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### FSAP team and context
- FSAP team headed by Dimitri G. Demekas and comprised Amadou Sy, Bergljot Barkbu, Ana Carvajal, Dawn Chew, Marc Dobler, Nadège Jassaud, Emanuel Kopp, Fabiana Melo, Hiroko Oura, and Rodolfo Wehrhahn (all IMF), and Malcolm Rodgers, Christine Sampic, José Tuya, and Christina Urias (external experts).
- Report prepared by Dimitri G. Demekas and Amadou Sy with contributions from team members.
- FSAP findings discussed with the authorities during the Article IV Consultation mission in June 2013.
- Date on report: September 6, 2013.
- Italy deemed by the IMF to have a systemically important financial sector according to Executive Board decision 14736-(10/92); the stability assessment under this FSAP is part of bilateral surveillance under Article IV.
- Stated purpose: assess the stability of the financial system as a whole and help countries identify key sources of systemic risk and implement policies to enhance resilience; certain risk categories (operational, legal, fraud) are not covered.

### Executive summary — main findings and system assessment
- Systemic context and recent developments:
  - Italian financial system coping with a severe and prolonged recession and the crisis in Europe.
  - System expanded domestic deposits and built additional capital buffers without significant state support.
  - Announcement of Outright Monetary Transactions (OMT) and steps toward a banking union blunted sovereign debt crisis impact on banks.
  - Expansion of ECB liquidity facilities temporarily shielded banks from wholesale funding volatility.
- Key vulnerabilities:
  - Continuing weakness in the real economy and the sovereign–financial sector link.
  - Weak profitability and deteriorating loan quality; coverage of non-performing loans (NPLs) by provisions and collateral has declined since the crisis.
  - Large exposure to highly-leveraged Italian corporate sector implies loan quality will improve only with a lag and profitability will remain a major challenge.
  - Banks with large holdings of sovereign securities remain exposed to mark-to-market losses and higher funding costs if yields surge.
  - These factors also weigh heavily on Italian insurers.
- Stabilization caveat: decline of sovereign yields from peaks eased pressures, but the euro area crisis has not ended.
- Stress test high-level conclusions:
  - System as a whole able to withstand the baseline macro outlook and the phase-in of Basel III requirements, thanks to capital buffers above regulatory minima.
  - In an adverse macro shock aggregate capital ratios would be reduced to just above minimum Basel III requirements for the system as a whole.
  - Cooperatives and banks under significant influence of banking foundations fare noticeably worse; significant bank-by-bank variation.
  - Results could differ if BI inspections or the forthcoming ECB asset quality review change credit risk assessment.
  - Markets may demand higher capital ratios than regulatory minima if stresses materialize.
- Policy implication:
  - Targeted financial sector action, complemented by continued ECB liquidity support, is necessary and would benefit the real economy.
  - Preconditions for financial stability: maintain macro stability, prudent public finances, and continue structural reforms to raise growth.
  - High-priority measures: increase provisions, improve bank efficiency and profitability, develop a market to dispose of impaired assets, and strengthen capital and funding plans where needed.
  - Many steps have been initiated by the Bank of Italy (BI); the forthcoming ECB asset quality review and stress tests could pinpoint additional actions.
  - Continued ECB liquidity support is critical until funding conditions improve.

### Governance and supervisory findings
- Foundations:
  - Important as stable long-term bank shareholders but governance structure, weak internal accountability, and inadequate oversight create risks.
  - Suggested mitigants: tighten related-party transaction regulation and fit-and-proper rules for shareholders and directors; strengthen legal framework for foundations to require minimum standards of transparency, corporate governance, and financial management; encourage diversification; ensure robust oversight.
  - Weaker performance of foundations-linked banks in stress tests strengthens case for governance reforms.
- Cooperatives:
  - Largest cooperative banks should be encouraged to transform into joint stock companies.
- MPS (Banca Monte dei Paschi di Siena):
  - MPS is a systemic bank; rehabilitation is a key priority.
  - Problems partly rooted in governance and management failures; successful implementation of restructuring plan is critical.
- Supervisory strengths and gaps:
  - High compliance with international standards for banking and securities supervision; supervisory practices strong and sophisticated.
  - Gaps: regulation of related-party transactions; fit-and-proper rules for shareholders and directors; legal authority of BI to dismiss individual bank managers.
  - Top fifteen Italian banks expected to fall under direct ECB supervision; SSM preparations underway.
  - Consob should emphasize transparency, increase onsite inspections, and strengthen enforcement (including criminal sanctions).
  - Insurance supervision was relatively weaker but recent reorganization has strengthened it; key challenge is avoiding gaps during transition.

### Crisis management, resolution, and safety nets
- Current framework effective in countering crisis impact but can be strengthened.
- Recommended enhancements:
  - Allow differentiation between classes of creditors in resolution and introduce depositor preference.
  - Resolution regime should prevent shareholders blocking recapitalizations and include bridge bank and bail-in powers.
  - Powers should be deployable at an early stage, including when liquidity regulations are breached.
  - Provide statutory basis for recovery and resolution plans (RRPs) for all systemically important banks.
  - Remove active bankers from boards and executive committees of deposit guarantee schemes to prevent conflicts of interest.
- Alignment: recommendations broadly consistent with recent European Council position on the draft EU Bank Recovery and Resolution Directive.

### Key recommendations (priorities and timeframes)
- Bank-level (short to medium term highlights):
  - Issue prudential guidance to harmonize loan loss provisions and write-off practices [BI] — Short term.
  - Amend law to ensure effective oversight of banking foundations, require largest foundations to publish audited financial statements, have an asset allocation policy aimed at diversification, and impose leverage limits [MEF/Parliament] — Short term.
  - Amend regulation to require related-party transactions not carry more favorable terms relative to unrelated parties and exclude conflicted board members [BI] — Short term.
  - Gradually increase tax deductibility of bank provisions in the same tax year [MEF/Parliament] — Medium term.
  - Monitor restructuring plan for Monte dei Paschi di Siena and prepare contingencies if targets not reached [MEF/BI] — Medium term.
- Oversight (short to medium term highlights):
  - Expand fit-and-proper definition for bank and ISP directors to include adverse regulatory judgments [MEF/Parliament] — Short term.
  - Clarify in supervisory guidance that assessment of major shareholders includes capacity to provide additional capital [BI] — Short term.
  - Adopt group supervisory approach for nationally significant insurers [IVASS] — Short term.
  - Increase onsite inspections of ISPs and asset managers [Consob, BI] — Medium term.
  - Amend law to empower BI and Consob to impose fines on entities and raise sanction ceilings [MEF] — Medium term.
  - Enable supervisors to remove individual board members, officers, and auditors [MEF/Parliament] — Medium term.
  - Introduce risk sensitivity in solvency framework for insurers ahead of Solvency II [IVASS] — Medium term.
- Safety nets and resolution (short to medium term highlights):
  - Provide statutory basis and detailed guidelines for RRPs for all systemically important banks [MEF, BI] — Short term.
  - Adopt depositor preference; expand resolution tools to include bail-in, bridge bank powers, transfer ownership, selectively transfer assets and liabilities, trigger early [MEF, BI] — Short term.
  - Amend deposit guarantee framework to provide ex-ante funding, back-up credit line from MEF, and remove active bankers from DGS governance [MEF, BI] — Medium term.

### Banking structure, scale, and balance-sheet composition
- Sector structure and scale (end-2012):
  - 706 banks with total assets of about 220 percent of GDP.
  - 169 banks part of 75 banking groups.
  - Banks account for almost 85 percent of total financial sector assets.
  - Branch density: 1,806 inhabitants per branch in Italy versus European peer average of 2,168 inhabitants per branch.
- Balance sheet composition (end-2012):
  - Loans about 65 percent of total assets.
  - 37 percent of loans to resident non-financial corporations — highest share in any G-7 country.
  - SMEs account for almost 70 percent of business value added.
  - Loans to non-residents concentrated in large banks and account for a quarter of total loans.
  - Sovereign security holdings amount to 9 percent of total assets (mostly Italian sovereign bonds).
  - Banks funded primarily by resident deposits and retail bonds.
  - Deposit-to-loan ratio (including retail bonds) declined from 109 percent in 2007 to 94 percent at end-2012 due to withdrawals of nonresident deposits.
  - Bank bonds held by households historically close substitutes to term deposits.

### Impact of crises and ECB support
- NPL dynamics and profitability:
  - Average NPL ratio rose from 5½ percent in 2007 to about 14 percent at end-2012.
  - Flow of new NPLs remained high (started to abate in 2013).
  - Return on assets: 0.7 percent in 2007; -0.9 percent at end-2011; near-zero in 2012 (-0.1 percent).
  - Credit growth to non-financial private sector turned negative in August 2012 (year-on-year, corrected for securitization).
- Sovereign spread sensitivity and ECB financing:
  - BI estimates a 100 bps increase in the sovereign spread results in equivalent hike in bank bond yields within one quarter and a 60 bps hike in interest rates on new term deposits and repos within 3-4 quarters.
  - ECB financing of Italian banking system peaked at EUR 283 billion in July 2012 before declining to EUR 248 in July 2013; amount largely invested in liquid sovereign bonds and exceeds Italian banks’ total maturing wholesale debt over next three years.

### Capital, solvency, and leverage metrics (selected table highlights)
- Aggregate Core Tier 1 (CT1) capital rose by over EUR 40 billion since 2008, raising system CT1 ratio to 10 percent by end-2012.
- Table 2 (63 banking groups, 2007–12) selected figures:
  - Total assets, in billions of euro: 2007: 2,709; 2008: 2,816; 2009: 2,711; 2010: 2,765; 2011: 2,800; 2012: 2,849.
  - In percent of GDP: 2007: 174; 2008: 179; 2009: 178; 2010: 178; 2011: 177; 2012: 182.
  - Total deposits, in billions of euro: 2007: 1,542; 2008: 1,431; 2009: 1,358; 2010: 1,458; 2011: 1,436; 2012: 1,513.
  - Total capital ratio, in percent: 2007: 9.8; 2008: 10.4; 2009: 11.6; 2010: 12.1; 2011: 12.7; 2012: 13.4.
  - Tier 1 ratio, in percent: 2007: 6.8; 2008: 7.0; 2009: 8.3; 2010: 8.7; 2011: 9.5; 2012: 10.5.
  - Core tier 1 ratio, in percent: 2007: 6.3; 2008: 6.3; 2009: 7.4; 2010: 7.5; 2011: 8.7; 2012: 10.0.
  - NPL to gross loans: 2007: 5.6; 2008: 6.3; 2009: 9.5; 2010: 10.6; 2011: 11.9; 2012: 14.
  - Return on assets 2/: 2007: 0.7; 2008: 0.3; 2009: 0.3; 2010: 0.3; 2011: -0.9; 2012: -0.1.
  - Provisions to NPL: 2007: 50; 2008: 46; 2009: 40; 2010: 40; 2011: 40; 2012: 40.
  - Customer deposits+retail bonds to non-interbank loans: 2007: 109; 2008: 98; 2009: 99; 2010: 99; 2011: 93; 2012: 94.
- Table 3 (by size, 2012 examples):
  - Total assets, in billions of euro (2012): All: 2,849; Large: 2,318; Medium: 458; Small: 73.
  - Total capital ratio, in percent (2012): All: 13.4; Large: 13.9; Medium: 11.3; Small: 13.6.
  - NPL to gross loans (2012): All: 14.0; Large: 14.2; Medium: 13.2; Small: 19.1.
  - Return on assets 2/ (2012): All: -0.1; Large: -0.1; Medium: -0.1; Small: 0.5.

### High-profile case: Banca Monte dei Paschi di Siena (MPS)
- Scale and characteristics:
  - Third largest bank with EUR 224 billion in assets; 7 percent domestic market share; almost 3,000 branches; over 30,000 employees.
  - Historically controlled by the banking foundation of Siena.
- Causes and timeline:
  - Acquired Antonveneta in early 2008 for over EUR 9 billion.
  - Engaged in structured repo transactions in 2008–09 tied to sovereign bond carry trades; contributed to liquidity deterioration and frequent margin calls; aspects under criminal investigation.
  - Decline in deposits in early 2013.
- Key metrics and interventions:
  - Highest NPL ratio among large Italian banks (almost 22 percent at end-March 2013).
  - State injected a total of EUR 4.1 billion (0.3 percent of GDP) of capital in 2009 and 2013.
  - Reliance on ECB facilities: EUR 29 billion outstanding in LTRO, equivalent to 13 percent of its total assets.
  - “Monti bonds” carry a 9 percent and escalating coupon; if shares issued due to losses, state would own 35 percent of shares by 2015.
  - Restructuring plan aims to raise EUR 1 billion of new capital, revamp services, cut staff and administrative costs, and close branches; requires European Commission approval under state aid rules.
- Supervisory actions: BI intensified onsite inspections, closely monitored liquidity, banned bonuses and dividends, exercised moral suasion to change management and Board composition.
- MPS did not pass the EBA recapitalization exercise in 2012; early 2009 “Tremonti bonds” folded into larger recapitalization package.

### Economic outlook and risks for banks
- IMF forecasts cited:
  - Real GDP to decline by 1.8 percent in 2013, followed by growth of 0.7 percent in 2014.
- Implications:
  - Domestic demand not projected to recover before late 2013 at the earliest.
  - Downside risks dominate short-term forecast; low trend productivity growth likely to keep medium-term growth modest.
  - Financial fragmentation likely to keep funding costs high.
  - Rehabilitation of MPS is a systemic priority.

### Insurance sector: challenges and systemic links
- Key challenges:
  - Weak economy, high sovereign exposure, and impending regulatory changes (Solvency II, IFRS, IMD2, PRIP) create major challenges for insurers.
  - Recent supervisory reorganization (IVASS) risked creating transition gaps.
- Market signals:
  - Equity prices about half of 2007 values.
  - Insurers’ CDS spreads closely mirror sovereign CDS spreads.
- Three broad systemic risk sources and spillovers:
  - New negative growth shock or prolonged recession affecting bank profitability and asset quality.
  - Renewed wholesale funding stress once LTRO lapses impacting liquidity and refinancing.
  - Renewed sovereign yield pressures affecting bank balance sheets and systemic liquidity.
- Evolution of risk balance:
  - Early crisis: capitalization concerns dominated.
  - Height of sovereign debt crisis: liquidity risks peaked.
  - Since ECB interventions: market liquidity risk lowered and capital positions increased, but confidence remains low and asset quality concerns elevated.

### Loan quality, corporate vulnerabilities, and provisioning
- Loan quality:
  - NPL hike nearly 8 percentage points since 2007, concentrated in corporate sector.
  - Corporate sector NPL ratio: 26 percent as of May 2013.
- Corporate leverage and distress:
  - About half of corporate sector debt, largely to banks, from highly leveraged firms; interest expense accounts for over half of gross operating profit.
- Provision adequacy:
  - Italy’s loan classification rules more conservative; tax deductibility of provisions less generous.
  - Collateral (mostly real estate) increased during crisis, providing an uncertain buffer.
  - BI targeted inspections (late 2012–early 2013) on 20 mid-size and large banks covered 40 percent of system NPLs and revealed deficiencies in provisioning.
  - Supervisory action led to an increase of about EUR 7½ billion in provisions reflected in end-2012 financial statements; slight increase in provisioning coverage system-wide.
  - Raising overall coverage substantially will remain a challenge given continued asset quality deterioration and low bank profitability.

### Sovereign exposure impacts
- Sovereign exposures amount to about 9 percent of assets, mostly in trading and AFS accounts.
- Lower market prices would create mark-to-market valuation losses, affect solvency, and reduce collateral value for secured funding (including ECB).
- Acute sovereign distress could spill over to other market yields, aggravating pressures.

### Cross-border exposures and spillovers
- Foreign exposures:
  - About 20 percent of Italian banks’ total assets (US$3.8 trillion as of end-2012) vis-à-vis foreign counterparties.
  - Two-thirds of foreign claims vis-à-vis developed economies, especially core EU countries.
  - Exposures to CEE countries represent about a quarter of total foreign exposures; in nine CEE countries Italian banks’ gross foreign claims exceed 10 percent of host-country bank assets, reaching over 40 percent in Croatia.
- Cross-border intra-group liquidity:
  - Head offices in Italy typically provide funds to foreign affiliates; no strong sign of liquidity inflows from affiliates to Italian head offices.
  - BI instructed major banks to limit reliance on intra-group liquidity sharing.
- Global banks’ exposures to Italy:
  - BIS reporting banks’ exposure to Italy declined over 40 percent between end-2007 and end-2012.
  - About 60 percent of remaining claims vis-à-vis corporate sector.
  - Total exposures to stressed countries generally smaller than creditor countries’ total bank capital except for French and Swiss banks.

### Macroprudential architecture and institutional roles
- Financial stability responsibilities shared among BI, IVASS, and Consob, with BI playing leading role; MEF and two DGSs included.
- MEF chairs ICCS and CSFS interagency committees.
- BI remit includes systemic risk monitoring, early warning, stress tests, shadow bank monitoring, and expanding tools for risk concentration.
- Two EU-adaptation options for macroprudential authority per ESRB recommendation:
  - BI as authority with formal cooperation arrangements.
  - New macroprudential body issuing public recommendations under “comply or explain”, with BI leading.
- Consideration to streamline inter-agency committees.

### Stress tests: coverage, scenarios, and key results
- Coverage and methodology:
  - Stress tests covered banks representing over 90 percent of system assets.
  - Solvency tests based on end-2012 data; macro scenarios over three- to five-year periods.
  - Liquidity tests based on end-March 2013 data; one-month horizon.
  - FSAP combined BI and FSAP team tests; parallel solvency tests with same data and macro assumptions.
- Scenarios:
  - Baseline: WEO-similar growth.
  - “Slow growth”: domestic growth lower by 0.7 percentage points each year during 2013–17; five-year cumulative growth at -0.1 percent.
  - “Adverse”: 1¼ standard deviation shock (-4.2 percentage points compared to baseline) on two-year cumulative real GDP growth during 2013–14; includes mark-to-market losses from sovereign securities with AFS filter and an all-exposures single-factor sovereign test.
- Solvency results — system-wide:
  - Baseline: capital adequacy remains well above Basel III minima.
  - Between five and ten banks (one-seventh to one-tenth of sample by assets), depending on capital definition, would need capital increase; shortfall EUR 1.1-3.4 billion (0.1-0.2 percent of GDP) by end-2017.
  - “Slow growth”: system-wide ratios decline but remain above minima; 11-15 banks (a fifth to a quarter) slip below minima; total shortfall EUR 5-10 billion (0.3-0.7 percent of GDP) by 2017.
  - “Adverse”: system-wide CET1 capital declines by EUR 51 billion (Tier 1 by EUR 59 billion) but remain at or above regulatory minima by 2015; credit losses main driver; capital ratio for 13-20 banks (a quarter to a third) falls below CET1 and Tier 1 minima; total shortfall EUR 6-14 billion (0.4-0.9 percent of GDP) by end of test horizon.
- Bank-level heterogeneity:
  - Mid-size banks (ranked 11–20) relatively more vulnerable; aggregate capital ratios could drop below hurdle rates in both “slow growth” and “adverse” scenarios.
  - Large (top 10) and small banks maintain ratios at or above hurdle rates even in “adverse”.
  - Banks influenced by foundations and cooperative banks particularly vulnerable.
    - Banking-foundation-influenced banks: group capital ratio would fall below hurdle rates even in baseline; “adverse” shortfall up to EUR 5.4 billion (0.3 percent of GDP).
    - Cooperative banks would not pass the test under “adverse”.
    - Together, these two groups account for more than three-quarters of total shortfall in “adverse”.
  - Drivers: lower profitability, weaker initial capital, and higher fraction of capital not eligible for Basel III CET1 and Tier 1.
- Sovereign-risk sensitivity:
  - “Adverse” includes sovereign spread hikes between 110-270 bps across maturities compared to end-2012.
  - Direct impact on capital ratios from this hike amounts to 50 bps (stress applied to HFT and AFS portfolios with AFS filter mitigation).
  - Sensitivity test stressing entire sovereign portfolio (without AFS filter): a 100 bps hike across maturities from end-2012 implies a 70 bps decline in capital ratios.
- Credit concentration sensitivity:
  - Default of all large exposures reduces system capital by less than half.
- Liquidity stress tests — design and results:
  - BI measures Net Liquidity Position (NLP): liquidity buffer (“counterbalancing capacity”) net of cash outflows; buffer is unencumbered ECB-eligible collateral net of ECB haircut.
  - Bank passes if NLP remains positive over one month.
  - Two scenarios:
    - “Adverse”: one-notch sovereign downgrade; two-notch bank downgrades; deposit outflows; 150 bps jump in sovereign spreads; combined shocks more extreme than end-2011 severe liquidity stress.
    - “Alternative”: similar but without deposit outflows and with 180 bps jump in sovereign yields.
  - Results:
    - ECB liquidity availability removed vulnerability to wholesale funding volatility, especially for large banks.
    - System can withstand “adverse” NLP remains comfortably positive for system as a whole.
    - Five small and mid-size Italian banks and two foreign banks do not pass adverse test; fail mainly due to deposit withdrawals.
    - Under “alternative” (market funding only), almost all banks pass except one Italian and one foreign bank.

### Liquidity stress specifics and drivers
- Deposit outflows are the single largest component of liquidity pressures under stress scenarios.
- Outflow rates in “Adverse Scenario”: 5 percent for retail customers, 20 percent for corporate depositors, and 33 percent for sovereign and public sector entities.
- Mid-size and small banks relying heavily on deposits are most affected.
- Foreign-owned banks operating in Italy show weaker liquidity positions and higher sensitivity to liquidity shocks.
- BI’s weekly liquidity monitoring shows potential cash outflows dropped visibly since LTRO take-up in early 2012; counterbalancing capacity rose due to expanded eligible collateral and LTRO uptake.
- Caveats:
  - Stress tests based on market and supervisory data at a point in time without independent validation.
  - Results could differ if BI inspections or ECB asset quality review change credit risk assessment.
  - Tests do not fully incorporate second-round effects or policy responses; non-linear effects and unknown patterns may emerge under extreme shocks.
  - Renewed sovereign distress could have more pervasive effects beyond direct impacts measured.
  - Tests use Basel III minima as hurdle rates; markets and regulators may demand higher capital.

### Policy recommendations — targeted financial sector actions
- Increase provisions:
  - Strengthen coverage to absorb losses and bolster credibility.
  - BI targeted inspections increased provisions by about EUR 7½ billion in end-2012 statements.
  - Change tax treatment to allow deductibility in same tax year to incentivize provisions.
  - BI to issue guidelines for harmonized loan loss provisions and write-off practices.
- Improve efficiency and profitability:
  - Consolidation and branch rationalization to improve cost structure and achieve economies of scale.
- Dispose of impaired assets:
  - Accelerate NPL sales and judicial process for foreclosure and debt restructuring.
  - Effective transfer of credit risk to buyer is key.
- Strengthen capital plans:
  - Maintain extra capital buffers above regulatory minima.
  - Prompt capital planning needed for weaker banks (cooperatives and foundation-influenced) to comply with Basel III.
  - BI already required additional Pillar 2 capital buffers and issued remuneration and dividend guidelines.
- Strengthen medium-term funding plans:
  - Many banks need to reduce funding gaps and find alternative funding sources before LTRO expiration.

### Governance, AML/CFT, CCPs, and safety-net operational issues
- Governance of foundation-owned banks:
  - Stress tests justify strengthening governance, fit-and-proper rules, related-party transaction provisions, transparency, diversification, leverage caps, term limits, cooling-off periods, and robust oversight (MEF or new entity empowered).
- Cooperative banks:
  - Re-assess governance aspects; “one member, one vote” and other features can hamper control in large-scale banks; BI urged large listed cooperatives to convert to joint stock companies.
- AML/CFT:
  - Italy last assessed in 2005; authorities requested Fund reassessment tentatively scheduled January 2015; necessary to implement 2012 AML/CFT standard.
- CC&G (Italian CCP):
  - Systemically important; link with LCH Clearnet SA creates cross-border exposures and imbalances.
  - Historical episode: November 2011 margin requirement increases (500 basis points on 7–10 year maturities) forced CC&G to raise margins and post intraday margins about 12 times greater than average for other months of 2011.
  - CC&G’s risk management robust; further EMIR and PFMIs compliance work underway.
  - Concern: current mutual initial margin arrangements may be insufficient in extreme scenarios; joint analysis by CCPs requested and prioritized.
- Supervisory early intervention and RRPs:
  - BI empowered to adopt graduated measures but lacks powers to suspend/replace management, remove statutory auditors, and apply pecuniary sanctions at bank level; recommendation to provide BI with these powers in legislation.
  - No clear legal basis for RRPs; recommendation to provide statutory basis and guidelines for RRPs for all systemically important domestic banks.
- Official support principles:
  - Historical support preserved depositor confidence without large costs; state recapitalization should entail burden-sharing and measures to mitigate moral hazard.
  - MPS recapitalization: state could hold approximately 35 percent of shares by 2015 if shares issued to cover coupons; intensified BI oversight and contingency planning recommended.
- ELA and disclosure:
  - BI provided asset swap facility (EUR 5.4 billion disbursed) and bilateral swap with MPS in fall 2011 (similar to ELA effect).
  - ECB financing peaked at EUR 283 billion in July 2012.
  - Recommendation: consider flexibility in content and timing of ELA-related disclosure to preserve ELA utility.

### Deposit Guarantee Schemes (DGS) and MEF role in interventions
- MEF role in SA/CAL:
  - BI cannot initiate SA or CAL without an MEF decree; MEF has thus far always endorsed BI assessments.
  - Consider empowering BI to commence SA or CAL without MEF approval for bank failures that do not present systemic risk; MEF endorsement should remain when public funds likely involved.
- DGS structure:
  - Two DGSs: Interbank Deposit Guarantee Fund (FITD) and Mutual Bank Depositor Guarantee Fund (FGDCC).
  - Both private-law consortia supervised by BI; mandates include payout of insured deposits, open bank assistance, and funding P&A if less costly than payout.
  - EU-aligned coverage: EUR 100,000 per depositor per bank; payout within 20 working days.
- Governance and funding recommendations:
  - Remove active bankers from Boards and Executive Committees; replace with independent members; consider MEF and BI voting representatives.
  - Establish separate bankers’ consultative committee.
  - Move to ex-ante funding and provide unsecured credit line from MEF at market rates.
  - Enhance public awareness of DGSs.
  - Embed insured depositor and DGS subrogation preference in law; suggested ranking: preferred insured deposits, eligible deposits, then other senior creditors.

### Household and corporate vulnerabilities (selected statistics and stress results)
- Households:
  - 21 percent of households are indebted (BI 2010 Survey).
  - Vulnerable households (debt service >30 percent of income) represent 10 percent of indebted households and hold about 20 percent of total household debt.
  - Debt-at-risk: 1.3 percent of household debt held by vulnerable households with negative net wealth.
  - Adverse scenario (income -3 percent, interest rates +100 bps): vulnerable share increases to 14 percent; debt-at-risk rises to 1.6 percent.
  - Extreme scenario (interest rates +300 bps, income -15 percent): debt-at-risk increases to 2.2 percent.
  - Housing price shocks: moderate decline 5 percent → debt-at-risk 1.7 percent; extreme 20 percent decline → 6 percent.
- Housing market:
  - Transactions dropped almost 50 percent since 2006.
  - Cumulative decline in prices of 3¼ percent since peak in 2011.
  - Slow sale times: more than eight months; discount-to-ask price: 16 percent.
- Corporate sector:
  - Leverage ratio (debt/(debt+equity) at balance sheet value): 52 percent on average (2011 BI estimates).
  - Micro and small firms leverage: 55–58 percent.
  - Distressed firms (interest expenses >50 percent of gross operating profits): 31 percent; they hold 48 percent of corporate sector debt (“debt at risk”).
  - Stress simulation (profits -15 percent, interest rates +100 bps): debt at risk increases by 9 percentage points to almost 55 percent.

### Tail shocks, scenario calibration, and modeling assumptions
- Scenario design:
  - Macroeconomic variables projected using BI and IMF models; stress assumptions calibrated from 2006-2012 historical volatilities.
  - Baseline: BI baseline projections similar to WEO April 2013; sovereign yields set at forward rates as of end-2012 (30-160 bps increases across maturities).
  - Protracted slow growth: growth 0.7 percentage points weaker each year during 2013-17 (rates: -2.4, -0.7, 0.3, 0.7, 0.7 percent); five-year cumulative growth -0.1 percent; sovereign yields set at forward rates as of end-2012 (30-160 bps increases).
  - Adverse (double-dip): growth -4.2 percent in 2013, -1.7 percent in 2014, 1.0 percent in 2015; cumulative growth over 2 (3) years at -4.6 (-3.6) percent; sovereign yields increase by 80-110 bps across maturities compared to baseline (110-270 bps vs end-2012).
- Sensitivity analysis:
  - Sovereign risk: 100 bps parallel shift in Italian sovereign yield curve vs end-2012.
  - Credit concentration: default of largest, largest three, five, ten, and all large exposures; LGD set at 45 percent.
- Risk parameter calibration:
  - Point-in-time PDs and LGDs; starting RWA through-the-cycle (TTC); PDs proxied by inflows into four NPL categories; evolution of PDs under stress via SUR and dynamic credit risk models.
  - LGDs approximated by actual coverage ratios as of December 2012; bank-specific LGDs increase by 7.5 percent and 12.4 percent under slow growth and adverse scenarios, respectively.
- Behavioral assumptions (first set):
  - Constant balance sheet and RWA except Basel III impacts; EaD under stress increases about 20 percent (CCF 75 percent); maturing assets replaced by same-type exposures; no credit growth, no strategic disposals; losses recognized in same year; elimination of prudential AFS filter per Basel III (20 percent a year).
- Alternative assumptions:
  - Time-varying RWA; dividend payout 50 percent; positive net operating income taxed at 25 percent; other loss recognition assumptions as above.

### Banking sector liquidity risk — scope and tail shocks
- Institutions included: top 33 banks including 6 foreign banks’ subsidiaries; together >90 percent of sector assets; excludes Cassa Depositi e Prestiti.
- Data base date: liquidity position as of end-2012; rating and market valuation as of March 2013.
- Liquidity stress horizon: 30 days.
- Adverse tail shock assumptions (motivated by end-2011 experience):
  - 0 percent roll-over rate for maturing wholesale funding (including central bank funding).
  - One-notch sovereign downgrade and two-notch bank downgrades by all four rating agencies causing increased ECB haircuts and some securities ineligible for ECB operations.
  - Deposit outflows: 5 percent retail; 20 percent corporate; 33 percent sovereign/public.
  - Widening credit spreads: 150 bps jump in Italian sovereign yields increasing haircuts and margin requirements.
- Alternative market-focused scenario: similar but no deposit outflows and 180 bps sovereign yield jump.
- Reporting: changes in net liquidity position and counterbalancing capacity, drivers, pass rates by bank groups, differentiation between foreign-owned and Italian banks.

*International Monetary Fund — Italy FSAP report (prepared by Dimitri G. Demekas and Amadou Sy; September 6, 2013).*

### 2013. The FSAP findings were discussed with

### 2013. The FSAP findings were discussed with

### FSAP team and context
- The FSAP team was headed by Dimitri G. Demekas and comprised Amadou Sy, Bergljot Barkbu, Ana Carvajal, Dawn Chew, Marc Dobler, Nadège Jassaud, Emanuel Kopp, Fabiana Melo, Hiroko Oura, and Rodolfo Wehrhahn (all IMF), and Malcolm Rodgers, Christine Sampic, José Tuya, and Christina Urias (external experts).
- This report was prepared by Dimitri G. Demekas and Amadou Sy with contributions from the members of the team.
- The FSAP findings were discussed with the authorities during the Article IV Consultation mission in June 2013.
- Date on report: September 6, 2013.
- Italy is deemed by the IMF to have a systemically important financial sector according to Executive Board decision 14736-(10/92), and the stability assessment under this FSAP is part of bilateral surveillance under Article IV of the IMF’s Articles of Agreement.
- Purpose of FSAPs (as stated): assess the stability of the financial system as a whole and not that of individual institutions; intended to help countries indentify key sources of systemic risk in the financial sector and implement policies to enhance its resilience to shocks and contagion. Certain categories of risk affecting financial institutions, such as operational or legal risk, or risk related to fraud, are not covered in FSAPs.

### Executive summary — main findings and system assessment
- The Italian financial system is coping with a severe and prolonged recession at home and the crisis in Europe.
- The system has managed to expand domestic deposits and build additional capital buffers without significant state support.
- The announcement of outright monetary transactions (OMT) and steps toward a banking union have blunted the impact of the sovereign debt crisis on banks.
- Expansion of European Central Bank (ECB) liquidity facilities has temporarily shielded Italian banks from wholesale funding volatility.
- Key vulnerabilities:
  - Continuing weakness in the real economy and the link between the financial sector and the sovereign.
  - Weak profitability and deteriorating loan quality are the most pressing vulnerabilities affecting Italian banks.
  - Coverage of non-performing loans by provisions and collateral has declined since the crisis.
  - Large exposure to the highly-leveraged Italian corporate sector implies loan quality will improve only with a lag and profitability will remain a major challenge.
  - Banks with large holdings of sovereign securities remain exposed to direct mark-to-market losses and higher funding costs if sovereign yields surge again.
  - These factors also weigh heavily on Italian insurers.
- Stabilization caveat:
  - The decline of Italian sovereign yields from their peaks has eased pressures, but the crisis in Europe has not ended.
- Stress test conclusions:
  - Stress tests suggest the system as a whole is able to withstand the baseline macro outlook and the phase-in of Basel III requirements, thanks to banks’ capital buffers above regulatory minima, strengthened in recent years.
  - These capital buffers are sufficient to absorb most losses in an adverse macroeconomic shock, although aggregate capital ratios for the system as a whole would be reduced to just above minimum Basel III requirements in such a scenario.
  - Some categories of banks—notably cooperatives and banks under significant influence of banking foundations—fare noticeably worse in the stress tests, with significant bank-by-bank variation.
  - Results could differ if ongoing inspections by BI or the forthcoming asset quality review by the ECB result in significant changes in credit risk assessment.
  - Markets may demand higher capital ratios than regulatory minima if stresses materialize.
- Policy implication:
  - Targeted financial sector action, complemented by continued ECB liquidity support, is necessary and would ultimately benefit the real economy.
  - Preconditions for financial stability: maintaining macroeconomic stability, prudent public finances, and continuing structural reforms to raise Italy’s growth rate.
  - Specific high-priority measures: increase provisions, improve bank efficiency and profitability, develop a market to dispose of impaired assets, and strengthen capital and funding plans where needed.
  - Many steps have already been initiated by the Bank of Italy (BI) and need to continue.
  - The forthcoming asset quality review and stress tests by the ECB could help pinpoint additional necessary actions, depending on design and available backstops.
  - Continued liquidity support by the ECB would be critical until funding conditions improve.

### Governance and supervisory findings
- Foundations:
  - Foundations have been important as stable long-term bank shareholders, but their governance structure, weak internal accountability, and inadequate oversight create risks.
  - Suggested mitigants: tighten banking regulations on related-party transactions and fit-and-proper rules for bank shareholders and directors; strengthen legal framework for foundations to require minimum standards of transparency, corporate governance, and financial management; encourage diversification; ensure robust oversight.
  - The weaker performance of foundations-linked banks in stress tests strengthens the case for governance reforms.
- Cooperatives:
  - The largest cooperative banks should be encouraged to transform into joint stock companies.
- Banca Monte dei Paschi di Siena (MPS):
  - MPS is a systemic bank; its rehabilitation is a key priority.
  - Problems in MPS are partly rooted in an accumulation of governance and management failures.
  - Successful implementation of the ambitious restructuring plan is critical for both MPS and the system.
- Supervisory strengths and gaps:
  - Compliance with international standards for banking and securities supervision is high; supervisory practices are strong and sophisticated.
  - Gaps in banking supervision remain: regulation of related-party transactions; fit-and-proper rules for shareholders and directors; legal authority of BI to take certain corrective actions, such as dismissing individual bank managers.
  - The top fifteen Italian banks are expected to fall under direct supervision of the ECB; preparations for the Single Supervisory Mechanism (SSM) are underway.
  - Consob (securities supervisor) should continue to emphasize transparency and distribution obligations, increase onsite inspections, and strengthen enforcement, including criminal sanctions.
  - Insurance supervision had been relatively weaker, but recent reorganization has placed it in a much stronger footing; key challenge is avoiding supervisory gaps during the transition period.

### Crisis management, resolution, and safety nets
- Current framework:
  - The framework for crisis management and bank resolution has been effective in countering the impact of the crisis but can be further strengthened.
- Recommended enhancements:
  - Allow authorities to differentiate between different classes of creditors in resolution and introduce depositor preference.
  - Resolution regime should prevent shareholders blocking recapitalizations and include bridge bank and bail-in powers.
  - Powers should be deployable at an early stage, including when liquidity regulations are breached.
  - Provide a statutory basis for recovery and resolution plans (RRPs) for all systemically important banks.
  - To prevent conflicts of interest, active bankers should be removed from the boards and executive committees of deposit guarantee schemes.
- Alignment:
  - Most recommendations are broadly consistent with the recent position of the European Council on the draft EU Bank Recovery and Resolution Directive.

### Key recommendations (priorities and timeframes)
- Bank-level recommendations:
  - Issue prudential guidance to ensure a minimum level of harmonization in loan loss provisions and write-off practices [BI] — Short term.
  - Amend law to ensure effective oversight of banking foundations by the MEF, require the largest foundations to publish audited financial statements, have an asset allocation policy aimed at diversification, and impose leverage limits [MEF/Parliament] — Short term.
  - Amend regulation to require that related-party transactions do not carry more favorable terms relative to those with unrelated parties, and that board members with conflicts of interest are excluded from the decision [BI] — Short term.
  - Gradually increase the tax deductibility of bank provisions in the same tax year [MEF/Parliament] — Medium term.
  - Monitor closely the implementation of the restructuring plan for Monte dei Paschi di Siena and prepare contingency measures if plan targets are not reached [MEF/BI] — Medium term.
- Financial sector oversight recommendations:
  - Expand the definition of fit and proper for bank and investment service providers (ISP) directors so that adverse regulatory judgments can be taken into consideration [MEF/Parliament] — Short term.
  - Clarify in supervisory guidance for licensing that the assessment of financial suitability of major shareholders should include the capacity to provide additional capital [BI] — Short term.
  - Adopt a dedicated group supervisory approach for the nationally significant insurers [IVASS] — Short term.
  - Increase use of onsite inspections of ISPs, including asset managers [Consob, BI] — Medium term.
  - Amend law to empower BI and Consob to impose fines not only on individuals but also on financial sector entities and raise the ceiling for sanctions [MEF] — Medium term.
  - Amend law to enable supervisors to remove individual board members, officers, and auditors of financial institutions [MEF/Parliament] — Medium term.
  - Introduce risk sensitivity in the current solvency framework for insurers in anticipation of the EU implementation of Solvency II [IVASS] — Medium term.
- Financial safety nets and resolution recommendations:
  - Provide a statutory basis and detailed guidelines for RRPs to be prepared by all systemically important banks [MEF, BI] — Short term.
  - Adopt depositor preference, expand the resolution tools to include bail-in, bridge bank powers and to recapitalize and transfer ownership, selectively transfer assets and liabilities, and be able to trigger these at an early juncture when the firm is no longer viable [MEF, BI] — Short term.
  - Amend the deposit guarantee framework to provide for ex ante funding, with a back-up credit line from the MEF, and remove active bankers from the board and executive committees of deposit guarantee schemes [MEF, BI] — Medium term.

*International Monetary Fund — Italy FSAP report (prepared by Dimitri G. Demekas and Amadou Sy; September 6, 2013).*

### 1.      The Italian financial system is dominated by banks. Banks account for almost 85 percent

### The Italian financial system is dominated by banks. Banks account for almost 85 percent of total financial sector assets.

### Banking structure and scale
- At end-2012, there were 706 banks with total assets of about 220 percent of GDP.
- Of the 706 banks, 169 were part of 75 banking groups.
- Banks account for almost 85 percent of total financial sector assets.
- Branch density: 1,806 inhabitants per branch in Italy versus a European peer average of 2,168 inhabitants per branch.
- Number of banks by licence type, as of end 2012: Total: 706 (breakdown shown in figures in source).
- Assets in billions of euro by licence type, as of end 2012 (figures shown in source).

### Balance sheet composition and funding
- At end-2012, loans accounted for about 65 percent of total assets.
- 37 percent of loans were to resident non-financial corporations—the highest share in any G-7 country.
- SMEs account for almost 70 percent of business value added.
- Loans to non-residents (mainly in Germany and Austria) are concentrated in large banks and account for a quarter of total loans.
- Sovereign security holdings (mostly Italian sovereign bonds) amount to 9 percent of total assets.
- Banks are funded primarily by resident deposits and retail bonds.
- Deposit-to-loan ratio (including retail bonds) declined from 109 percent in 2007 to 94 percent at end-2012 due to withdrawals of nonresident deposits.
- In Italy, bank bonds held by households are very close substitutes to term deposits (historically popular due to the favorable tax treatment, compared to deposits, in place until 2012).

### Impact of the global financial crisis, sovereign-debt crisis, and recession
- Average nonperforming loan (NPL) ratio climbed from 5½ percent in 2007 to about 14 percent at end-2012.
- Flow of new NPLs remained high (started to abate in 2013).
- Return on assets dropped from 0.7 percent in 2007 to -0.9 percent at end-2011, and recovered to near-zero in 2012.
- Credit growth to the non-financial private sector (year-on-year, corrected for securitization) turned negative in August 2012.
- Bank of Italy (BI) estimates: a 100 bps increase in the sovereign spread results in an equivalent hike in bank bond yields within one quarter and a 60 bps hike in interest rates on new term deposits and repos within 3-4 quarters.
- Banks tapped Eurosystem refinancing facilities heavily; ECB financing of the Italian banking system peaked at EUR 283 billion in July 2012 before declining to EUR 248 in July 2013.  
  - This amount largely invested in liquid sovereign bonds, exceeds Italian banks’ total maturing wholesale debt during the next three years, and is equivalent to almost one-third of the total euro system take-up.
- Announcement of Outright Monetary Transactions (OMT) helped bring down 10-year government bond yields in Italy from 6.7 percent in July 2012 to 4.5 percent at end-December 2012; yields declined further in 2013.

### Capital, solvency, and liquidity metrics
- Aggregate Core Tier 1 (CT1) capital rose by over EUR 40 billion since 2008, raising the system’s CT1 ratio to 10 percent by end-2012.
- Improved solvency ratios partly reflect Pillar 2 capital add-on charges requested by BI and capital buffers mandated by the EBA.
- Italian banks’ leverage ratios compare favorably to those in many other European countries, but solvency ratios remain relatively low compared with peers given larger exposures to corporate loans with higher risk weights.
- Table 2 (63 banking groups, 2007–12) highlights:
  - Total assets, in billions of euro: 2007: 2,709; 2008: 2,816; 2009: 2,711; 2010: 2,765; 2011: 2,800; 2012: 2,849.
  - In percent of GDP: 2007: 174; 2008: 179; 2009: 178; 2010: 178; 2011: 177; 2012: 182.
  - Total deposits, in billions of euro: 2007: 1,542; 2008: 1,431; 2009: 1,358; 2010: 1,458; 2011: 1,436; 2012: 1,513.
  - Total capital ratio, in percent: 2007: 9.8; 2008: 10.4; 2009: 11.6; 2010: 12.1; 2011: 12.7; 2012: 13.4.
  - Tier 1 ratio, in percent: 2007: 6.8; 2008: 7.0; 2009: 8.3; 2010: 8.7; 2011: 9.5; 2012: 10.5.
  - Core tier 1 ratio, in percent: 2007: 6.3; 2008: 6.3; 2009: 7.4; 2010: 7.5; 2011: 8.7; 2012: 10.0.
  - NPL to gross loans: 2007: 5.6; 2008: 6.3; 2009: 9.5; 2010: 10.6; 2011: 11.9; 2012: 14.
  - Return on assets 2/: 2007: 0.7; 2008: 0.3; 2009: 0.3; 2010: 0.3; 2011: -0.9; 2012: -0.1.
  - Provisions to NPL: 2007: 50; 2008: 46; 2009: 40; 2010: 40; 2011: 40; 2012: 40.
  - Customer deposits+retail bonds to non-interbank loans: 2007: 109; 2008: 98; 2009: 99; 2010: 99; 2011: 93; 2012: 94.
- Table 3 (by size, 2008 and 2012) provides size-segmented metrics (selected examples shown in source):
  - Total assets, in billions of euro (2012): All: 2,849; Large: 2,318; Medium: 458; Small: 73.
  - Total capital ratio, in percent (2012): All: 13.4; Large: 13.9; Medium: 11.3; Small: 13.6.
  - NPL to gross loans (2012): All: 14.0; Large: 14.2; Medium: 13.2; Small: 19.1.
  - Return on assets 2/ (2012): All: -0.1; Large: -0.1; Medium: -0.1; Small: 0.5.

### High-profile case: Banca Monte dei Paschi di Siena (MPS)
- MPS characteristics and scale:
  - Italy's third largest bank with EUR 224 billion in assets.
  - 7 percent domestic market share; almost 3,000 branches; over 30,000 employees.
  - Historically controlled by the banking foundation of the city of Siena.
- Causes and timeline:
  - Large acquisition: acquired Antonveneta in early 2008 for over EUR 9 billion.
  - Engaged in structured repo transactions in 2008–09 tied to sovereign bond carry trades; these contributed to liquidity deterioration and frequent margin calls.
  - Several aspects of these transactions are subject to criminal investigations.
  - Decline in deposits in early 2013 (later arrested).
- Key metrics and interventions:
  - MPS had the highest NPL ratio among large Italian banks (almost 22 percent at end-March 2013).
  - State injected a total of EUR 4.1 billion (0.3 percent of GDP) of capital in 2009 and 2013.
  - MPS relied heavily on ECB liquidity facilities: EUR 29 billion outstanding in the form of LTRO, equivalent to 13 percent of its total assets.
  - Recapitalization instrument (“Monti bonds”) carries a 9 percent and escalating coupon, payable in cash or shares; if shares are issued due to losses, the state would own 35 percent of shares by 2015.
  - Restructuring plan aims to raise EUR 1 billion of new capital, revamp services, cut staff and administrative costs, and close branches; plan requires European Commission approval under state aid rules.
- Supervisory actions:
  - BI intensified onsite inspections, closely monitored liquidity, banned bonuses and dividends, and exercised moral suasion to change senior management and Board composition.
  - MPS did not pass the EBA recapitalization exercise in 2012; the early 2009 “Tremonti bonds” were folded into the larger recapitalization package.

### Economic outlook and risks for banks
- IMF forecasts cited:
  - Real GDP to decline by 1.8 percent in 2013, followed by growth of 0.7 percent in 2014.
- Short-term and medium-term implications:
  - Domestic demand not projected to recover before late 2013 at the earliest.
  - Elevated uncertainty around growth prospects in Italy and Europe means downside risks dominate the short-term forecast.
  - Over the medium term, low trend productivity growth likely to keep economic growth—and thus investment and profit opportunities for Italian banks—modest.
  - Financial fragmentation is likely to keep funding costs high.
- Systemic priority:
  - Rehabilitation of MPS, as a systemic bank, is an important priority for the system as a whole.

*Source: IMF staff report content provided in the supplied PDF content unit.*

### 8.      The same factors are posing major challenges for the Italian insurance industry. The

### 8.      The same factors are posing major challenges for the Italian insurance industry. The

### Insurance sector: challenges and market perceptions
- Current weak economic environment and high exposure to sovereign debt, together with major impending regulatory changes (such as Solvency II, IFRS, IMD2, and PRIP), are creating major challenges for Italian insurers.
- Recent changes in the supervisory architecture, notably the setting up of IVASS, risk creating supervisory gaps during the transition period.
- Market signals:
  - Equity prices at about half of their 2007 values.
  - Insurers’ CDS spreads closely mirroring sovereign CDS spreads.

*Figure noted in source: Selected Insurers’ Share Price and CDS Spreads (Source: Bloomberg L.P.).*

### Key systemic risk sources and spillovers
- Three broad sources of risk for financial stability:
  - A new negative growth shock or prolongation of the recession could affect bank profitability and lead to further deterioration of asset quality.
  - Renewed stress and dislocations in wholesale funding markets, especially once the LTRO lapses, could have a significant adverse impact on liquidity and refinancing conditions.
  - Renewed pressures on sovereign yields, reflecting an intensification of the euro area crisis, could have a major effect on bank balance sheets and systemic liquidity.
- Evolution of risk balance:
  - Early part of the crisis: concerns about the level of bank capitalization dominated.
  - Height of the sovereign debt crisis: all other risk factors, especially liquidity, peaked.
  - Since ECB interventions: market liquidity risk lowered significantly and Italian banks have increased substantially their capital positions.
  - Nevertheless, market confidence in Italian banks remains low; concerns about asset quality (current and prospective) remain elevated.

### Domestic macro-financial linkages and transmission
- Staff analysis (G-VAR estimates) indicates:
  - On average, feedback effects from other sectors on banks are stronger than feedback effects from banks to other sectors.
  - Italian banks’ credit spreads rise appreciably in case of distress in the real economy, the corporate sector, and the sovereign sector.
  - Weak GDP and credit growth augment corporate sector vulnerabilities, further jeopardizing bank asset quality.
- Recent lending surveys suggest that, since late 2012, credit supply conditions are becoming important, partly due to weak growth expectations.

### Loan quality, corporate vulnerabilities, and provisioning
- Loan quality is the most pressing vulnerability for Italian banks:
  - Sharp hike in NPL (nearly 8 percentage points since 2007 and rising) was concentrated in the corporate sector.
  - Corporate sector NPL ratio: 26 percent as of May 2013.
- Corporate sector leverage:
  - About half of corporate sector debt, largely to banks, is from highly leveraged firms, with interest expense accounting for over half of gross operating profit.
- Household credit risk appears limited given modest household debt burden and substantial positive net wealth (see Appendix II in source).
- Provision adequacy:
  - Loan classification rules in Italy are more conservative, supervisory practices more stringent, and tax deductibility of provisions less generous than elsewhere in Europe.
  - Collateral (mostly real estate) was increased during the crisis and provides an additional, if uncertain, buffer.
  - The Bank of Italy (BI) conducted a targeted inspection program in late 2012–early 2013 on a sample of 20 mid-size and large banks; the inspection covered 40 percent of system NPLs and revealed deficiencies in provisioning practices in a number of banks.
  - Ensuing supervisory action led to an increase of about EUR 7½ billion in provisions reflected in the end-2012 financial statements, and a slight increase in the level of provisioning coverage for the system as a whole.
  - Further raising overall coverage substantially will remain a challenge given continuing asset quality deterioration and low profitability of Italian banks.

### Sovereign exposure and potential impacts
- Banks have Italian sovereign exposures amounting to about 9 percent of the assets, mostly in trading and available-for-sales accounts.
- Lower market prices for sovereign bonds would:
  - Create mark-to-market valuation losses, affecting bank solvency.
  - Reduce the collateral value of these bonds for secured funding, including from the ECB.
- Acute sovereign distress can spill over to other market yields, further aggravating pressures on the financial sector.

### Capital buffers, liquidity, and ECB policy effects
- Many Italian banks have strengthened their capital buffers in recent years, providing some shield against additional shocks and helping cope with the phase-in of Basel III requirements (as noted, Basel III is expected to lead to substantial declines in capital ratios due to phase out of certain capital components; rise in RWA expected to be small).
- Expanded ECB monetary policy framework and LTROs:
  - Market funding by Italian banks has been markedly reduced and replaced by LTRO proceeds, lowering maturing wholesale funding subject to roll-over risks.
  - BI’s weekly liquidity monitoring tool shows potential cash outflows dropped visibly since take up of the two LTROs in early 2012.
  - Expansion of eligible collateral and LTRO uptake contributed to a rise in counterbalancing capacity.

### Cross-border spillovers — inward exposures
- Foreign exposures of Italian banks:
  - About 20 percent of Italian banks’ total assets (US$3.8 trillion as of end-2012) are vis-à-vis foreign counterparties.
  - Two-thirds of these foreign claims are vis-à-vis developed economies, especially core EU countries.
  - Exposures to CEE countries represent about a quarter of Italian banks’ total foreign exposures.
  - A substantial share of claims on CEE is held by affiliates in host countries using local funds.
- Cross-border intra-group liquidity:
  - Data suggest head offices in Italy typically provide funds to foreign affiliates and act as providers of equity capital.
  - No strong sign of liquidity inflows from affiliates to Italian head offices; BI has instructed major banks to limit reliance on intra-group liquidity sharing.

### Cross-border spillovers — outward presence in CEE
- Italian banks have significant local presence and systemic importance in some CEE countries:
  - Italy is the second largest creditor to CEE countries after Austria.
  - In nine CEE countries, the share of Italian banks’ gross foreign claims in percent of total bank assets of the host country is above 10 percent, reaching over 40 percent in Croatia.
  - Local funding through deposits or other funding appears to be important for these host countries.

*Source: _cr13300 - 8.      The same factors are posing major challenges for the Italian insurance industry. The (PDF chapter/section).*

### 20.      The potential direct spillover to global banks of an isolated shock in Italian banks is

### The potential direct spillover to global banks of an isolated shock in Italian banks is limited; instead, macroeconomic conditions in Italy are more important in transmitting shocks from Italy to other countries

### Foreign exposures and channels of spillover
- Global banks have significantly reduced their Italian sovereign and bank exposures; residual risk stems mainly from corporate exposures.
- BIS reporting banks’ exposure to Italy has declined by over 40 percent between end-2007 and end-2012.
- About 60 percent of the remaining claims are vis-à-vis the corporate sector.
- As of end-2012, the total exposures to countries under market stress are generally smaller than creditor countries’ total bank capital in the system, except for French and Swiss banks.

_Source note from text: Source: BIS consolidated statistics, ultimate risk basis; IMF FSI statistics; staff calculation._

### Macroprudential architecture and institutional roles
- Responsibility for financial stability is shared among three entities (BI, IVASS, and Consob), although in practice BI plays the leading role.
- The institutional framework also includes the Ministry of Economy and Finance (MEF), and two deposit guarantee schemes (DGS).
- MEF chairs two interagency committees: the Inter-ministerial Committee on Credit and Savings (ICCS) and the Committee for the Safeguard of Financial Stability (CSFS).
- BI’s remit: monitoring systemic risk, early warning indicators, stress tests, monitoring shadow banks and non-banking institutions, and expanding tools to capture risk concentration.
- Insurance-sector measures used in the crisis included allowing the difference between cost value and market value of EU sovereign bonds available for sale to be used as capital in the form of a “non-distributable reserve” (use peaked in 2011 and declined to negligible levels in 2012).
- Two EU-adaptation options for macroprudential authority implementation (per ESRB recommendation):
  - BI as the macroprudential authority, with formal cooperation arrangements (e.g., an MoU) to cover market infrastructures and non-banking intermediaries where Consob has a key role.
  - A new macroprudential body that would make public recommendations under a “comply or explain” mechanism, with BI maintaining a leading role.
- Consideration to streamline inter-agency committees (e.g., eliminating ICCS and re-focusing CSFS on crisis preparedness and management).

### Stress tests: coverage and methodology
- Stress tests covered banks representing over 90 percent of system assets.
- Solvency stress tests: based on end-2012 data; macroeconomic scenarios covered a three- to five-year period depending on the scenario; banks evaluated against Basel III requirements for Common Equity Tier 1 (CET) and Tier 1 capital.
- Liquidity stress tests: based on end-March 2013 data; one-month horizon.
- FSAP combined BI’s stress testing framework with the FSAP team’s tests; both ran parallel solvency tests using different models but same data and macro assumptions; liquidity tests performed by BI with agreed assumptions.
- Scenario-based solvency tests: baseline, “slow growth”, and “adverse”.
  - Baseline: real GDP growth similar to April 2013 WEO forecast.
  - “Slow growth”: domestic growth lower than baseline by 0.7 percentage points each year during 2013–17, leaving the five-year cumulative growth rate at -0.1 percent.
  - “Adverse”: incorporates a 1¼ standard deviation shock (-4.2 percentage points compared to baseline) on two-year cumulative real GDP growth rate during 2013–14; includes mark-to-market losses from Italian sovereign securities in trading books and AFS accounts assessed with the AFS filter and supplemented by a single-factor test of sovereign risk covering all exposures without the AFS filter.
- Banks assessed against Basel III minimum requirements with the conservation buffer phased in per Basel Committee arrangements.

### Solvency stress test results — system-wide findings
- System-level:
  - In the baseline, capital adequacy would remain well above Basel III regulatory minima for the system as a whole.
  - Between five and ten banks (one-seventh to one-tenth of the covered sample by assets), depending on capital definition (CET1 or Tier 1), would need to increase capital to comply with Basel III; the shortfall would be EUR 1.1-3.4 billion, or 0.1-0.2 percent of GDP by the end of 2017.
  - In the “slow growth” scenario:
    - System-wide capital ratios would decline but remain well above Basel III minima.
    - Between 11-15 banks (a fifth to a quarter of the sample), depending on capital definition, would see solvency ratios slip below regulatory minima.
    - The total shortfall would be EUR 5-10 billion (0.3-0.7 percent of GDP) by 2017 for CET1 and Tier 1 capital, respectively.
  - In the “adverse” scenario:
    - System-wide CET1 capital would decline by EUR 51 billion (Tier 1 capital by EUR 59 billion) but both would remain at or above respective regulatory minima by 2015.
    - Credit losses would be the main driver; sovereign and other market losses and weak profitability also contribute.
    - Capital ratio for 13-20 banks (a quarter to a third of the sample) would fall below CET1 and Tier 1 minima, respectively.
    - Total shortfall limited to EUR 6-14 billion (0.4-0.9 percent of GDP) for CET1 and Tier 1 capital by the end of the test horizon; shortfall could rise further after the test horizon depending on profit recovery.

### Bank-level vulnerabilities and heterogeneity
- By bank size:
  - Mid-size banks (banks ranked 11–20) are relatively more vulnerable: least progress in adding extra capital buffers, weaker initial capital at end-2012, relatively low operating profits under stress, and higher impact from Basel III phase-in imply aggregate capital ratios for mid-size group would drop below hurdle rates in both “slow growth” and “adverse” scenarios.
  - Large (top 10) and small banks (the rest) would maintain capital ratios at or above hurdle rates even in the “adverse” scenario.
- By ownership/type:
  - Banks influenced by banking foundations and cooperative banks appear particularly vulnerable.
  - Banking foundations defined as those in which foundations control at least 20 percent of shares.
  - Banking-foundation-influenced banks: aggregate capital ratio for this group would fall below hurdle rates even in the baseline; in the “adverse” scenario, the shortfall for this group would be up to EUR 5.4 billion (0.3 percent of GDP).
  - Cooperative banks (banche popolari) would not pass the test under the “adverse” scenario.
  - Together, these two groups account for more than three-quarters of the total shortfall for the system as a whole in the “adverse” scenario.
  - Drivers: relatively lower profitability, weaker initial capital, and a higher fraction of capital not eligible for Basel III CET1 and Tier 1.

### Sovereign-risk and credit-concentration sensitivity tests
- Sovereign risk:
  - The “adverse scenario” already includes a hike in sovereign spreads ranging between 110-270 bps across maturities compared to end-2012 levels.
  - Direct impact on capital ratios from this hike amounts to 50 bps (reflects stress applied only to HFT and AFS portfolios and AFS filter mitigation).
  - Sensitivity test stressing the entire sovereign portfolio (without AFS filter): a 100 bps hike across all sovereign maturities from end-2012 would imply a 70 bps decline in capital ratios.
- Credit concentration:
  - Simulated default of largest borrowers indicates credit concentration risk is moderate.
  - The default of all large exposures would reduce the banking system’s capital by less than half.

### Liquidity stress tests — design and results
- Framework:
  - BI’s liquidity stress testing measures Net Liquidity Position (NLP): liquidity buffer (“counterbalancing capacity”) net of cash outflows.
  - Liquidity buffer consists of unencumbered ECB eligible collateral valued at market prices net of ECB haircut.
  - A bank passes if NLP remains positive throughout the one-month horizon.
  - BI monitors systemic liquidity weekly and uses the framework to stress market and funding risks (including Eurosystem funding).
- Two scenarios tested:
  - “Adverse scenario”:
    - One-notch sovereign downgrade (raising ECB haircuts applied to Italian sovereign securities to maximum possible level).
    - Two-notch downgrades to banks (bringing several Italian banks, including large banks, to below investment grade and making their securities ineligible for ECB operations).
    - Deposit outflows.
    - 150 bps jump in sovereign spreads leading to declines in liquidity buffer and higher margin calls for repos.
    - Combined shocks are more extreme than severe liquidity stress experienced at end-2011.
  - “Alternative scenario”:
    - Similar to “adverse scenario” but without deposit outflows and with a 180 bps jump in sovereign yields.
- Results:
  - Availability of ECB liquidity has removed Italian banks’ vulnerability to wholesale funding volatility, especially for large banks.
  - Banking system can withstand shocks in the “adverse scenario”: NLP remains comfortably positive for the system as a whole.
  - Five small and mid-size Italian banks and two foreign banks do not pass the adverse test; they represent a small share of the system and fail mainly because of deposit withdrawals.
  - Under the “alternative scenario” (market funding only), almost all banks pass except one Italian and one foreign bank, as LTROs have largely substituted short-term wholesale funding and eligible collateral holdings increased.

*Source: BIS consolidated statistics, ultimate risk basis; IMF FSI statistics; staff calculation.*

### 35.      Deposit outflows are the single largest component of the liquidity pressures under the

### Deposit outflows are the single largest component of the liquidity pressures under the stress scenarios

### Liquidity Stress Test Results
- Deposit outflows are the single largest component of the liquidity pressures under the stress scenarios.
- Mid-size and small banks that rely more heavily on deposits for funding are therefore the most affected.
- Foreign-owned banks operating in Italy show a weaker liquidity position and a considerably higher sensitivity to liquidity shocks.
- Aggregate Net Liquidity Position (NLP) metrics referenced in figures:
  - Banks (33)
  - Top 5
  - Medium-Large
  - Small
  - Foreign Subs (6)
- Outflow rates used in the “Adverse Scenario”: 5 percent for retail customers, 20 percent for corporate depositors, and 33 percent for sovereign and public sector entities.
- Stress tests report:
  - NLP before stress and NLP after stress (in percent of total assets, left scale).
  - Number of banks with stressed NLP below 0% (right scale).
- Contributions to declines of NLP shown by component: Downgrade/Sovereign spread, Wholesale outflow, Deposit outflow (In percent of total assets).

### Overall Assessment and Caveats
- Stress test results should be interpreted with caution:
  - FSAP stress tests are based on market and supervisory data available at a certain point in time, without independent validation of these data.
  - Results could differ if ongoing inspections by BI or the forthcoming asset quality review by the ECB result in significant changes in credit risk assessment.
  - Stress tests provide estimates under hypothetical scenarios based on simplifying assumptions and do not fully incorporate second-round effects or the impact of policy responses.
  - Non-linear effects may be captured, but unknown patterns could emerge, especially under extreme shocks.
  - Renewed distress on the sovereign could have more pervasive effects beyond direct impacts measured in stress tests.
  - Stress tests use Basel III regulatory minima as hurdle (“pass-fail”) rates; markets and regulators (through Pillar 2) may demand higher capital ratios.
- The fragile financial situation of the Italian corporate sector increases uncertainty; a delayed recovery or weaker economy could force corporates to default or restructure, eroding bank profits.
- FSAP stress test results underscore the value of extra capital buffers above regulatory minima and ECB liquidity support in an uncertain environment.
  - These backstops need to continue until the European crisis is convincingly over and the Italian economy and financial system are on the path of sustainable recovery.

### Policy Recommendations (Targeted Financial Sector Actions)
- Increase provisions.
  - Increasing provision coverage would strengthen banks’ capacity to absorb losses and bolster credibility.
  - BI targeted inspections already impacted bank provisions; BI plans to extend this program.
  - The forthcoming ECB asset quality review will probe loan classification and collateral valuation practices.
  - Changing the tax treatment of loan loss provisions to allow deductibility in the same tax year could provide an important incentive.
  - BI should issue guidelines to ensure minimum harmonization and strengthen prudential considerations in loan loss provisions and write-off practices.
- Improve efficiency and profitability.
  - Italy’s banks have yet to reap full benefits of consolidation; the number of banks is still large, and Italy has more branches per capita than other European countries.
  - Short-term scope to improve cost structure; longer-term consolidation could generate more economies of scale.
- Dispose of impaired assets.
  - Accelerating disposal of impaired assets, for instance through NPL sales, would help clean balance sheets.
  - There is scope for market-based solutions; accelerating judicial process for foreclosing and debt restructuring could make a major contribution.
  - Key to benefits is effective transfer of credit risk to the buyer.
- Strengthen capital plans, where needed.
  - The Italian banking system as a whole appears able to meet regulatory minima under baseline projections.
  - Stress test results underscore the benefit of extra capital buffers above regulatory minima; these capital buffers should, as a minimum, be maintained.
  - Some weaker banks—particularly among cooperative banks and banks under considerable influence of banking foundations—need prompt capital planning; without action several would face difficulty complying with Basel III requirement even under the baseline.
  - BI has already required additional Pillar 2 capital buffers (for Basel III and asset quality) and issued guidelines on remuneration and dividend policy.
  - Note: “18 This would also be consistent with the EBA recommendation issued in July 2013, subsequent to the FSAP.”
- Strengthen medium-term funding plans.
  - Resilience in liquidity tests largely reflects their short-term nature.
  - Over the medium term, many banks will need to reduce the funding gap and find viable alternative funding sources to prepare for eventual expiration of the LTROs.

### Financial Sector Oversight and Infrastructure
- Italy’s financial sector oversight and payments infrastructure are a critical pillar of financial stability.
- Compliance with international standards for banking and securities supervision is high relative to other advanced economies; insurance supervision has been relatively weaker but recent reorganization will strengthen it.
- Assessment of financial sector oversight was based on detailed compliance assessments with supervisory standards for banking, securities, and insurance; associated ROSCs are included in a separate document.

### Banking Supervision
- Italy was the first country assessed under the revised BCP approved by the Basel Committee in September 2012 and requested assessment on both essential and additional criteria.
- BI has a strong supervisory review process and applies Pillar 2 capital add-on extensively.
  - Supervisory Review and Evaluation Process (SREP) grades key risk areas and assigns overall risk grades.
  - BI takes corrective actions on quantitative and qualitative issues.
- Gaps in legal and regulatory framework are largely mitigated by intensive supervisory action, but areas need attention:
  - Lack of powers to suspend and remove individual directors and senior managers may hamper BI’s corrective action capacity.
  - Narrow definition of fit and proper criteria should be expanded to account for adverse regulatory judgments for directors and financial soundness of shareholders.
  - Lack of power to remove external auditors is a limitation.
  - New regulation for related-party lending fills a gap but has deficiencies: some exposures risk-weighted for limit calculation, no specific requirement that related-party lending be on market terms, and definition not aligned with large exposures definition. BI can apply stricter definitions via supervisory discretion.
  - Regulatory framework for country and transfer risk management is not adequate; BI should issue guidance applicable to all banks.

### Securities Markets Supervision
- Very high level of implementation of IOSCO principles; legal and regulatory framework is sound and offsite supervision arrangements are sophisticated.
- Dominance of banks as issuers, managers, and distributors is a key source of conflict of interest; Consob has emphasized distribution obligations since 2009.
- Offsite supervision should be complemented by additional onsite inspections to detect conduct, operational risk, governance, and internal control weaknesses.
- Enforcement should be strengthened:
  - Remedial actions are necessary but not sufficient; stronger fines and ability to impose sanctions on legal entities are recommended.
  - Criminal sanctions should be used sparingly and strategically.
- Licensing framework should be strengthened:
  - Expand fit and proper definition and add power to remove individual directors.
  - Establish consultation process with Consob for reviews of bank applications to provide investment services.
  - Streamline twin peak structure to eliminate ambiguities and strengthen functional approach.

### Insurance Supervision
- IAIS assessment (based on situation prior to reorganization on January 1, 2013 and transformation of ISVAP into IVASS) found adequate regulatory framework but revealed gaps.
  - ISVAP was poorly organized, undertook few inspections, and had weak internal quality control; reorganization is addressing these gaps.
  - Valuation and capital practices remain based on Solvency I; brokers are not properly supervised; risk management and consumer protection are strong.
- Critical areas needing improvement:
  - Move from Solvency I to stronger risk-sensitive valuation and capital practices.
  - Clarify margins, parameters, and technical reserve calculation methodology.
  - Overhaul supervisory structure and processes, including quality controls and specialized onsite supervision.
- Transition risks:
  - Ensure reorganization into IVASS does not create gaps; IVASS in existence since January 1, 2013 with preparations since September 2012.
  - IVASS supervising a critical merger of major insurers; failure could have substantial market impact.
  - Continue quality work on internal model pre-approval processes; sufficient resources and expertise required.
- Stress testing:
  - IVASS’s annual industry-wide stress test replaced by EIOPA stress test; disadvantage is lack of tailor-made shocks for Italian market.
  - IVASS should design market-specific severe but plausible macro scenarios and use reverse stress testing as a regular supervisory practice.

### Financial Sector Governance
- Banking foundations are a distinctive feature of Italy’s banking system:
  - They were critical in bank privatization in the 1990s and have been stable long-term shareholders, supporting recapitalization efforts (about one-fifth of the capital raised by the largest Italian banks came from foundations).
  - Foundations have peculiar governance structure, weak internal accountability, little oversight (especially after a 2003 Constitutional Court decision curtailing MEF authority), non-uniform accounting rules, and sometimes non-transparent appointment of governing bodies.
  - At least 20 percent of banking system assets are currently controlled or under the significant influence of one or more foundations.
  - Foundations are controlling shareholders in four of the top 10 banking groups and nominate the majority of the board members of the two largest groups.

*Source: IMF staff summary of the FSAP stress test and oversight assessment as presented in the provided content.*

### 56.      The stress test results make a compelling case for strengthening governance and

### _cr13300 - 56.      The stress test results make a compelling case for strengthening governance and

### Governance and management of foundation-owned banks
- Finding: The stress test results make a compelling case for strengthening governance and management in banks owned or significantly influenced by foundations. MPS has also been until recently under the control of a single foundation.
- Risk: Chronic weaknesses in governance can lead to trouble.
- Regulatory recommendations:
  - Tighten banking regulations in a few areas, such as fit-and-proper rules to ensure high standards for bank directors and the financial soundness of major bank shareholders, including their ability to provide additional financial support, if needed.
  - BI should consider tightening its related party transaction provisions in the current regulation or, at a minimum, use its supervisory discretion to apply stricter definition of related parties to and intervene in situations when economic influence is relevant.
- Legal framework reform for foundations (should ensure):
  - Minimum standards of transparency. Foundations should follow a harmonized set of accounting principles to enhance transparency and public accountability. Audited financial accounts should be required at least for the largest foundations.
  - Investment policy aimed at diversification and caps on leverage. Foundations should move towards a more balanced portfolio and follow prudent asset allocation policies (diversification, minimum reserves invested in safe assets, etc.). A leverage cap would also be advisable in order to prevent excessively leveraged acquisitions.
  - Stronger corporate governance arrangements, such as term limits for foundation Board members and a cooling-off period between a political office and the appointment to a foundation (or vice-versa)—a provision currently left to the "Code of Ethics."
  - Robust oversight. The MEF (or a new entity) should be empowered to play the oversight role originally envisaged in law 461/98, with adequate sanctioning powers.

### Cooperative banks (banche popolari)
- Finding: Certain governance aspects in cooperative banks should be re-assessed. The cooperative bank model works well locally but can be problematic for larger cooperatives operating at a national or international level.
- Governance concerns:
  - Restrictions on voting rights (“one member, one vote”), limits on proxies, caps on ownership, and membership requirements may hamper effective shareholder control once the bank grows beyond a certain size and may thwart potential outside investors.
  - These effects can be especially pernicious in a crisis.
- Recommendation: BI has urged large listed cooperative banks to reform and turn themselves into joint stock companies.

### Anti-money laundering / Combating the financing of terrorism (AML/CFT)
- Finding: Italy was last assessed against the AML/CFT standard in 2005 and is due for a reassessment.
- 2005 assessment conclusion: Italy’s AML/CFT framework was extensive and mature but required some improvements.
- Developments: Authorities reported having taken steps to address the deficiencies identified, notably by strengthening customer due diligence rules and reporting of suspicious transaction requirements.
- Further action: Necessary to implement the 2012 AML/CFT standard.
- Process: The authorities have requested the Fund to conduct its next assessment, which is tentatively scheduled to take place in January 2015.
- Note: Although outside the 18-month timeframe, under the circumstances, the planned assessment is acceptable for the purposes of the FSAP.

### Systemically important infrastructures — CC&G (Italian CCP)
- Role and links:
  - The Cassa di Compensazione e Garanzia (CC&G) is systemically important for the Italian market and, through the link with the French CCP, also relevant for cross-border financial stability.
  - CC&G is the only CCP that clears the cash and derivatives markets operated by Borsa Italiana and shares clearing of electronically traded Italian government securities (cash and repos) with LCH Clearnet SA.
- Risk exposures:
  - Through the link with LCH Clearnet SA, a substantial amount of cross-border transactions is handled and large credit exposures have built between both CCPs.
  - The positions held by the two CCPs towards the link are currently imbalanced and the bilateral inter-CCPs exposures have greatly increased since 2008.
- Historical episode:
  - In November 2011, LCH Clearnet SA raised its requirements against positions in Italian government securities substantially (500 basis points on 7–10 year maturities) following the widening of spreads between Italian government paper and European benchmark securities that reached 550 basis points. CC&G had to raise its own margin requirements to maintain the connection with the French CCP. The increase was notified to the markets and went into effect at the opening of the trading day on November 9; the same day CC&G requested the posting of intraday margins about 12 times greater than the average for the other months of 2011. Source: April 2012 BDI Financial Stability Report.
- Resilience and improvements:
  - CC&G’s current risk management framework is robust and further changes are in the process of being implemented to comply with EMIR and PFMIs, and improvements are underway in the risk management of the link with LCH Clearnet.
  - Concern: Current arrangements that require each CCP to deposit initial margins to each other and to exchange an additional initial margin do not appear sufficient to cover fully all current and future exposures in extreme but plausible scenarios, as required by the PFMIs.
  - Action: The French and Italian authorities have jointly requested both CCPs to provide an in-depth joint analysis of the risks created by the current imbalance, and proposals (compliant with EMIR requirements for interoperability arrangements) to adequately address the identified risks, if needed. This issue has been given high priority.

### Financial sector safety nets — Supervisory early intervention
- BI powers:
  - BI is empowered to adopt a broad range of measures against banks, graduated to reflect the gravity of the situation.
  - The Banking Law empowers BI to take different measures when a bank does not comply with applicable laws or regulations, or when sound and prudent management is at risk.
- Gaps identified:
  - BI lacks powers to suspend and replace management, remove the statutory auditors, and apply pecuniary sanctions at the bank level.
  - The BCP assessment highlighted these gaps; some will be addressed in the context of the forthcoming CRD IV directive.
- Recommendation: The authorities should provide the BI with all these powers in legislation.
- Recovery and Resolution Planning (RRP):
  - While the RRP process is underway for Unicredit Group (UCG), there is no clear regulatory framework for RRPs.
  - BI currently relies on its general power to obtain information to require the preparation of UCG’s recovery plan.
  - Lack of a clear legal basis for RRPs has led to difficulties in obtaining relevant information from the Polish subsidiaries of UCG, causing possible gaps in the RRP.
  - Recommendation: The authorities should provide a statutory basis and develop comprehensive guidelines for preparing RRPs, which should be required for all systemically important domestic banks.

### Official financial support (crisis-era measures and principles)
- Historical measures and impacts:
  - Between October 2008 and February 2009, the authorities announced a series of measures to support liquidity and solvency of banks, including a three-year deposit guarantee.
  - These measures helped preserve depositor confidence and maintain financial stability without ultimately entailing significant costs.
  - Banks strengthened buffers by raising capital from core shareholders, selling nonstrategic assets, and cutting dividends.
  - Debt capital was made available to banks by the state in 2009 (the so-called “Tremonti bonds”) to avoid excessive deleveraging. Only four banks used this instrument. One of these banks, MPS, has gone on to receive significant further official support, while the other three have repaid or are in the process or repaying these bonds.
- Principle: State capital support should be accompanied by measures to protect taxpayer money and mitigate moral hazard.
  - State recapitalization of insolvent banks should entail some burden-sharing with private owners and creditors (e.g., attributing losses to shareholders and subordinated creditors through dilution and/or restrictions on dividend and coupon payments).
  - Should be accompanied by measures to mitigate moral hazard (such as replacing the Board and senior managers responsible for the failings, and placing restrictions on compensation to management).
  - Plans should be put in place to secure new capital from private sector sources and ensure an exit strategy for the state.
- MPS recapitalization specifics:
  - The latest public recapitalization scheme for MPS gives the bank time and incentives to restructure and secure new private capital, but implementation should be closely monitored.
  - If the bank continues to make losses and coupon payments on these bonds are made in shares, the state will progressively become the major shareholder (with approximately 35 percent of the shares) by 2015.
  - Interim arrangements: A new management has started implementing the restructuring plan and searching for new investors; however, uncertainties include MPS’s weak starting position (its NPL ratio is well above that of its peers), difficult economic environment for restructuring, possible deleveraging effects on loan quality, protracted approval by the European Commission creating uncertainties for potential new investors, and the state not represented at the Board and relying on new management and BI supervision.
  - Recommendation: To safeguard taxpayer interest, intensified oversight by BI should continue and the authorities should prepare contingency measures if plan targets appear out of reach.
- Emergency liquidity assistance (ELA) and Eurosystem rules:
  - BI provided an asset swap facility for the sector as a whole in 2008-09, which disbursed only EUR 5.4 billion.
  - After this facility expired, BI provided an asset swap on a bilateral basis with MPS in the fall of 2011 which, while not technically ELA, had a similar effect.
  - Subsequently, the Italian banking system has been able to directly access significant liquidity from the ECB using ample available collateral. ECB financing of the Italian banking system peaked at EUR 283 billion in July 2012, equivalent to one-quarter of the total euro system take-up.
- Disclosure concern:
  - The current arrangements for publishing the monthly balance sheet of BI could diminish the usefulness of ELA as a policy tool because disbursement of sizeable ELA could be inferred from the published format.
  - Recommendation: Financial stability considerations may justify flexibility in both the content and timing of the disclosure of information relating to ELA provision, for example by considering a different format with less granularity for BI’s monthly accounts.

### Orderly and effective resolution (framework and recommended enhancements)
- EU context:
  - Discussions took place against impending changes in the resolution regime at the EU level. The European Council’s position on the draft BRRD in July 2013 crystallized many changes; the draft BRRD remained subject to agreement with the European Parliament and the Directive was only expected to be finalized by end-2013 or early 2014.
  - The proposed directive establishes a range of instruments for pre-emptive, early intervention, and resolution stages, including appointment of a special manager and a broad range of resolution powers (sale of business, bridge institution, asset separation and bail-in).
- Current Italian resolution framework:
  - The framework and toolkit in Italy has been successfully used to resolve small banks during the crisis.
  - The regime extends to parent banks, banking groups, and investment firms, and has two major tools typically deployed sequentially:
    - Special administrator (SA): appointed by BI when a bank has suffered serious capital (but not liquidity) losses or there are serious irregularities in administration or violations of law or regulations. The administrator assumes the powers of the managers but cannot take decisions pertaining to shareholders (e.g., mergers, large divestments, new capital issues).
    - Compulsory administrative liquidation (CAL): can be launched by BI based on the same triggers as SA, but when grounds are of an exceptionally serious nature. The CAL can also be triggered independently, without the need to go through SA. These powers can be used to suspend payments and, in the case of CAL, trigger liquidation and deposit insurance payouts, and transfer assets and liabilities (“purchase and assumption”—P&A) to a purchaser.
  - Since 2009, twenty-seven banks and one banking group have been placed into SA of which nine have subsequently went into CAL.
- Cost and creditor-treatment considerations:
  - The current resolution powers are effective at preserving depositor confidence but could increase the potential cost to the deposit guarantee funds (DGS).
  - Only in rare cases—for example where DGS funds were used to payout insured depositors (one out of the 28 recent resolutions) in liquidation—have uninsured creditors incurred losses.
  - In most resolutions, DGS funding is used to support the recovery or merger of the bank (“open bank assistance”) or to fund transfer of all creditors, not just insured or even eligible deposits, to a purchaser.
  - Protecting uninsured creditors may be necessary in a systemic crisis, but transferring only insured deposits would generally entail lower cost to the DGS and lower moral hazard, as uninsured creditors (e.g., bondholders) would also absorb losses.
  - Constraint: In Italy, transferring only insured deposits would not be permitted even in benign systemic conditions due to the strict pari passu provisions in the Italian civil code and insolvency law (Article 2741 of the Civil Code and Article 11 of the Insolvency Law).
- Recommendations to align with FSB Key Attributes (broadly consistent with draft BRRD):
  - Provide powers for selective transfer of assets and liabilities (e.g., only insured deposits and assets) in legislation, complemented by explicit depositor preference and an exemption from the pari passu requirement.
  - Expand the resolution toolkit to prevent shareholders blocking recapitalization or mergers and include bridge bank, bail-in, and bad-bank powers.
  - Revise the triggers for resolution powers to allow deployment at an early juncture, when the firm is no longer viable or likely to be no longer viable, and include both quantitative (e.g., when regulatory liquidity or capital requirements are seriously breached) and qualitative triggers.
  - Provide a statutory test in the Banking Law to ensure that any assistance provided by the DGS is least cost, net of recoveries.
  - Curtail the courts’ powers to suspend or reverse resolution measures and ensure redress should only take the form of compensatory damages.

*Italicized source attribution: IMF staff summary of chapter content.*

### 75.      The MEF’s role in commencing intervention proceedings could be reconsidered.

### _cr13300 - 75. The MEF’s role in commencing intervention proceedings could be reconsidered.

### MEF role in commencing Special Administration (SA) or Co-ordinated Administration of Liquidation (CAL)
- Current framework:
  - BI cannot initiate SA or CAL on its own; an MEF decree is required.
  - The system has worked well to date: the MEF has "thus far always endorsed BI’s assessments," and both BI and the MEF consider the arrangement appropriate.
  - MEF endorsement is already required when public funds are likely to be involved.
- Recommendation / consideration:
  - To prevent any future possibility of divergence of views or conflicts of interest, consideration should be given to empowering BI to commence SA or CAL without MEF approval for bank failures that do not present a systemic risk.
  - MEF endorsement should continue to be required when public funds are likely to be involved.

### Deposit Guarantee Schemes (DGSs): structure and mandate
- Two DGSs:
  - Interbank Deposit Guarantee Fund (FITD) — for banks incorporated as joint-stock companies and cooperatives.
  - Mutual Bank Depositor Guarantee Fund (FGDCC) — for mutual banks.
- Legal and operational features:
  - Both are private-law consortia of banks, administered by representatives of member banks and supervised by BI.
  - Broad mandate includes paying out insured deposits upon liquidation, providing open bank assistance, and funding P&A transactions, provided it is less costly than a payout of insured deposits.
  - In line with EU directives: coverage is EUR 100,000 per depositor per bank and payout has to be made within 20 working days.

### Governance and funding issues for DGSs — findings and recommendations
- Governance:
  - Current composition: active bankers sit on the Boards and Executive Committees, with a delegate of BI as observer.
  - Risks: the presence of active bankers could create potential conflicts of interest and access to commercially sensitive information given the DGSs’ broad mandates.
  - Recommendations:
    - Active bankers should be removed from the Boards and Executive Committees and replaced with independent members.
    - Consider including voting representatives from the MEF and BI.
    - Establish a bankers’ consultative committee distinct from the Board and Executive Committee to keep the banking community informed and consulted on major policy changes while protecting confidentiality.
- Funding:
  - Current practice: DGSs are currently ex-post funded but have been able to raise funds quickly when needed.
  - Recommendation:
    - Move to an ex-ante funded scheme to underpin credibility and reduce the pro-cyclical effect of ex-post funding. This would align with proposed amendments to the EU DGS Directive and the draft BRRD.
    - Provide access to credible back-up funding: an unsecured credit line from the MEF should be made available at market rates.
    - Efforts should be made to assess and enhance public awareness of the DGSs.
- Creditor ranking and depositor preference:
  - Current legal position: while the DGS is subrogated to the claims of a depositor, depositor preference rights are not currently embedded in the law.
  - Recommendation:
    - Insured depositors and the DGS (through subrogation) should be given a priority ranking over the estate of the failed bank.
    - Suggested order: preferred insured deposits, then eligible deposits, then other senior creditors — to reduce DGS resolution costs and facilitate partial transfer and bail-in powers.
    - This approach would be consistent with the current draft BRRD.

### Household sector vulnerability and stress scenarios (key statistics and stress results)
- Baseline metrics:
  - 21 percent of households are indebted (BI’s 2010 Survey of Household Income and Wealth).
  - Vulnerable households (debt service above 30 percent of income) represent 10 percent of indebted households.
  - Vulnerable households hold about 20 percent of total household debt.
  - Only 1.3 percent of household debt is held by vulnerable households with negative net wealth ("debt-at-risk").
- Adverse and extreme scenario results:
  - Adverse scenario: income declines by 3 percent and interest rates increase by 100 bps:
    - Share of vulnerable households increases to 14 percent of indebted households.
    - Debt-at-risk rises to 1.6 percent.
  - Extreme scenario: interest rates +300 bps and income -15 percent:
    - Debt-at-risk increases to 2.2 percent.
  - Housing price shocks:
    - A moderate decline in housing prices of 5 percent would increase debt-at-risk to 1.7 percent.
    - An extreme shock to house prices of 20 percent would raise debt-at-risk to 6 percent.
- Observations:
  - Italian households’ substantial positive net wealth provides a buffer, and the loan default rate for Italian households is relatively low.

### Housing market indicators and recent developments (key statistics)
- Housing transactions have dropped by almost 50 percent since 2006.
- Cumulative decline in housing prices of 3¼ percent since the peak in 2011.
- Current market frictions:
  - Slow sale times: more than eight months.
  - Discount-to-ask price: 16 percent.
- Affordability indices suggest the gap between market and long-term prices is limited, but weak activity points to further downward pressure on prices.

### Corporate sector vulnerability and stress scenarios (key statistics and stress results)
- Leverage and distress:
  - Leverage ratio (debt to debt plus equity at balance sheet value): 52 percent on average (2011 BI estimates).
  - Leverage for micro and small firms: 55–58 percent.
  - Proportion of distressed firms (interest expenses above 50 percent of gross operating profits): 31 percent (based on 2011 balance sheets extrapolated to 2013).
  - These distressed firms hold 48 percent of corporate sector debt ("debt at risk").
  - These firms’ loan default rate is already high.
- Stress simulation (BI):
  - Combined severe shock: profits decline by 15 percent and interest rates increase by 100 bps (compared with below a 10 percent profit decline and about a 50 bps rate increase in the 2011-12 downturn).
  - Result: share of debt at risk increases by 9 percentage points to almost 55 percent.

### Links to EU frameworks and potential future operational considerations
- Several recommendations in the DGS domain are broadly consistent with the draft BRRD and draft DGS Directive.
- Note on resolution speed:
  - Once wider resolution powers (which could be used to impose losses on creditors) are introduced in the context of the BRRD, resolution may need to proceed on a faster track (potentially in a matter of days), since the appointment of a special administrator to an open bank may create a greater risk of triggering creditor flight.

*Source: _cr13300 - 75. The MEF’s role in commencing intervention proceedings could be reconsidered.*

### 3. Tail shocks

### 3. Tail shocks

### Scenario analysis
- Macroeconomic variables projected using the BI macroeconomic forecasting model and IMF projection models for Italy and other countries/regions.
- Stress assumptions on sovereign yields, corporate debt yields, and equity as well as fund prices are calibrated from historical volatilities during 2006-2012.

Baseline scenario:
- BI baseline projections (GDP growth very similar to WEO in April 2013).
- Sovereign yields are set at forward rates as of end 2012 (30-160 bps increases across maturities).

Protracted slow growth scenario:
- Growth is assumed 0.7 percentage points weaker than baseline each year during 2013-17 (resulting in growth rates of -2.4, -0.7, 0.3, 0.7, and 0.7 percent); cumulative growth over 5 years at -0.1 percent.
- Sovereign yields are set at forward rates as of end 2012 (30-160 bps increases across maturities).

Adverse scenario (double-dip):
- Growth rates of -4.2 percent in 2013, -1.7 percent in 2014, and 1.0 percent in 2015; cumulative growth over 2 (3) years at -4.6 (-3.6) percent.
- Double-dip shock constitutes a 1¼ standard deviation move in two-year cumulative real GDP growth rate for 2013–14. While growth recovers in the third year, output gap remains.
- Sovereign yields increase by 80-110 bps across maturities compared to the baseline (corresponding to the 80th percentile of the empirical distributions for annual yield changes).
- This amounts to a 110-270 bps increase across maturities compared to end 2012 (corresponding to the 95th percentile of the empirical distribution for annual yield changes).

### Sensitivity analysis
- Sovereign risk: a 100 basis point parallel shift in the Italian sovereign yield curve compared to end 2012 levels.
- Credit concentration risk: Default of the largest, the largest three, five, ten, and all large exposures (according to FSI definition). LGD is set at 45 percent.

### Risks and buffers (credit, market, profits, OBS, cross-border)
Exposures to sovereign:
- Sovereign risks (Italy): mark-to-market valuation of securities in HFT and AFS/FVO.
- In sensitivity test, HTM exposures were stress tested, too (banking and trading book).

Credit risk:
- Estimated according to Basel II/III framework, i.e., EaD*PD*LGD.
- Increasing asset correlations proxied by expert judgment (15% add-on to PDs under the adverse scenario).
- Loan losses estimated according to Basel II/III framework, i.e., EaD*PD*LGD.
- Asset correlations are reflected in changes of RWA as per Basel formula.

Market risk other than sovereign:
- Equity and funds price shock.
- Debt instruments issued by private sector.

Profits:
- Estimated according to evolution of macroeconomic variables (satellite model).
- Interest income declines for the amount of lost income from defaulted loans.
- Interest expenses increase due to rising funding costs (in line with higher sovereign yields).
- Net fee and commission income, and other income are kept constant at 2012 levels.
- No change in business models (i.e., no new income).

Off-balance sheet (OBS) items:
- Included using Credit Conversion Factor.
- In adverse scenario, higher fraction of OBS exposures faces stress.
- Securitization exposures are excluded as analysis revealed that the exposures no longer pose a threat to banks.

Cross-border exposures:
- Credit risks from cross-border loan exposures in all economies, excluding interbank and public loans.

Basel III phase-in:
- The effects on capital components and RWA are estimated by BI in consultation with individual banks for each year of the forecasting time-horizon.

### Behavioral adjustments in macro scenario tests
Balance sheet (first set of assumptions):
- Constant balance sheet and RWA, except for the impact of Basel III.
- EaD under stress increases about 20 percent, reflecting higher use of committed but previously unused credit lines (using a CCF of 75 percent).
- Maturing assets are replaced by exposures of the same type and risk.
- No changes to credit portfolio or funding structure. No credit growth.
- No strategic asset disposals or other managerial responses are allowed.

Retained earnings (first set):
- No payout or tax effects.

Realization of losses (first set):
- Losses are recognized in the same year when a shock hits (no gradual recognition over time is allowed).
- Elimination of prudential filter on AFS portfolio (unrealized gains and losses) as foreseen under Basel III (20 percent a year).

Balance sheet (alternative/time-varying assumptions):
- Time-varying RWA according to regulatory Basel II/III framework.
- No changes to credit portfolio or funding structure. No credit growth. No strategic asset disposals or other managerial responses are allowed.
- Maturing assets are replaced by exposures of the same type and risk.

Retained earnings (alternative):
- Dividend payout: 50 percent payout ratio.
- Positive net operating income is taxed at 25 percent.

Realization of losses (alternative):
- Losses are recognized in the same year when a shock hits (no gradual recognition over time is allowed).
- Elimination of prudential filter on AFS portfolio (unrealized gains and losses) as foreseen under Basel III (20 percent a year).

### Calibration of risk parameters and regulatory standards
Parameter definition:
- Point-in-time (PiT) PDs and LGDs.
- Starting point RWA is measured with through-the cycle (TTC) approach. Additional changes are driven by point-in-time (PiT) PDs and LGDs.

Parameter calibration:
- Starting point PD is proxied by inflows into four NPL categories over total loans, including transitions across different categories.
- Evolution of PDs under stress determined by SUR model incorporating three systematic factors.
- Evolution of PDs under scenarios is forecasted using dynamic credit risk model estimates incorporating latent aggregate credit cycle.
- Initial LGDs are approximated by actual coverage ratios. The coverage ratios as of December 2012 data reflect the results of the BI’s on-site inspections performed in early 2013.
- In each scenario, loan migrations across different NPL categories increase LGDs (at least 20 percent on average across banks).
- LGDs remain constant in baseline scenario. They increase in stress scenarios in line with house prices, as projected in macroeconomic scenarios. Bank specific LGDs increase by 7.5 and 12.4 percent under the slow growth and the adverse scenario, respectively. These shocks are assumed instantaneous and persistent.

Regulatory standards (scenario analysis):
- Capital definition according to Basel III / CRD IV, including Common Equity Tier 1, and Tier 1. Capital components that is no longer eligible for CET1 and Tier 2 capital components are phased out gradually.
- Hurdle rates (including conservation buffer) follow Basel III minimum and phase-in arrangements, including Capital Conservation Buffer on top of all capital definitions. No SIFI surcharges were applied.
- Treatment of prudential AFS filter according to Basel III phase-in, i.e. 20% a year.

Sensitivity analysis:
- Since the reference date was Dec-2012, Basel II capital definitions were applied. Unrealized losses from AFS portfolio is assessed without AFS filter.

### Reporting format for results (capital stress)
Scenario analysis outputs:
- Evolution of CET1 and Tier 1 capital ratios over time, for system as a whole and specific groups of banks (by size: top 10 banks, top 11-20, and top 21-32; by type of institutions: cooperative banks (banche popolari), banks under considerable influence of banking foundations, subsidiaries of foreign banks).
- Evolution of risk parameters resulting from satellite models.
- Contribution of key drivers to aggregate results, expressed in terms of CET 1 ratio.
- Distribution of individual banks’ capital ratios.
- Number of banks and share of total assets below hurdle rates.
- Capital shortfall under each scenario resulting from the aggregation of each bank’s individual capital shortfall (in absolute terms and in relation to annual GDP).

Sensitivity analysis outputs:
- Changes in capital ratios for banking system as a whole.
- Associated recapitalization costs, if any.
- Notes: CRD IV, Capital Requirements Directive IV; CCF, Credit Conversion Factor; EaD, Exposure at Default; LGD, Loss Given Default; TTC, Through-the cycle; PD, Probability of Default; PIT, Point-in-time.
- 1/ The CDP is a specialized lending entity majority owned by the government. It funds itself mostly with postal and customer deposits, and it is required to deposit the liquidity provided by postal savings on an account at the treasury, which makes up nearly a half of its assets.

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### Banking Sector Liquidity Risk

### Institutional perimeter and data
- Institutions included: Top 33 banks, including 6 foreign banks’ subsidiaries, bank by bank analysis.
- Excluding Cassa Depositi e Prestiti.1
- Market share: Together more than 90 percent of the sector’s total assets.
- Data and base date:
  - BI’s standard weekly liquidity monitoring data on consolidated basis (except for foreign banks), covering short, medium and long term maturities for both retail deposits and wholesale funding, including durations.
  - Supervisory information/data on sovereign risk, collaterals, and retail deposit volatility in weekly/monthly time intervals.
  - Base date: Liquidity position data as of end 2012. Rating and other market valuation data as of March 2013.

### Channels of risk propagation (methodology)
- Liquidity stress for 30 days.
- Cash outflows due to refinancing risks with wholesale funding and deposit outflows.
- Reduction of liquidity buffer owing to sovereign and bank downgrades (which can increase haircuts set by the ECB) and declines of market valuation of sovereign securities.

### Risks and buffers
Risks:
- Funding liquidity shock, involving deposit withdrawal and complete loss of wholesale funding.

Buffers:
- Unencumbered securities eligible for ECB collaterals, assessed at market values net of ECB haircut at security-by-security levels (i.e., “counterbalancing capacity”).

### Tail shocks (size of the shock)
Adverse scenario (motivated by actual distress experience at end 2011):
- Refinancing risk with wholesale funding: 0 percent roll-over rate for maturing wholesale funding (including central bank funding).
- Changes of ECB haircut caused by multiple downgrades: one-notch downgrade to sovereign by all four rating agencies (causing jumps in ECB haircut to the highest possible levels for sovereign securities that remain eligible for ECB operation without a program); and two-notch downgrade to banks by all four rating agencies (some banks, including large ones, lose investment grade as a result, and therefore their securities become ineligible for ECB operations) including their covered bonds and asset backed securities.
- Increased volatility of deposits: deposit outflows (5 percent for retail customers, 20 percent for corporate depositors, and 33 percent for sovereign and public entities). Outflow rates are estimated as the maximum experienced by each bank in 2011-12 periods with LCR-prescribed outflow rates as floors.
- Widening credit spreads: a 150 bps jump in Italian sovereign yields, which increases haircut as well as margin requirements for repo positions.

Alternative scenario focusing on market factors:
- Same assumption on refinancing risks and changes with ECB funding as in adverse scenario.
- No deposit outflows.
- Widening credit spreads: a 180 bps jump in Italian sovereign yields.

### Regulatory and market-based standards and parameters (liquidity)
- Maintaining net positive liquidity position (i.e., counterbalancing capacity above potential cash outflows in stress scenario in 30day horizon).

### Reporting format for results (liquidity)
- Changes in net liquidity position and counterbalancing capacity for each scenario.
- Results drivers of banks’ liquidity position and counterbalancing capacity, for each scenario.
- Number of banks (pass rates) below minimum requirement, for each scenario.
- Differentiation between foreign-owned banks operating in Italy and Italian banks (top five, large-medium sized and small-sized).
- 1/ The CDP is a specialized lending entity majority owned by the government. It funds itself mostly with postal and customer deposits, and it is required to deposit the liquidity provided by postal savings on an account at the Treasury, which makes up nearly a half of its assets.

*Source: IMF staff.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-publications/external/pubs/ft/scr/2013/_cr13300.pdf_