As Mario Draghi seeks to form a new government, the banking system must cope with a deep recession combined with the return of political turmoil.
While the Covid-19 emergency rages, Italy is in the midst of new political turmoil.
Underpinning the crisis are the formidable challenges and opportunities linked to the huge investment available through the EU recovery fund, which could be as much as €209bn.
Italy will receive the investment as long as the European Commission is convinced it will be used to reform an economy that has lagged its eurozone peers over the past three decades.
Investment in improving public administration, including the justice and the tax system, as well as education and infrastructure is much needed.
The government of former prime minister Giuseppe Conte – who resigned on January 26 – typically used EU pandemic funds to help households and businesses cope with the economic fallout from Covid-19, but did not show any clear desire to implement vital structural reforms.
On February 3, former European Central Bank (ECB) president Mario Draghi agreed to try to form a government of national unity to steer Italy through the pandemic. As prime minister, Mr Draghi will be tasked with presenting a credible plan to the EU for the funds.
In light of the problems experienced by Italian banks in the aftermath of the subprime crisis and subsequent sovereign debt crisis, an obvious question to ask is how the banking system will be affected by the impact of a deep economic recession (the contraction in output last year was more than 9%) combined with the return of political turmoil.
Italy is the second-most indebted country in the world with a debt-to-gross domestic product ratio of more than 160%. Is the country heading for a new banking crisis?
Then and now
I do not think there will be another banking crisis, at least in the near future. My reasoning is as follows.
First, compared with end-2007, Italian banks are much better capitalised. Italian banks’ average Tier 1 capital ratio back then was lower than 7%. At the end of 2019, the average Tier 1 ratio exceeded 15% prior to the Covid-19 crisis.
A second consideration is the amount of risk-weighted assets (RWAs) in banks’ balance sheets. The RWA ratio in terms of total assets declined from about 65% in 2007 to 45% at the end of 2019.
This trend has been led by improved risk management and a robust reduction in credit supply that followed the sovereign debt crisis and the implementation of Basel III. (The reduction in credit supply also had the effect of worsening economic performance in 2013-2014.)
In light of the problems experienced by Italian banks in the aftermath of the subprime crisis and subsequent sovereign debt crisis, an obvious question to ask is how the banking system will be affected
This de-risking did not occur last year because of guarantees provided by the government once the EU’s Stability and Growth Pact was suspended in the eurozone, combined with the huge liquidity injection from the ECB.
The amount of credit provided by banks to the economy, particularly to companies, increased last year without affecting RWAs because of extended public guarantees, and helped limit further reductions in output.
Third, in the latest recession we have yet to observe an increase in non-performing loans (NPLs). NPLs rose rapidly in the aftermath of the sovereign debt crisis (and also, more slowly, after the subprime crisis): in 2015-2016, Italy accounted for about half of eurozone figures for this indicator of instability.
However, policies put in place by the government of then-prime minister Matteo Renzi set the wheels in motion for the gradual reduction of NPLs, which has continued, helped by the payment moratoria encouraged by the Conte government to combat the pandemic.
These three factors have allowed Italian banks to perform quite well despite the upheaval and turbulence witnessed last year.
Challenges and consolidation
New challenges are on the horizon, however. In April, measures to stop companies slashing jobs will end, leading to a rise in unemployment. It’s vital to keep in place credit-supporting measures until the economy is in recovery to avoid a resurgence in NPLs.
At the same time, it’s possible a prolonged period of ultra-low interest rates will force banks to restructure and merge to better exploit cost reductions and in the face of new competition from technology-led intermediaries and fast-growing fintechs.
A period of consolidation and the search for new areas of stability will, therefore, characterise the banking sector in Italy in the near future.
Giorgio Di Giorgio is professor of monetary theory and policy at Luiss University in Rome.
