Italy has been slow to bounce back from the financial crises that have rocked both the globe and the eurozone, but its banks are driving recovery by taking tough measures to slim down and sharpen their focus.

Jean pierre mustier

The Italian banking sector is in the midst of a major transformation. In several respects, the challenges resemble those facing the rest of the European banking sector following the financial crisis and Great Recession, although national particularities tend to dominate the attention in the market as well as the broader media.

National differences are certainly worth understanding. When the financial crisis erupted in 2007, two major vulnerabilities were exposed in the European banking industry.

Boom and bust

In some countries, most notably Spain and Ireland, an excessive exposure to the construction sector was revealed, and a relatively standard real estate boom-bust picture evolved into a financial crisis. In other countries, for example Germany, excessive exposure to new – and poorly understood – financial derivative products was revealed, causing losses many banks could not absorb.

As a result, between 2008 and 2011, many European governments spent in the order of 12% to 17% of gross domestic product (GDP) recapitalising their banks. In most cases, between one-third and one-half of these outlays have since been recovered.

The two notable exceptions to this financial crisis, followed by bail-outs, were France and Italy, where virtually no taxpayer money was required to repair the banks’ balance sheets. However, as the financial crisis rolled straight into the eurozone sovereign debt crisis in 2011, most of Europe fell into its second recession even before having recovered from the first downturn, and particularly so in southern Europe.

In the case of Italy, this second recession exacerbated the weak growth trend, which had plagued the country for about 10 years. As a result, by 2013, the real Italian GDP had fallen back to around its 1999 level, which – unsurprisingly – pushed the level of non-performing loans (NPLs) in the Italian banking system to unsustainable levels.

Return to growth

Italy has since returned to positive (if still modest) GDP growth, and as banks have modernised their lending practices, the NPLs have moderated and finally declined. By late 2016, the stock of NPLs had, for the first time, dropped below levels a year earlier.

At face value, Italian NPLs amount to about €360bn, which is about one-third of all NPLs in the eurozone. Depending on the valuation of collateral and prices in the secondary market for each category of NPLs, the stock of NPLs represent a 'hole' in the system of about 5% to 7% of Italian GDP. While not particularly large compared with the size of balance sheet weaknesses in other European banking systems during the crisis, it is an issue that needs to be addressed with a great degree of urgency. 

This includes both action to reduce the stock at a more rapid clip, and better processes to ensure only a minimum of new loans end up as NPLs. Currently, it takes six to eight years of court proceedings to take possession of the collateral on NPLs.

A law passed in early 2016 will dramatically accelerate this process, but only for loans made after the new legislation came into force. In addition to making fast-track procedures available also for existing NPLs, considerations could be given to facilitating a more liquid and well-functioning market for trading NPLs.

Quartet of challenges

In addition to these national characteristics of the challenges facing the European banking system, virtually all European banks face four common challenges.

First, amazing technology developments of recent years present opportunities for the financial sector, which so far have not been fully exploited. But while digitisation presents huge opportunities, it also presents challenges. New technologies have made it easier to quantify and track risk, but rolling it out across the many services provided by banks needs to match the capabilities of the customer base.

For example, while broadband access in Italy is only slightly below the average for developed countries, the proportion of banking sales that take place online is only about one-tenth of what is found elsewhere in western Europe. That said, banks in Italy are making a strong push in the digital area, reaching out to new and existing customers through an expanding and ever more versatile set of channels. 

Second, by almost any standards, Europe is overbanked. The solution to this is either the merger of banks (followed by cut-backs) or the closure of banks. However, after years of mergers by financial institutions around the world, it is difficult to find more than a few examples of potential mergers of complementary banks – where one plus one would equal more than two. And in most cases the closure of banks – even the smallest local banks – seems to run into political trouble.

Third, most banks have too large a branch network. Many branches are expensive to operate, both because of the required real estate, but also because of the required staffing, relative to the business conducted through their physical presence. Yet banking cannot be just for the privileged few in the cities. To support sustainable economic development, banking also needs to be available for small businesses and households in towns and villages across the country.

Fourth, and through all the national and pan-European challenges, banks are navigating an ever-tighter regulatory environment. The good news is that European banks have already raised more than €250bn in new rights issues since the beginning of the crisis. But these new owners need to be serviced with a competitive return on their capital, while significantly more staff are allocated to deal with the huge increase in regulatory and supervisory demands.

Improving efficiency

So far for the banking system in the eurozone as a whole, this requirement has not been met. According to the European Central Bank, on average, the cost of funding for banks in the eurozone has exceeded their return on equity for the past seven years. Clearly, this is not sustainable. Greater efficiency, including cost cutting, will have to be part of the necessary adjustments.

Before drawing conclusions too hastily in this respect, however, it is worth remembering that banks continue to be more productive than most other sectors of the European economy. In the eurozone as a whole, banks contribute about 3.3% of gross value added (GVA) for the entire economy with only about 1.5% of the employment.

In Italy, productivity in banking relative to the rest of the economy is even more pronounced. As for the eurozone as a whole, about 1.5% of total Italian employment takes place in banking, but it produces an impressive 4% of total Italian GVA.

Hence, while adjusting to the ever-changing world is the inescapable requirement of any business, creating a strong Italian banking sector for the future requires not retreat, but the streamlining and indeed expansion of services to clients, who themselves are busy adjusting to the new and increasingly uncertain world.

At its core, banking is about intermediating financial flows between savers and investors as well as smoothing consumption and investment over time. As such, it plays an important role in easing the extremes of the business cycle. To do this safely and efficiently, banks need to attract and service as diverse a client base as possible on both sides of the balance sheet.

On the funding side, this includes the whole spectrum from household depositors to larger institutional creditors to equity owners. Banks need to be in a continuous position to pay a competitive interest and dividend to creditors and owners, compatible with the risk they take.

On the asset side, diversity is also crucial, from risk-free assets to working capital for small and medium-sized enterprises, to household loans. Geographical diversity is also important, both as part of risk management, but also because a large part of the client base are global businesses, and to service them efficiently across their multiple financial services needs, banks need a compatible global footprint.

The Italian banking sector has occupied the headlines in recent months because of the sequencing of the impact of the Great Recession on the financial sector, and the resulting later work-out than in other European countries, but the future model is clear, and great progress is now being achieved in streamlining Italian banking for the future.  

Jean Pierre Mustier is the CEO of UniCredit.

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