Report on the Italian Banking System: NPL, Bad Bank and M&A Wave

Introduction

Markets all around the world have been characterized by high volatility and unsatisfying returns in recent weeks, primarily because of the dramatic drop in oil prices and the alarming data on China’s growth, which has failed to meet analysts’ expectations for the fourth quarter of 2015 by about one percentage point. The issue of growth appears not to be limited to China, with the ECB warning that economic recovery in Europe has not yet picking up as desired, despite the large scale quantitative easing implemented by Mario Draghi. Among the European countries suffering from this situation of semi-stagnation is, of course, Italy.

While there is a good number of different reasons why Italy is failing to achieve recovery (most, but not all of them, attributable to the country’s failure to implement structural reforms when the time was right), one current impediment is definitely the situation of its banking system. In fact, the Italian stock market has seen tremendous sell-offs of troubled institutions such as Monte dei Paschi di Siena (MPS), amid fears of bankruptcy. Just a few months ago, four smaller Italian banks had in practice gone bankrupt (Banca Etruria, Banca Marche, Cassa di Risparmio di Chieti, Cassa di Risparmio di Ferrara), if not for a government decree that “revived” them, saving jobs and depositors’ money, but charging most losses on creditors (which were for a good part simple retail investors).

The purpose of this report is to understand the main cause of the banking crisis, to analyze the solution envisaged by the Italian government, and to take a look at the consequences that a successful implementation of such solution could bring about, especially in terms of consolidation in the Italian banking system.

The Issue: Non-Performing Loans

The problem with Italian banks revolves around the so-called Non-Performing Loans (NPLs), or Non-Performing Credits. An NPL is a loan on which the borrower has failed to make interest and/or principal payment for a certain period after the scheduled deadline. Payments may therefore come in late, or never arrive. Harmonization at the European level has led to the application in Italy of Basel regulations, so that now NPLs (in Italian “CreditiDeteriorati”, with many subcategories) are classified as such when the delay in payment exceeds 90 days.

It is actually normal for a bank to deal with some NPLs during the course of its business. These potential losses are in fact booked in advance and an expense is recorded in the income statement. The issue arises when an important portion of a bank’s loans are non-performing, especially when the bank in question follows a business model that is centered primarily on corporate loans, just like Italian banks. In Italy, figures are alarming. Italian Banks’ balance sheets host around €350bn of NPLs, making up about 17% of total loans and the same share of gross domestic product. These bad credits have been piling up since the aftermath of the financial crisis (Figure 1). Most of them consist of corporate NPLs, with the greatest concentration in southern Italy.

According to data compiled by Bloomberg, the Italian banking industry has a coverage ratio of about 43%, and for banks such as Monte dei Paschi di Siena and Banco Popolare SC, potential write-offs on loans they have not provisioned for may exceed tangible common equity by more than two times.

It is clear that the situation is critical, which is why the Italian government has stepped in, proposing a solution involving the use of a “Bad Bank” as a vehicle to securitize a good part of the NPLs out of the banks’ balance sheets, thus reducing the risk of large potential write-offs. The solution has recently been approved by the European Commission, which has clarified that the move shall not be considered state aid. The structure of the “Bad Bank” proposal is outlined in the next paragraph.

The Solution: “Bad Bank”

The “Bad Bank” proposal, designed by the Italian government under the lead of Minister of Finance Pier Carlo Padoan, is practically a securitization process whereby the NPLs are transformed into securities and sold in the market, with the additional feature that the payments of the senior tranche of such securities will be guaranteed by the government.

Specifically, the NPLs in the Italian banks’ balance sheets will be packaged into pools according to their characteristics (e.g. maturity) and prepared for sale. Meanwhile, a new entity will be created, the so-called “Bad Bank”, which will act as purchaser of such securities (in securitization jargon, the Special Purpose Vehicle, SPV). The Bad Bank will finance the purchase of the NPLs by issuing tranches of bond-like securities to investors on the market. Thus, the securities in circulation will substantially be NPL-backed securities, with the (eventual) payments from the troubled debtors flowing through the SPV and straight into the market to the security holders.

The underlying idea is that, while banks will clearly have to sell their NPLs at a great discount to the Bad Bank for it to be able to issue bonds that investors will actually consider a reasonably good investment, this system will still prevent banks from having to put in place massive write-offs. It is exactly for this reason that the government is guaranteeing the senior tranche of these securities. In fact, this will reduce the cost of funding for the Bad Bank (as the bonds issued will be less risky), thus improving the terms on which it will be able to buy the NPLs from the banks and reducing the overall balance sheet impact.

Effects on the economic growth

The final aim of this transaction is to decrease the risk weighted assets of the banks, by selling at least a portion of the non-performing loans. If the selling price of the NPLs is sufficiently high, banks will not have to book massive capital losses and at the same time assets will be less risky, capital requirements will fall, and the excess capital could be used to give out more loans to virtuous companies, thus triggering economic growth. It is worth noting that the Italian economy is composed mainly by small and medium companies which basically receive funding only through the banking system. This proposal would help the economy recover: according to BCG’s estimates, the Italian GDP would grow about 1.5-2% with the securitization of €100bn of NPLs.

Even if we assume that all these transactions will be successful, it is not 100% sure that banks will use the excess capital to fund new loans: Intesa recently closed the fiscal year with extra-profits well exceeding the expectations, however the board decided to return most of the current profit to shareholders as dividends, realizing a payout ratio of 88%. It is a signal that they think there are no profitable opportunities in which to invest the extra capital, and it is possible that other banks will follow the same path in the aftermath of the securitization.

Effects on the NPL market

As explained, the provision of the guarantee on the senior tranche has the final aim of creating a market for NPLs. Nowadays there is no such market simply because demand and offer do not match. Banks require a price that is at least 40% the book value, while most investors are willing to pay up to 20-25%. With the public guarantee, the SPV would be able to get more funds from the sale of the senior tranches of the ABS, so as to be able to pay a higher price to the banks for the purchase of the NPLs. This would presumably reduce the difference between demand and offer, creating an active market.

Pricing is indeed a crucial aspect of this transaction because of the following:

– There are no recent comparable transactions in Italy, the only one is related to the NPL sale of the four recently rescued local banks (Banca Etruria, Banca Marche, Carife and CariChieti), whose NPLs were sold at 20% of their book value. Someone could argue that this transaction took place in a liquidation phase, so in normal circumstances the price could be slightly higher.

– Price is heavily affected by the slowness of the court process. It takes 7 years on average to obtain the underlying guarantee of the loan. This is another reason why similar transactions in other countries cannot be considered comparable. The government recently proposed to create special courts, specialized in NPLs, in order to make the process faster. Equita SIM estimates that a time reduction of just one year could increase the value of the securities by more than 2%.

Effects on the Italian public debt balance  

The Italian treasury must provide the guarantee at market prices, in order to comply with EU rules on state aid. The market price of the guarantee is considered to be equal to that of the CDS related to securities with the same rating as the ABS issued by the bad bank. Banks will have to pay for that in order to attract more investors and obtain better conditions on the market (i.e. higher selling price), but it is not clear whether the balance of the two things will be positive or negative for the banks. Given that the guarantee is only delivered on the senior tranche, it is unlikely that the state will actually have an outflow of money, indeed it is likely that the result for the public institution will be positive. Moreover, the cost of the guarantee will increase over time in order to push banks to shorten the whole process.

Effects on the banking system

As stated before, the main problem is that these loans have a book value which is far higher than the market value. Given the aforementioned range for pricing (20-40 % of the book value), all the banks which decide to securitize their loans will have to book a capital loss in the moment of derecognition, which will be extremely high if the bad bank cannot afford to pay high prices for the purchases, reducing the equity value. In this case it is possible that some banks will have to raise capital in the market in order to continue to comply with the Basel capital requirements.

If these measures will not be as effective as the government expects, the NPLs will continue to be a great problem for the Italian banks, as they seem to be the main obstacle for the industry consolidation. Indeed, mergers between firms with profitable assets are much easier than between distressed companies. Consolidation in the industry will also benefit from the reform of the governance of “Popolari” banks, which is expected to take off if the bad bank program is successful.

M&A wave for Popolari banks

Framework of the Italian banking industry

The Italian banking market is particularly fragmented. Italy boasts 780 banks and more branches per person than any other member of the OECD. These banks have high costs and some of the lowest interest margins and returns on assets in the European Union. Collectively, Popolari represent about 25% of Italian deposits and loans, according to Assopopolari, their industry group. The 10 biggest co-ops have 525bn euros in assets, about two-thirds of UniCreditSpA, Italy’s biggest bank according to assets’ size.

But why is the market still so fragmented and consolidation has not taken place yet? The main problems are to be found in the peculiarities of the players in the Italian banking industry which includes:

– The “one head-one vote principle”, whereby shareholders are entitled to one vote only, regardless of the number of shares held.

– Shareholding cap, limiting the number of shares that each shareholder is entitled to hold in a Mutual Bank (i.e., 1% or the lower cap provided for in the bylaws of each Mutual Bank).

– The shareholders’ admission process, whereby a shareholder is entitled to exercise voting rights only once (and if) “admitted” by the board of directors, although a shareholder is always entitled to exercise the economic rights pertaining to its shares (regardless of its admission).

– Limitations on proxy voting, whereby each shareholder is entitled to vote by proxy on behalf of maximum 10 other shareholders (or the lower limit set out in the relevant bylaws).

– Limitation on distributions of dividends, whereby Mutual Banks have to set aside at least 10% of their annual net profits in a statutory reserve.

In particular, the ‘one-head, one-vote’ rule, together with ownership restrictions and limits on proxy voting, have distorted governance by allowing minority shareholders in cooperative lenders to block unwanted change. Moreover, although the necessary legal change has been discussed for more than a decade, it has always been fiercely opposed by local banking unions and politicians. Indeed, Italy’s midsized lenders have traditionally had close ties to local communities and have argued that mergers could deprive some towns and regions of their own banks.

The Need for consolidation

In January 2015 Mr. Renzi’s government approved a bill under which Italy’s midsized popolari banks would be transformed into joint stock companies with the ultimate aim that better governance will enable the banks to release more credit to Italian small business owners. The bill will make it more difficult for unions to prevent potential mergers, as has happened in the past. The passage to joint-stock companies will open banks’ capital to big institutional investors and will help fund extraordinary operations, such as capital increases, which has been often opposed by small investors. The 10 banks affected by the reform are UBI, Banco Popolare, BPM, Bper, Creval, Popolare di Sondrio, Banca Etruria, Popolare di Vicenza, Veneto Banca and Popolare di Bari. Banca Monte dei Paschi di Siena and Carige’s involvement in the process also has to be considered since both banks have conceded they have no independent future having failed the ECB’s health assessment.

What will happen in practice?

The 10 biggest popolari banks will be forced to reform their one shareholder, one vote governance. Namely, the reforms oblige popolari banks with assets above €8bn to become joint stock companies and modernize their voting structure.

If the threshold is surpassed, the bank’s managing body has to summon an assembly meeting and decide whether to reduce the assets below the limit, to transform the bank into a joint-stock company or to liquidate it. If no action has taken within a year, the Bank of Italy can forbid it from engaging in new operations. Alternatively, it can enforce a special administration or, as a third option, asking the ECB to revoke the noncompliant bank’s authorization.

The transformation of the bigger Mutual banks into more “ordinary banks” will, on the one hand, attract the interest of foreign investors (which had traditionally no interest in them because of their peculiar features), on the other hand, it will push them to consider mergers in order to strengthen their capital, improve their market position and competitiveness and the banks could be better equipped to properly address new banking regulations.

Therefore, the reform is expected to provide new investment opportunities for strategic investors, lenders, and equity and bond traders, increasing, at the same time, the efficiency of the Italian banking system.

Moreover, we know that the Italian banking system suffers from low profitability, partly due to heavy cost structures. There is room for significant reduction in the Italian banks cost bases over time if these were to converge towards average European peers’ retail distribution models. Italy has one of the highest levels of branch density in Europe and maintaining these large and expensive branch networks is not optimal. In-market M&A would see a significant degree of branch overlaps amongst the large Popolari banks, causing the need to rationalize distribution. Cross border M&A activity would generate fewer savings from branch overlaps but could also bring in more advanced, already developed multichannel platforms.

However, it has to be noted that the Italian reality of M&A deals in the banking industry has proved somewhat different. A series of mergers from 2005 to 2008 that led to the creation of banks including Banco Popolare and UBI didn’t generate in most cases the expected revenue and cost savings. The banks that emerged from that wave currently have low returns compared with the rest of the industry and there is no evidence that cost-cutting increased after the tie-ups. The total of integration charges of Italian banks since the merger years has exceeded their cumulative cost savings, suggesting a loss of equity, a loss of value.

Potential Partners

The fragmented Italian banking industry is composed by a few major players and by a number of minor ones. UniCredit is the largest Italian bank, with total assets of €841bn, followed by Intesa with assets that account for €628bn. Struggling in the third position we find Monte dei Paschi, with assets of €196bn. These main companies are followed by a collection of small and midsized banks, many of which are regionally based.

It is widely believed that the merger wave will take place among the first four of the popolari banks: UBI, Banco Popolare, BPM and Bper, but, as we mentioned, we should also consider Banca Monte dei Paschi di Siena and Carige.

The table gives a clear indication of the relevance of NPL for each bank in relation to the size of its assets (Incidence). We note that MPS is by far the bank that faces the most difficulties. Not only does it have the highest incidence of NPL, but it is also the poorest performing according to the P/B ratio. Considering its overall current condition, the success of the bad bank model will be determinant for its future. One option to save MPS would be an acquisition carried out by one of the main players in the market, either Unicredit of Intesa. However, an Intesa – MPS merger is not feasible since it would not grant the approval by the Antitrust commission given the strong presence of both banks in the central region of Italy (Tuscany in particular). Also an acquisition performed by Unicredit seem to be hardly possible considering that the bank is focusing its attention on major internal problems. UBI indeed appears to be a feasible solution. In fact the bank has €1.7bn capital surplus, as the stress tests revealed, and such a merger could cut 17% of the two banks’ branches. But UBI seems reluctant to make a bid for MPS at current conditions. The bank would instead be willing to proceed with an offer in the case it will be able to secure a control in Banca Popolare di Milano. BPM is indeed a jewel in the Italian market as it displays one of the best performances, has an extremely small amount of NPLs on its books and has a quite high capitalization. It is clear that for this merger to happen a lot of negotiations has to be done.

Given the quality of its situation as one of the banks which passed the ECB stress test with the best record, BPM is expected, along with UBI, to be one of the main consolidators in the system. It seems to be the ideal partner of two other popolari banks that will take a leading role in the reorganization of the banking sector – Banca Popolaredell’Emilia Romagna (Bper) and Banco Popolare. In fact, the Milan-based bank, with c.€50bn of assets in its portfolio, aims at creating the third-largest Italian banking group behind UniCredit and Intesa Sanpaolo. For this reason, it is realistic to think that the BPM merger could play a central role in the possible consolidation of the sector. In the case of BPM – Banco Popolare, it would be “merger of equals” as both banks have a market capitalization of about €4bn while a Banco Popolare and Banca Popolare di Milano tie-up could eliminate 14% of branches.

Although there is a number of different feasible mergers on the market, one of the main drivers of future M&A decisions will be the success of the Bad Bank model. The implementation of such a model is indeed expected to reshape the assets and overall quality of the Italian banks. It is, therefore, premature to talk about the terms of potential acquisitions since the banks that we see now on the market may be extremely different from those that we will have once the NPLs will be securitized.

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