Italian banks are facing a renewed urge to merge. A decade after the euro zone crisis erupted, the country’s lenders have shed most of their bad loans, while doubling their capital ratios. The problem now is that they can’t earn decent returns. Ultra-low interest rates and attempts to limit their holdings of government bonds make the need to join forces with rivals all the more pressing.
For years Italy’s bad loans were the main headache for European regulators. Now the pain is easing. A flurry of disposals has allowed Italian banks to halve the overall stock of gross bad credit on their balance sheets to 177 billion euros by June last year, from 360 billion euros at the peak of the crisis in 2015. Many large transactions, including UniCredit’s mammoth 18 billion euro FINO or “Failure is Not an Option” sale and Banco BPM’s 5 billion euro “Exodus”, had dramatic names that stressed bankers’ awareness of the urgency of the situation.
After deducting provisions, net bad loans stood at 30 billion euros in November last year, or 1.7% of total loans. Meanwhile, Italian banks have boosted their capital buffers. The average common equity Tier 1 capital ratio was 13.6% of total risk-weighted assets at the end of September, twice the level before the global financial crisis erupted in 2007.
The cleanup effort has successfully reduced financial risk, but at a cost. Many Italian banks were forced to take big writedowns when they sold their sour credits, or increase provisions against future losses. The industry has collectively generated an annual return on equity of just 0.8% since 2007, according to Italy’s banking association ABI.
Profitability has picked up since: the average ROE at the end of September was 8%, according to the European Central Bank. However, that’s still below the industry’s cost of capital, which senior Italian bankers estimate at more than 10%. That is one reason why listed Italian banks trade on average at half their book value.
There’s little prospect of improvement. While grappling with Italy’s stagnating economy, domestic banks also face an extended period of negative official interest rates. Meanwhile, regulators seem inclined to keep raising capital requirements.
And banks have new problems. Italian lenders hold about 400 billion euros of government debt. At 10% of combined assets, this is one of the highest proportions in Europe – and more than twice the level before the financial crisis. That reinforces the “doom loop” which ties troubled banks to their cash-strapped governments.
To discourage such high concentration, German Finance Minister Olaf Scholz in November suggested stripping state debt of its risk-free status. Other ideas proposed by policymakers and academics include putting a cap on the amount of their own government’s debt that banks can hold. Buying relatively high-yielding Italian sovereign bonds has been a cheap way for banks to boost their interest income. But if capital charges or curbs come into place, that will dry up.
Faced with uncertainty over their future earnings, Italian bank executives have all the more reason to consolidate. Italy has 490 different credit institutions, roughly one for every 123,000 inhabitants, twice as many as Spain. The action is likely to focus on domestic combinations, where overlaps can generate greater savings. Mid-sized players like Giuseppe Castagna’s Banco BPM and Victor Massiah’s UBI Banca might start the merger dance. Asset managers like Banca Generali or Azimut could also become targets. Mediobanca, which has some spare cash and is building up its wealth management business, is already on the prowl.
Successful mergers face hurdles, though. Regulators are likely to demand that any merged bank completely writes down any lingering dud loans. That may require lenders to raise capital and delay any near-term promise of increased dividends. Also, rigid Italian labour laws may limit banks’ ability to reduce staff.
If they delay, however, bank CEOs may have to present investors with the unappealing prospect of gradually eroding profitability. They would also miss the opportunity to take advantage of a scheme the government is offering to fund early retirement. Troubled lender Banca Carige has already used it as part of its wide-ranging restructuring. Meanwhile, the threat of regulators slapping Italian lenders with higher capital charges if they continue to hold too much state debt cannot be dismissed.
Despite some recent high-profile tie-ups, such as the creation of Banco BPM, or Intesa Sanpaolo’s purchase of two troubled Veneto-based lenders in 2017, Italian banks still have plenty of scope to consolidate. With pressure mounting, sitting still is no longer an option.