in our opinion.

Chart 2

We anticipate nonperforming exposures (NPEs) will gradually increase in 2024, although staying well below the peak reached in the previous downturn. We factor into our assessment our estimate of credit losses of 60 bps to 65 bps of total loans in 2023 and 70 bps-80 bps in 2024 (see chart 3). We also consider the potential benefits from government guarantees on over €200 billion of loans granted to small and midsize enterprises and larger corporations, primarily as part of support measures to tackle the consequences of the pandemic and the Russia-Ukraine conflict.

Chart 3

These guarantees provide a meaningful cushion for credit losses over the next two to three years, in our view, since they are for 80%-100% of the value of the loans covered. They also give the bank the option of triggering the guarantee as soon as a customer defaults. These guaranteed loans are amortizing, mainly over the next three years, and about 80% of them mature by 2025. According to recent data from the Bank of Italy, the default rates of loans guaranteed by the Italian government are higher than on loans not guaranteed (2.1% versus 1.1%), although still manageable.

In our forecast, we assume that Italy will not face a meaningful recession. In such a context, the corporate sector entered 2024 in a position of strength compared to the 2009-2011 double-dip recession. Companies, generally, have sound liquidity buffers, also sustained by the use of cheap loans provided during the pandemic, with most of the proceeds deposited at banks. According to our analysis, rated Italian corporations appear quite resilient and, on average, better prepared than in past to manage difficult economic conditions (see "Italian Corporate Outlook 2024: Resilience In Tough Times," published Nov. 21, 2023, on RatingsDirect).

Overall, we think the gradual economic recovery we project beyond 2024 will be key for Italian banks' asset quality next year. Higher interest rates have been weighing on households with floating-rate mortgage loans, contributing to a slight deterioration of asset quality in the second part of 2023, with household default rates climbing to 0.9% from 0.5%.

Related NPEs are likely to remain manageable, since more than 70% of the residential mortgage loans in Italy are at fixed rates, and on favorable conditions because most loans were taken or renegotiated when interest rates were low; and unemployment rates have declined. The housing sector in Italy is also holding up better than in most other markets, likely because it has not experienced a spike in prices in recent years. We also expect unemployment to remain relatively stable over the next few years. Furthermore, banks have acted quickly to address the increase of loan installments for potentially struggling customers.

Risk-Adjusted Capitalization Is Now A Rating Strength

Italian banks' capitalization has strengthened over the past few years, thanks to deleveraging, earnings retention, and capital-enhancing measures. Most rated banks will also benefit from increased capital generation in 2023-2025. Although many have announced generous dividend distributions, we anticipate that business growth will consume a limited amount of capital, and earnings should be sufficient to support continued capital accumulation.

For most banks in Italy, our risk-adjusted capital ratios are below those of their European peers, except for Greek banks (see chart 4). This primarily reflects banks' high exposures to the Italian government, although we don't regard these as risk free as assumed in regulatory capital; and still relatively high economic risks for Italian banks.

Chart 4

Funding And Liquidity: A Manageable Impact From The End Of TLTRO III

Although the banking sector's deposit portfolios had shrunk by about 5% as of Nov. 30, 2023, year on year, retail funding still exceeds outstanding loans, which showed a decrease during that period. Among other factors, the surplus deposits partly explain the lower-than-expected pass through of interest rate increases to retail depositors throughout 2023. We do not expect this trend to change materially in 2024.

At the same time, the repayment of banks' TLTRO III obligations have not caused particular strain on rated banks' funding and liquidity positions so far. As of Sept. 30, 2023, Italian banks had €152 billion of TLTRO outstanding compared to €450 billion as of June 30, 2022. Banks have repaid most of the TLTRO III using their large liquidity reserves deposited at the ECB. But they have also refinanced almost half of that through other retail and wholesale funding sources.

The picture among individual banks is highly mixed, however, as indicated by data from the Bank of Italy. At the banking system level, the amount of excess liquidity (€192 billion as of Sept. 30, 2023) was much higher than the outstanding amount of TLTRO. Yet, most of the large banks we rate made sizeable net issuances of bonds in 2023 and eventually refinanced through medium-term funding sources, leaving them with meaningful liquidity buffers. Banks' sound liquidity and funding ratios (see chart 5) will, however, eventually decline closer to the regulatory requirements. In contrast, a number of small banks (most not rated) need to raise funds to repay their maturing TLTRO exposures and might have to rely on new central banking funding in the coming months.

Chart 5

Compared to other countries, Italian banks' liquidity buffers rely more on securities, in particular Italian government bonds (see chart 6). Most banks hold a sufficient amount of securities maturing at the same time as the TLTRO III obligations expire, and will use the proceeds to repay them.

Chart 6

Consolidation Could Be On The Cards In 2024

The sharp rise of net interest income, paired with contained credit losses, have definitely boosted the profitability of all Italian banks, allowing generous distributions to shareholders. Although we expect interest rates to fall, particularly in 2025, they will likely remain higher than 2% and not fall back to the much lower levels seen in the past decade.

Still, maintaining sound net interest income will not solve the structural challenges some small and midsize banks face, in our view. We continue to see risks in the business models of small traditional banks, linked to digitalization trends, increasing commoditization of certain banking services, and the ongoing shift in customers' banking preferences.

Despite meaningful consolidation in the recent past, the structure of Italy's banking system remains quite different from that of most large European banking systems. The largest bank, Intesa Sanpaolo, has a market share of 20%-30% and maintains a strong competitive advantage, taking into account that UniCredit's size largely reflects its foreign operations.

The Italian Treasury's disposal of a 25% equity stake in Monte dei Paschi di Siena (MPS; the country's sixth largest bank) in October 2023 is likely the first step of its planned exit from the previously troubled institution. The Treasury still owns about 40% of the bank. The disposal of further stakes in MPS, although it is still unclear how or when this might occur, could spur further consolidation in the banking system.

Chart 7

Related Research

• Various Rating Actions On Italian Banks On Balance Sheets' Resilience To Economic Cycles, Oct. 25, 2023
• European Banks: Cyclical Earnings Boost Is No Panacea, Nov. 21, 2023
• Economic Outlook Eurozone Q1 2024: Headed For A Soft Landing, Nov. 27, 2023
• Italian Corporate Outlook 2024: Resilience In Tough Times, Nov. 21, 2023