Italy, Transcript of a Conference Call on the release of the Staff Reports of the 2013 Article IV Consultation and Financial System Stability Assessment

Washington, Friday, September 27, 2013

Kenneth Kang, Assistant Director, European Department
Dimitri Demekas, Assistant Director, Monetary and Capital Markets Department
Simonetta Nardin, Communications Department

MS. NARDIN: Good morning. Welcome to this conference call on the release staff reports on Italy. Let me first remind you that this conference call is under embargo as well as the documents that you have already received. All the documents are under embargo until 12 noon, Washington time, which is 18:00, 6 p.m. Rome local time. Kenneth and Dimitri will introduce the reports with very short remarks and then we will open it up for your questions.

MR. KANG: Thank you. Let me outline just a few key messages from the Article IV report. On the first key message, the good news is that nearly after two years of recession, the economy is showing signs of stabilizing. Confidence indicators continue to improve. Exports have held steady and the drag on fiscal adjustment is expected to ease this year and next. On this basis, we forecast a modest recovery to take hold later this year and for growth to rise gradually from minus 1.8 percent in 2013 to plus 0.7 percent next year.

The second key message is on policies. We have said this before, but it’s worth repeating. To sustain recovery and revive growth, Italy urgently needs further structural and fiscal reform. In recent years, Italy has come a long way in fiscal consolidation and embarked on a wide-ranging agenda for structural reform. Italy knows well what it needs to do and it’s time to move to vigorous implementation of these reforms to secure a strong recovery.

Let me highlight a few of the key reforms described in our staff report. First in the area of structural reform, there is an urgent need to improve the business environment by reducing regulatory obstacles and barriers to competition especially in services. In particular, improving the efficiency of a judicial system such as by rationalizing the appeal system and reducing the huge backlog of pending cases would generate significant benefits across the economy. More also needs to be done to raise Italy’s employment rate, which is one of lowest in the OECD, particularly for the youth and the women.

Here are steps to improve active labor market policies, such as through have better coordination between national and local government in providing unemployment insurance, and job services would better help the unemployed find work. In fiscal policy, another priority is to reduce the vulnerabilities from Italy’s high public debt. It is worth nothing that Italy has made significant progress in fiscal consolidation, and along with Germany, now enjoys one of the highest primary surpluses in the EURO area, a key factor strengthening Italy’s policy credibility and confidence. That said, public debt continues to rise and remains high leaving Italy vulnerable to shock. Reducing Italy’s high debt will require maintaining a sizeable primary surplus for many years to come. To lock in Italy’s fiscal gains, it will be important to find the needed savings to meet Italy’s fiscal target this year and to remain on track to achieve a structural balance in 2014 under the new constitutional fiscal rule. At the same time, to support growth, there’s a need to rebalance adjustments towards spending cuts and lower taxes on labor and capital, which are among the highest in the EURO area. Taking steps to cut unproductive spending and broaden the tax base could free up savings to reduce the taxation on labor and capital as a way of giving a needed boost to employment and investments.

On the financial system, let me turn to my colleague, Dimitri, who will discuss the highlights from the Financial System Assessment Program (FSAP) report.

MR. DEMEKAS: Thank you Ken, and good morning ladies and gentlemen. Now the Financial Sector Assessment that we did in Italy this year is a special assessment focusing specifically and in-depth on financial sector structure and risks and policies. FSAP examined three aspects of the country’s financial system. The key risks facing the system and the resilience of the system to possible shocks, the quality of financial sector supervision and what we call financial safety nets, which cover the regime for back resolution, deposit insurance, emergency liquidity assistance arrangements, etc. These detailed financial sector assessments take place at the lower frequency than the annual Article IV consultations, typically every five to seven years. The last FSAP in Italy was in 2006. So this was an appropriate time for the reassessment.

In 2010, the IMF decided to make these FSAP mandatory every five years for countries with systemically important financial sectors and Italy is of course one of them. So you can expect the next assessment five years from now. Now the assessment is summarized in the Financial System Stability Assessment document or FSSA, and the details on the supervisory compliance assessments in the ROSS document. I am sure you’ve had the chance to look at them, so I’m not going to present them in detail. Instead, I would like to make four key points.

First the Italian banks, and of course, Italy banks dominate the financial system, are coping with a deep recession at home and a severe crisis in Europe. It is in fact remarkable that the system has so far managed to overcome these shocks and indeed expand domestic deposits and build additional capital buffers. And I should note that in contrast to other European countries, this was accomplished without significant state support. But of course the longer the situation continues, the higher the risks. The two key vulnerabilities for the system today are weak profitability and deteriorating loan quality. And both are likely to remain big challenges until the economy recovers and/or market conditions return to normal. The second point I’d like to make is one should be very careful in making cross-country comparisons. Some market analysts just look at aggregate indicators of asset quality like nonperforming loans and the level of provisions and compare them across countries.

The Bank of Italy has been making for a long time the point that their regulations are stricter than those in other countries. In the FSAP, we took a close detailed look at this, and we have indeed substantiated it and the results are summarized in the Box 3 of the FSSA. That said, there is no doubt, no doubt, that the level of provisions in Italy needs to rise and the Bank of Italy of course recognizes this and has undertaken targeted inspections in 20 banks earlier this year, and these have already made a difference. The provisions rose slightly for the first time at the end of 2012. They are now expanding the scope of these inspections.

The third point is that our stress tests show that in case of an adverse microeconomic scenario, in case of a severe microeconomic shock, banks’ low profits would not be sufficient to absorb the impact and therefore losses would lead to a large decline in the aggregate banking system capital by more than one third. This is a very substantial decline in total banking capital in the case of an adverse scenario, but, and this is a key point, the starting position of the Italian Banking System as a whole, was strong and therefore the system, even in an adverse scenario will remain at or slightly above regulatory minimum. Now these stress tests have three important caveats. First, the result differed significantly across different categories of banks, in particular, cooperatives and banks under the substantial influence of banking foundations fare much worse in the stress test as the FSSA details. So looking just at the aggregate figure for the system as a whole, it’s missing these pockets of vulnerability. And second, the stress test used the regulatory minima as what we call pass/fail rates for banks. But we know that in periods of stress, investors expect banks and banks themselves have a strong incentive to target higher capital issues than the regulatory minimum. So drawing the line at the absolute bare minimum of the regulation can give an excessively reassuring picture of system resilience.

And lastly, my fourth point, in addition to capital buffers that the Italian banks have built, Italy enjoys a strong supervisory system with a high degree of compliance with international standards for supervision of banks, insurance and securities. This provides reassurance that the authorities would like in a timely fashion to mitigate the impact of shocks or limit their consequences. Nevertheless, our reports identify some gaps, which need to be addressed. And so conclude against this background, what should be the priority for financial sector policies? To be sure, as my colleague, Ken, mentioned before, the most important three conditions for financial stability are maintaining micro-economic stability and prudent public finances and preserving with the structure reforms that will raise Italy’s growth rate. But at the same time, we believe and we detail in the reports the targeted measures aimed at increasing provisions improving bank efficiency and profitability, developing a market to dispose of impaired assets, and strengthening capital plans where needed are the high priority. Many of these steps have already been initiated by the Bank of Italy.

We also believe that continued liquidity support by the European Central Bank would be critical until market conditions improve. Enhancing governance in foundation owned and in cooperative banks would strengthen the system and the case for these reforms is even more compelling given the relatively weaker performance of these groups of banks in the distressed debt. And lastly, as I mentioned earlier, it is important to address the remaining gaps and financial sector oversights. Let me stop here and I’m happy to answer any questions.

QUESTION: Thank you very much. Mr. Demekas, I was wondering if you could expand a bit on this idea of developing a market to dispose of impaired assets of Italy’s troubled bank system.

MR. KANG: Okay. I’ll take that question. Yes, as noted in the staff corps, we have a box there describing the situation with nonperforming loans in Italy and one concern that we raise is that given the slow case of write-offs by banks, it would take some time for banks to reduce these nonperforming loans unless actions were taken to accelerate the write-off. And there are several reasons why write-off rates are slow. It’s the slow judicial process. It’s the tax disincentive. It’s the loan-lock provisions and also the reliance on collateral by Italian banks. And we highlight that one possible way to give banks an additional instrument to help manage their bad loans to reduce the NPLs is to look for ways to support the private market for distressed debt. Now such a market did exist in Italy in the mid-1990s when banks were active and unloading the nonperforming loans to the market and we see a potential for expanding this market again now to allow banks to more efficiently and quickly manage and dispose of the nonperforming loans. I’ll just point out that it’s not just Italy, but other countries in Europe and elsewhere have used such a market with effective results.

QUESTIONER: Actually you talked about setting up a bad bank in Italy.

MR. DEMEKAS: Yes. This is something we discussed. Usually the arguments of setting up a bad bank are compelling in cases where the extent of nonperforming loans is so large that the financial system has stopped operating and the only way out is a central solution. We believe this is, not yet at least, the case in Italy. We believe that the financial system is functioning. Of course their large percentage of nonperforming loans does have an impact on credit supply and or course on the economy, but we think that the market-based solution, like the one that my colleague underlined a minute ago will go a long way towards addressing this.

QUESTION: I just want to know, which are the conditions of the stress test you made and if they are just microeconomic and the impact on NPLs and in this calculation and made some talk also with ECB thinking about its own stress testing procedures.

MR. DEMEKAS: Okay. Thanks. We have examined three scenarios in our stress tests, one, the so-called baseline scenario, which is our best guess of developments for the next five years. And then two adverse microeconomic scenarios. One is slow growth where the growth in Italy remains very low over the next five years. So the recovery that we envisioned is not materializing. And one the so-called adverse scenario where if growth declines very sharply, there is another renewed microeconomic shock and growth declines very sharply during 2013 and ’14. These are the two central microeconomic scenarios. Each of them of course includes a set of consistent assumptions for interest rates and other instruments. In addition to those, we have also run a series of what we call single-factor shocks, particularly for sovereign risks and these you can read about in the FSSA.

What I wanted to stress is that the adverse scenario in particular and -- well first, both the adverse and the slow growth scenario are just that, hypothetical scenarios, not the Fund’s projections. Both of them, in particular the adverse growth scenario is fairly severe, but this is exactly the purpose of the stress test is to the test the resilience of the system under fairly adverse conditions. As regard to your question about the ECB, we have not discussed with the European Central Bank (ECB) what their scenario will be simply because they are fairly early in preparing their, or the ECB /European Bank Authority (EBA) stress tests. So they are not yet in a position to discuss or to have ideas about what will be the stress scenarios that they will use in these stress tests. I will remind you that before the ECB stress test of course, we’re going the ECB asset quality reviews or what they call comprehensive balance sheet assessments early next year and the stress test would only come later in 2014.

QUESTIONER: You said that the results are good just in consideration of the minimum requirements, but in case of stress testing, the Italian banks need to increase their capital buffer. Is that right?

MR. DEMEKAS: What I said is that the results -- I don’t think I said the results are good. The results are not good in the sense that in an adverse scenario, profitability that is weak to begin with would be so low that the microeconomic impact would directly affect bank capital. But what is good about it is that the Italian banks today at the starting point have built up additional capital buffers over and above regulatory minimum and so even in an adverse scenario, they will manage to stay at or just slightly above these regulatory minimums. So that is I think a fair summary of the stress test results. However as I also mentioned, we know as a matter of fact that in periods of stress, markets expect banks to have capital that is above the regulatory minimum. And so just aiming at the absolute bare minimum may not be sufficient.

MS. NARDIN: This concludes this conference call on the Article IV consultations with Italy. As a reminder, all the documents are under embargo for another two hours, which is until 12 noon here in Washington and 6 p.m. in Italy. Thank you very much. There is a possibility of listening again to this call, if the operator could kindly let you know how to do that. Thank you very much again.



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