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«BLUEPRINT SERIES 25 EUROPEAN BANKING SUPERVISION: THE FIRST EIGHTEEN MONTHS Dirk Schoenmaker and Nicolas Véron, editors Thomas Gehrig, Marcello Messori, ...»

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Conclusion Overall, European banking supervision is viewed as justifiably strict by Greek bankers and supervisors. They consider it to be tough but fair, and believe its involvement lends credibility to bank balance sheets and helps banks to raise private funding. The SSM handled well the challenges arising out of the Greek crisis: it very closely monitored the situation on a daily basis, and acted quickly to assess capital requirements as soon as a new bailout agreement was reached. Even though the size and modalities of the recapitalisation may be questioned ex post, ex ante they seemed eminently sensible in view of the uncertainties involved, as well as the need to minimise the cost to taxpayers (including through CoCos) and the state’s equity participation. Thus, European banking supervision can be assessed as having done a good job so far in supervising the systemic banks. The ECB may, however, have been too slow to take over the supervision of Attica Bank from the Bank of Greece.

8 Italy Marcello Messori The Italian banking landscape Italy’s banking system is less concentrated than those of most other euro-area countries, especially when the absence of large institutional protection schemes such as those in Germany or Austria is taken into account. Following a series of mergers in the 1990s and 2000s, two groups, UniCredit and Intesa Sanpaolo, are positioned ahead of their peers, with combined assets representing 47 percent of the Italian total. All other Italian SIs combined add up to only 25 percent of this same total, and about 500 LSIs account for the remaining 28 percent.

In other words, the Italian banking system can be described as two large pan-Italian banks (even though, with less than €1 trillion each in assets, they are not among the very largest in the euro area), and a ‘long tail’ of small banks, most of which only have a regional or local footprint92.

Italy had historically relied on strong local and regional public savings banks (Casse di Risparmio or Monti di Pietà), and a number of national state-owned banks from nationalisations during the first half of the twentieth century. In the 1990s and early 2000s, the savings banks were transformed into commercial entities and the stateowned banks were privatised, triggering a wave of mergers that led to 92 The figures in this paragraph are based on data from different sources. The consistency of these sources has been checked with the Bank of Italy.


the formation of Intesa BCI, UniCredit, SanPaolo IMI and Capitalia.

As a result of the savings banks reform and bank mergers, the local public interests in the biggest banks were managed through foundations, which retained controlling stakes in the consolidated groups.

In 2007 Intesa and SanPaolo merged, and Capitalia was absorbed by UniCredit. Meanwhile foundations typically became minority shareholders, and Italy’s central government almost entirely exited the banking sector93.

Among the medium or small-sized banks a number are cooperatives (Banche Popolari and Banche Cooperative) with governance historically based on a one-shareholder-one-vote principle, as opposed to the usual one-share-one-vote – ie all shareholders, large or small, have identical voting power, even for those Banche Popolari (SI or LSI) that are publicly listed. The Banche Cooperative are local banks, often very small.

The national central bank, Bank of Italy (Banca d’Italia, often referred to as Bankitalia), is the Italian national supervisory authority and also the national resolution authority.

The 2014 comprehensive assessment and its interpretation From mid-2012 to the end of 2013, Italian banks started a process of recapitalisation and continued the deleveraging process started in the second half of 2011, when Italian sovereign spreads rose significantly.

However, this was insufficient to align Italian banking indicators with European ones in terms of risk-weighted capitalisation and profitability. Crucially, the Italian banks were unable to reduce their stockpile of non-performing loans (NPLs), which instead kept growing. These are the main reasons for the Italian banking sector’s poor performance in the 2014 comprehensive assessment, which involved an asset quality review (AQR) and stress tests.

93 Cassa Depositi e Prestiti (CDP), a large government-controlled entity, is not a bank but a special financial institution supervised by the Bank of Italy.

116 | BRUEGEL BLUEPRINT The final report published on 26 October 2014, identified 25 banks as failing the assessment as of the end of 2013, with an aggregate capital shortfall of €24.6 billion and an additional asset value adjustment (from the AQR) of €37 billion, adding up to a total impact of €61.6 billion. Of these 25 banks, nine were Italian, or three-fifths of the 15 Italian banks reviewed94. Italy thus contributed 36 percent of all banks failing the assessment, with a total capital shortfall of €9.7 billion (around 39 percent of the total), far higher than any other euro-area country.

By the beginning of 2014, the majority of these banks realised they would not meet the capital adequacy conditions. They therefore intensified their recapitalisation efforts during the first three quarters of that year. By the end of September 2014, 12 of the 25, including five of the nine Italian banks, were able to overcome their capital shortfall by implementing recapitalisations during 2014 for an aggregate amount of €15 billion (€8.2 billion for the five Italian banks). Conversely, the other 13 banks, including four Italian banks, still had inadequate capital by the time of publication of the comprehensive assessment’s results. The four Italian banks accounted for an aggregate capital shortfall of €3.3 billion or a third of the €10 billion total for the 13 remaining ‘outliers’ The four Italian banks were: Banca Popolare di Milano.

(BPM), Banca Popolare di Vicenza (BP Vicenza), Cassa di Risparmio di Genova (Carige) and Monte dei Paschi di Siena (MPS).

These four, together with the other nine negative outliers from other countries, were given two weeks to establish capital plans that would rectify their capital gaps within nine months. BPM and BP Vicenza had approved but not yet implemented capital adjustments 94 See ECB (2014a) and Bank of Italy (2014a). The list of 130 banks participating in the comprehensive assessment in 2014 does not completely match the list of SIs euro-area-wide. This also applies to Italy. Banca di Credito Valtellinese and Credito Emiliano were assessed in 2014 but are now designated as LSIs. The 15 Italian banks assessed accounted for 11.5 percent of the total number in the comprehensive assessment, making up 10.4 percent of total assets.


sufficient to meet these conditions as of September 2014. Thus, by the end of October 2014, only MPS and Carige failed to meet the new requirements, with a shortfall of €2.92 billion still representing slightly more than 30 percent of the total residual capital shortfall in the euro area.

The ECB and Bank of Italy presented different public interpretations of the results. The ECB (2014a, 2014c) focused on the final results based on bank balances at the end of December 2013. Conversely, the Bank of Italy (2014b, 2014a) focused on the updated AQR results, taking into account the recapitalisation efforts during 2014. It also emphasised that the capital shortfall of Italian banks according to the AQR at the end of 2013 was only €3.25 billion out of their total shortfall of €9.68 billion, or in other words, the major part of the shortfall arose from the stress test results, the adverse scenario in particular.

Moreover, the updated bank balances at the end of September 2014 showed that none of the 15 Italian banks (even MPS and Carige) had any capital shortfalls resulting from the AQR and that all the late-2014 shortfalls came from the stress tests, especially the adverse scenario95.

This different emphasis framed a three-pronged narrative promoted by the Bank of Italy. First, the AQR was also a measure of the effectiveness of previous supervision; hence, the overall compliance of Italian banks with respect to AQR requirements meant an absence of past supervisory failures in Italy. Second, Italian banks did not represent a problem for the European banking sector – their limited capital shortfall involved only two banking groups and was mainly a consequence of the severity of the Italian adverse scenario. Third, as opposed to most other European countries, these results were attained with minimum public financial support since the start of the crisis.

95 Of course, stress tests are not a forecast of a country’s economic evolution. Moreover, according to the Bank of Italy, the Italian adverse scenario was particularly severe because it under-assessed the effects of the double recession characterising the Italian economy (pro-cyclicality bias: see also the Bank of England’s position).

118 | BRUEGEL BLUEPRINT Thus the ECB and Bank of Italy had starkly different interpretations of the same events.

The Bank of Italy’s view is supported by the fact that the Italian economy was one of the euro area’s worst performers in terms of growth and sovereign spreads. Italian banks consequently faced deep increases in borrower insolvency and bankruptcy, and an increase in the cost of their liabilities, which were often independent of their specific riskiness. In light of this negative legacy, the average performance of the Italian banking sector was not that poor. Apart from cases such as that of MPS, the Bank of Italy had been able to guarantee stability during a tumultuous period characterised by more than six years of national recession. That said, if one ignores the legacy problems and takes a snapshot of the Italian banking sector at the end of December 2013 or even at the end of September 2014, the comprehensive assessment’s results unambiguously demonstrated that Italian banks represented one of the biggest problems for the European banking sector as a whole.

Four additional points deserve mentioning with respect to the

comprehensive assessment:

• First, as the ECB (2014c, 2014b) partially acknowledged, the capital definitions were generally sounder in Italy than in other member states. The comprehensive assessment, being based on the national transposition of the European CRR/CRDIV, suffered distortions because of different national definitions and measures of capital often deriving from heterogeneous accounting rules of banking sectors.

All Italian banks applied IFRS, unlike a number of German banks.

On the other hand, since 2015, Italian banks have been allowed to count deferred tax credits (DTCs) as capital. Full implementation of the single rulebook could complete transitional arrangements and overcome these problems and other harmonisation deficiencies.


• Second, traditional credit risk was treated more harshly than risk from capital market activities. The Italian banking sector is characterised by a dominant weight of loans as a share of total assets. It can be argued that European regulation is biased against bank loan risks in favour of financial asset risks. As a consequence, Italian banks could have been penalised by the emphasis on credit risks relative to market and operational risks. However, even though the ECB did increase capital requirements in one go by 100 basis points during the comprehensive assessment, it only applied CRR/CRDIV regulation in assessing different types of risk. The ECB cannot be blamed of any bias inherent in the EU legislation.

• Third, and in relation to the previous point, Italy was penalised by the European emphasis on risk-weighted assets. Italian banks had an average CET1 ratio below the European mean, but also had among the soundest leverage ratios on average. A number of scholars (Haldane, 2012; Acharya and Steffen, 2014a; Dermine,

2015) have highlighted weaknesses in the risk-weighted regulatory approach underpinning CET1 ratio calculations, eg pro-cyclicality and excessive complexity. Moreover, econometric exercises such as Barucci et al (2015) suggest that the leverage ratio tends to be more effective than risk-weighted measures in controlling for the riskiness of banks in the stress tests. From this point of view, the methodology used for the comprehensive assessment may have been too focused on risk-weighted measures. It would be a stretch, however, to argue that the leverage ratio could entirely replace the risk-weighted capital framework.

• Fourth, Italian banks suffered from their lack of use of internal ratings-based (IRB) risk models. IRB models are costly to build, complex to manage, and thus only affordable for large and sophisticated banking groups. On the other hand, IRB models often allowed the introduction of devices to disguise the riskiness of assets (Behn 120 | BRUEGEL BLUEPRINT et al, 2014; Barucci et al, 2015). Thus, their comparative under-utilisation may have penalised Italian banks in the comprehensive assessment. However, it should be noted that, starting in 2010, international banking regulation has tended to strengthen risk management and internal controls instead of cutting down IRB.

In sum, one can identify many shortcomings in the comprehensive assessment, but these do not conclusively add up to the identification of a negative bias against the Italian banking sector, only that a level playing field has yet to be built for banks across the euro area. With a lack of trust between member states, and weak cooperation between European institutions and national governments, this can explain why the first moves of the new European supervision were characterised by a certain rigidity. In this sense, the ECB and SSM behaved more as rule-setters than supervisors (see also European Parliament, 2016, point 16).

The evolution of supervision Once in place, European banking supervision shifted its attention to the SREP process, using a methodology based on a common set of rules (ECB 2015b, 2015e). In principle, the SREP methodology follows EBA guidelines, with an overall risk control framework that frames the SSM’s constrained judgement of each examined bank. Every judgement implies the inclusion of the bank under assessment in one of the four score categories. However, the evaluation is too complex to be reduced to a simple score, so European banking supervision retains discretion for modulating the requirements for each bank’s riskweighted capital. This discretionary margin also applies to governance requirements.

The first full-fledged SREP exercise under the new European supervisory framework started in February 2015 and ended in November of the same year. It is difficult to summarise its overall result, since each bank case was different. European banking supervision urged various


banks to strengthen their organisation and improve their governance.

Above all, it imposed increases in capital requirements that ranged from 60 to 120 basis points for all banks that met the comprehensive assessment’s minimum requirements; these increases were mainly due to a further tightening of Pillar-2 requirements96. The Bank of Italy was reported to disagree with the ECB on this approach, by means of a letter sent to the ECB’s Supervisory Board97. The Bank of Italy’s argument was that the new increases in capital requirements arbitrarily overlapped with those of the comprehensive assessment, and thus risked harming the banks’ operations and stability.

A recent unofficial note of the European Commission (2016; see also Draghi 2016) aimed to limit the SSM’s discretionary power to tighten Pillar-2 capital requirements98. An analogous approach is suggested by the European Parliament (2016, points 21-25). Hence, the next SREP exercise, which started at the end of February 2016 and will be concluded later in 2016, might have to introduce substantial changes in methodology.

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