Here is the text of the speech by the governor of the Bank of Italy, Ignazio Visco, on the occasion of the 25th edition of the AssiomForex Congress in Rome.
The conjuncture
Since the middle of last year the global economy has been slowing down. Production activity weakened significantly throughout the euro area; in Italy it recorded a decline. Various factors, partly of a temporary nature, contributed to the deterioration of the macroeconomic situation; the prospects for foreign demand, business expectations and the dynamics of investments worsened. In the second half of 2018, industrial production decreased by 0,5 per cent in the euro area. The drop was sharpest in Germany (2,2 percent) and Italy (0,8 percent), also due to the adjustment in the car sector to the new international legislation on polluting emissions from light vehicles. In Italy, domestic demand was affected by the marked increase in uncertainty, linked first to doubts about the country's position regarding participation in the single currency, then to the difficult path that led to the definition of the budget law, marked by disagreements with the European Commission that were resolved only at the end of the year. The resulting increase in risk premiums on government bonds was transmitted to the cost of private sector bond funding, in a context of falling share prices.
Our latest projections on the growth of the Italian economy for the current year, published in the January Economic Bulletin, come in at 0,6 per cent, in line with those elaborated by the main national and international forecasters, but with large risks discount. Compared with the early December estimates – when the central projection for GDP growth was 1,0 per cent – the revision largely reflects the inclusion of unfavorable data on economic activity that became available subsequently and confirmed by information on the quarter quarter released this week by Istat; the downsizing of business investment plans reported by our surveys and the worsening of expectations on foreign demand. The projections take into account the support provided to aggregate demand by the expansionary measures of the public budget for 2019, the actual extent of which will depend on the methods of implementation. The agreement reached by the Government with the European Commission resulted in a partial reabsorption of tensions on the government bond market with overall positive effects on demand. Economic activity will benefit from the maintenance of highly accommodating monetary conditions.
The prospects for the current year and the projections for the following two years, which envisage a return to growth of around 1 per cent, are weighed down by significant risk factors, of both international and domestic origin. Among the former, the main ones concern the trend of foreign trade, the vulnerabilities of emerging countries and the methods of the United Kingdom's exit from the European Union. On the domestic front, the trend in interest rates on government bonds is still relevant. The protectionist orientation of US trade policies towards China, with which a complex negotiation is underway, and the European Union, already hit last year by the introduction of tariffs on aluminum and steel, could worsen. Further uncertainties arise from the ongoing slowdown of the Chinese economy, also connected with initiatives aimed at containing private sector debt, and from the difficult political and economic conditions of important emerging countries. A no-deal exit of the United Kingdom from the European Union can have serious consequences, even if the direct effects linked to trade, serious for the United Kingdom, could be limited for Italy and for all the countries of the Union . Any malfunctioning of the financial markets could have significant repercussions for all the countries involved; to this aspect it is lending itself
maximum attention.
In Italy, the Government has prepared, in collaboration with the supervisory authorities, the measures to be issued in case of need; they provide for a suitable transitional regime to guarantee the integrity and operational continuity of the markets and intermediaries – both the British ones operating in Italy and the Italian ones operating in the United Kingdom – as well as interventions to protect investors and customers. Important decisions have already been adopted by the European Commission and the conditions which ensure the continuity of financial transactions between European intermediaries and British central counterparties are being defined. The Single Resolution Board also announced that it will adopt a flexible approach, in cases of non-recognition of securities issued in the United Kingdom, for the purpose of meeting the minimum requirement for own funds and liabilities eligible for bail-in (Minimum requirement for own funds and eligible liabilities, MREL). As the national and European authorities have repeatedly recalled, intermediaries must in any case play an active part in preparing for a possible no-deal exit. Since the peak in mid-November, the yield differential between ten-year Italian government bonds and the corresponding German bonds has decreased by around 80 basis points. The risk premium on Italian government bonds, equal to 250 basis points on average this week, however remains high; it is about double the average values of the first four months of last year.
Uncertainty about fiscal policy has not dissipated. The agreement with the Commission has been reached for 2019, but for 2020-21 many aspects remain to be defined and, especially, the future of the so-called safeguard clauses, the amount of which has been increased to 1,2 per cent of the output in 2020 and 1,5 in 2021. If they were deactivated without providing for compensatory measures, the deficit would be around 3 per cent of GDP in both years. To ensure effective support for economic activity, budgetary policy must preserve confidence in the process of rebalancing public finances and in the prospect of reducing the debt-to-product ratio. The amount of public securities to be placed on the market each year continues to be large: almost 340 billion for the renewal of bonds maturing in 2019 alone, which add up to the approximately 50 expected to cover the deficit. Financial market conditions remain tense. Compared to last spring's peak, share prices fell by 12 per cent in the euro area and by 17 per cent in Italy; over the same period, yields on corporate bonds increased by 40 and 100 basis points respectively (to 1,6 and 2,5 per cent). The divergence from the euro area average was most marked in the banking sector, where stock market indices fell by almost 40% on average, compared with a 30% decline in the euro area, and bond yields they almost doubled, to 2,4 per cent, against an average increase of 0,3 percentage points in the area as a whole.
The higher financing costs incurred by banks have so far been transmitted to interest rates on loans to a lesser extent than in the past, thanks to the greater capitalization of credit institutions and a recomposition of their liabilities towards financial instruments less exposed to changes in interest rates market interest. Signs of a moderate tightening of credit access conditions however, they are beginning to emerge in the surveys carried out among companies. Last week, the Governing Council of the European Central Bank expressed its concern about the heightened downside risks surrounding the outlook for euro area manufacturing activity and which could have repercussions on inflation over the medium term. The reduction in growth in consumer prices, to 1,4 per cent in January, mainly reflects the slowdown in the energy component but core inflation, equal to 1,1 per cent, is still struggling to recover. The transmission of the strengthening of wages to prices has been held back in recent months by the weakness of economic activity, which has been reflected in a decrease in corporate profit margins. The Council will continue to pursue the objective of price stability – defined as it is known by an inflation rate close to 2 per cent over the medium term – with tenacity and patience.
The maintenance of a significant monetary stimulus will be ensured by the low level of official rates, by the large amount of securities in the central banks' portfolios and by the reinvestment of capital when these come due, a measure which will continue for an extended period. Should the macroeconomic conditions require it, the Board is ready to use all the instruments at its disposal to ensure, with the stability of aggregate demand, the progressive readjustment of inflation towards the objective of price stability. In order to fully enjoy the benefits deriving from the expansive conditions determined by monetary policy, the contribution of reforms aimed at reducing the structural weaknesses of our economy is needed, weaknesses which accentuate the economic difficulties. Decisive progress is needed in creating an environment more favorable to innovation and business activity, participation in the labor market must be encouraged, the quality of human capital raised, the efficiency of public services increased. Since 1999, the annual growth rate of the Italian economy has been on average one point lower than that of the euro area. In the absence of consistent results on a structural level, what at an international level are slowdowns of a cyclical nature tend in Italy to turn into stagnation or a decline in productive activity. The well-being of families depends on numerous factors, but the capacity for growth of the economy is crucial. Public investments, complementary to private ones, carried out quickly and efficiently in the context of a progressive rebalancing of the state accounts can support it.
But, above all, interventions aimed at strengthening and modernizing the productive structure, making it more dynamic and able to create greater job opportunities, must continue to play a central role in the action of economic policy. Even if the results of new interventions, as for those of past years, they will need time to fully manifest, their implementation will immediately be able to support the confidence of businesses and households and, in this way, their propensity to invest and consume.
Financial intermediation
In Italy, the improvement in credit quality, which has been underway since mid-2015, continued last year. In the third quarter, the loan default rate fell to 1,7 per cent, in line with the values prevailing before the global financial crisis; for loans to businesses, the decline came to a halt in the last few months of the year with the economic slowdown. In the first nine months of 2018, also following numerous disposal transactions, the amount of non-performing loans fell from 259 to 216 billion euro gross of value adjustments, from 129 to 99 net. The impact on total loans decreased, on a net basis, from 6,1 to 4,8 per cent; the coverage ratio rose by nearly four percentage points to 54 per cent. For significant groups, the drop in net non-performing loans, equal to 2018 per cent of loans at the end of September 4,5, is consistent with the plans agreed by the banks with the Supervisory Authority.
The requests for increases in the outstanding provisioning rates, addressed to all the significant banks in the euro area, take into account the specific conditions of each of them; will become operational starting from next year, envisage the achievement of full coverage in a period of time that extends up to 2026 for banks with relatively high net incidences. For less significant banks, the ratio of net non-performing loans was 7,1 per cent at the end of September last year. The incidence exceeded 10 per cent for 50 of the 270 cooperative credit banks (BCCs), which accounted for about half of all impaired loans in the category; among the approximately 100 intermediaries other than the CCBs, an incidence of more than 10 per cent was observed for 23 banks, representing one third of the sub-fund's non-performing loans. The reduction plans prepared by the main less significant banks in recent months, based on the guidelines issued by the Bank of Italy at the beginning of 2018, are now being examined by the Supervisory Authority. Projects involving collaboration between intermediaries and operators specialized in the management of non-performing loans can also represent a good solution for "probable defaults", relating to companies in temporary difficulty. Profitability improved last year. In the first nine months, the return on capital, expressed on an annual basis, rose for all Italian banks to 6 per cent, from 4 per cent in the same period of 2017.
However, the share of revenues absorbed by operating costs, equal to an average of 65 per cent, is still too high, especially for less significant banks (where the average level is equal to 74 per cent). In the period considered, the latter recorded an increase in costs, against the reduction observed for the significant groups; the gap was large in the component linked to personnel expenses. In relation to risk-weighted assets, the best quality capital (CET1) decreased in the first nine months of 2018 from 13,8 to 13,1 per cent. The decrease reflected the losses in value associated with the tensions on the government securities market. The impact was greater for less significant banks, which typically invest a higher proportion of assets in government bonds. Since the end of 2017, when it had reached a low of 280 billion, banks' exposure to Italian public securities has grown; at the end of last November the value of the securities in the portfolio amounted to 330 billion, just under 10 per cent of total assets; it remains below the peak of 400 billion euro reached at the beginning of 2015. The purchases, concentrated in May and June, took place in parallel with the rise in yields, in a phase of weak credit demand. Bank investments help stabilize the prices of government securities in moments of greatest tension and can allow subsequent capital gains in the event of a recovery in prices; however, they do expose intermediaries to the risks associated with further price declines.
The share of securities classified in the portfolio valued at amortized cost, whose temporary changes in value do not affect assets, grew on average from 18 to 49 per cent between the end of 2017 and last November; it reached 61 per cent for less significant banks. This increase helps to mitigate the impact of fluctuations in the value of government bonds. The decrease in the average residual life of securities classified in portfolios designated at fair value goes in the same direction, from 4,2 to 3,6 years. The expansion of economic activity and orderly conditions on the sovereign debt market favor, with the return of investor confidence, a gradual decline in the amount of government bonds on bank balance sheets: this is demonstrated by the significant reduction in exposures achieved between the beginning of 2015 and the end of 2017. The global financial crisis, that of sovereign debt and the double recession that accompanied them have led to significant changes in the composition of the liabilities of Italian banks . Funding on the market fell sharply; risk premiums grew, due both to factors specific to the banking sector and to the evolution of public finance conditions. Since 2011, the decrease in interbank funding has been accompanied by a significant increase in recourse to central bank refinancing.
In recent years, through the four targeted long-term refinancing operations conducted between June 2016 and March 2017, the Eurosystem has allocated approximately €240 billion to Italian banks of the total €740 billion earmarked for intermediaries in the euro area. These operations helped to support the disbursement of credit to households and businesses and to reduce its cost. Net bond issues on international markets, which are mainly used by large banks, have been negative overall, from 2011 to today, by 47 billion; the incidence of bonds on total deposits decreased from 11,5 to 9,5 per cent. Difficulties in accessing international markets have recently become more pronounced with the re-emergence of tensions in the government bond market. The yield investors are looking for on 5-year senior unsecured bank bonds it is currently one percentage point higher than that required for the main French and German banks. The Eurosystem's support to banks' liquidity will continue as long as the financial situation of the area requires. However, the restoration of conditions of normal access to the wholesale markets is necessary for the proper functioning of the intermediation activity; it will also help contain the costs that medium-large banks will have to bear in order to build up the "cushion" of liabilities capable of absorbing losses envisaged by the new European rules for crisis management. During this year, the Single Resolution Committee will set a binding MREL target for most of the significant Italian banking groups, providing, if appropriate, for an adequate transitional period to achieve it.
In the discussion that led, at the end of last year, to the agreement on the so-called "banking package" (which provides for the updating of the regulations on prudential requirements and reviews the criteria for setting the MREL) we repeatedly stressed the need to reconcile the need to ensure adequate volumes of liabilities usable in the event of resolution with that of ensuring that their issue takes place in a gradual and orderly manner, avoiding repercussions on the financing of the economy. The possibility of accessing the resolution procedure, even with the concrete difficulties of implementing the bail-in, however, it is only foreseen for banks – of larger dimensions – for which there is a public interest such as to justify recourse to the resources of the Single Resolution Fund. In the event of a crisis involving smaller intermediaries, an orderly liquidation process can only take place in correspondence with a rapid and generalized intervention by an intermediary interested in acquiring assets and liabilities. In the absence of such an intervention, there would be no alternative to the ordinary (or "atomistic") liquidation procedure. The operation of this procedure, in addition to destroying value, can compromise the continuity of the supply of essential services at a local level, with possible wider-ranging contagion phenomena. I believe it is necessary to go back to reflecting on the European scene, also on the basis of the experience of the US FDIC (Federal Deposit Insurance Corporation), on institutions and measures that aim to make the exit from the market of smaller intermediaries as less traumatic and less expensive as possible.
For Italian banks, continuing on the path of strengthening their balance sheets and recovering adequate levels of efficiency and profitability remains a necessary condition for tackling the challenges that characterize the financial sector at a global level. More resources are required to meet the costs of a compliance whose scope has significantly expanded in recent years and on whose regulatory framework it is necessary to continue to work to increase its proportionality. Investments are needed to take advantage of digital technologies in order to improve the offer of services to customers. To support growth and to make the allocation of resources more efficient we need a more complex financial system. The financial needs of innovative and internationally active companies cannot be met by banks alone. Despite the progress made in recent years, the role of the capital market is still too limited, even in comparison with the other large economies of continental Europe. Policies to support the development of non-banking sources of business financing must continue. Banks can accompany and benefit from these developments by expanding and innovating the range of services offered. The most important challenge, in perspective, is that of technology which drastically reduces the costs of transmitting, processing and archiving information and pushes towards new forms of intermediation of financial transactions.
Entire chains within the financial industry, from payment services to credit provision, from securities trading to risk management, are already significantly affected in some countries by digitization and rapid market share growth of non-bank entities (FinTech). Further competitive pressures will come from global companies, at the frontier of technological innovation (including the so-called "Big Tech"), which they can exploit their presence in very large markets. The authorities must ensure that new intermediaries are adequately supervised, taking into account their potential and the risks associated with their business. In particular, they must stimulate both FinTech companies and banks to pay due attention to the possible negative consequences of cyber attacks in a system now immersed in digital technology. We are engaged, alongside other authorities and intermediaries, in an effort to maintain the IT security of the financial sector. We have also adapted the organization of the Supervisory function with the creation of structures dedicated to the analysis of FinTech initiatives, with the aim of anticipating market developments and updating intervention methods and tools.
The prospects for the Italian economy are less favorable today than a year ago. They are weighed down by downside risks that partly originate from abroad, but which continue to significantly reflect Italy's own weaknesses, above all the uncertainty regarding growth, as well as the orientation of fiscal policy and the recovery of a credible path to reduce the burden of public debt on the economy. A high premium for sovereign risk exacerbates the fiscal imbalance, jeopardizes the ability of fiscal policy to support the economy, compresses the resources available for investment in infrastructure. The decrease in the value of government securities negatively affects the savings accumulated by households and causes capital account losses for institutional investors, such as insurance companies and pension funds, and for banks, affecting their financing conditions on the markets; the ability of intermediaries to provide credit to the private sector and, in this way, support productive activity suffers. The triggering of this vicious circle is held back by the relatively high average duration of the public debt, by the expansive conditions of the monetary policy, by the capitalization levels of the credit institutions. These are favorable factors which may, however, be insufficient in the presence of sudden movements in the financial markets, a risk we have already experienced in the past.
This risk must be avoided keeping close attention to the balance of public finances – in the short and long term – and decisively implementing a comprehensive plan of reforms aimed at preserving the confidence of savers and regaining that of investors. The ultimate goal, to be achieved with continuity and determination, can only be that of a stable return to a path of economic and social development.
