Typical street scene in Santa Ana, El Salvador. (Photo: iStock)

Typical street scene in Santa Ana, El Salvador. (Photo: iStock)

IMF Survey : Italy’s Financial System Stabilized, Still Vulnerable

September 27, 2013

  • Low profitability, deteriorating loan quality remain key vulnerabilities
  • Risk monitoring and financial sector oversight are strong
  • Reforms needed to improve bank governance

Italy’s financial system has so far managed to overcome the financial crisis, and increase domestic deposits and raise additional capital under very difficult circumstances without significant state support. But a weak economy and the link between Italian banks and government finances are a strain on banks.

People walk past a bank in Rome, Italy: a weak economy is a strain on banks (photo: Gregorio Borgia/AP)

People walk past a bank in Rome, Italy: a weak economy is a strain on banks (photo: Gregorio Borgia/AP)

ITALY FINANCIAL SECTOR

Italy is one of the major 25 financial sectors that must undergo a review of its financial health every five years as part of the IMF’s surveillance. The latest assessment under the Financial Sector Assessment Program is the country’s first since the global economic crisis. The IMF also released its annual report on the health of the Italian economy.

The IMF said the Italian financial system has shown remarkable resilience in the face of a severe and prolonged recession at home and a major crisis in Europe, but the baseline outlook for the economy remains weak and the financial system is still vulnerable.

“If downside risks to this baseline materialize, the impact on banks could be significant, albeit substantially cushioned by their own capital buffers and the availability of liquidity from the European Central Bank ,” said Dimitri Demekas, an Assistant Director in the IMF’s Monetary and Capital Markets Department and head of the team that conducted the assessment.

The IMF assessment recommends a variety of measures to the Italian authorities. Those measures will have to be complemented at the euro area level with steps to strengthen the banking union.

Main risks

Banks have strengthened their capital position in the last years, but remain vulnerable to several key risks, in particular:

• The lackluster economic outlook and the large exposure to the highly-leveraged Italian corporate sector that keep credit risk rising and put pressure on bank profits. The ratio of non-performing loans (including past due, restructured, doubtful, and defaulted loans) to total loans has almost tripled since 2007 to 13.4 percent.

• The weak governance in some categories of banks—notably cooperatives and banks under significant influence of banking foundations— that fare noticeably worse in the stress tests.

• The large holdings of government bonds that leave banks exposed to losses and higher funding costs if yields on government bonds surge again. The yields on Italian government bonds have declined substantially from their peaks in 2011 but the crisis in Europe has not ended.

Key reforms

In its assessment, the IMF recommended the government enact a series of reforms, including the following:

• Implement targeted financial sector actions to increase provisions, strengthen capital and funding plans where needed, and encourage a market for distressed assets. The Bank of Italy has initiated many of these steps, and this should continue in preparation for the forthcoming asset quality review and stress tests by the European Central Bank.

• Enhance governance in certain categories of banks. Foundations that are bank shareholders should be subject to minimum standards of transparency, governance, and asset diversification, and the largest cooperatives, especially those with an international presence, should be transformed into joint stock companies.

• Rehabilitate the systemic bank, Banca Monte dei Paschi di Siena. Successful implementation of the current ambitious restructuring plan is critical not only for the bank itself but also for the financial system as a whole.

• Strengthen financial supervision by enhancing the fit-and-proper rules for bank shareholders and directors and allowing the supervisor to dismiss individual managers. The authorities should also ensure that the recent reorganization of the insurance supervisor does not create supervisory gaps during the transition period.

•Strengthen the crisis management framework, broadly in line with the draft European Union Bank Recovery and Resolution Directive. In particular, the resolution regime should prevent shareholders blocking recapitalizations and include depositor preference, bridge bank, and bail-in powers.