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Visco: Reforms must continue to sustain economic momentum

Italy’s economy, like those of its European neighbours, is showing encouraging signs of consistently strong growth. But how much of it should Italy take credit for — and how much is down to the broader improvements in Europe? Has Italy made the most of improving economic conditions and central bank support to enact enough reforms to escape its unwanted tradition of growing more slowly than other economies in the good times and shrinking further in the bad times? Ignazio Visco, governor of the Bank of Italy, answered these questions and many more in an interview with GlobalCapital’s Toby Fildes.

 

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: What will be the impact of the tapering and eventual withdrawal of quantitative easing on Italy’s access to capital markets? Is Italy ready for a return to more normal conditions?

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The Italian economy is strengthening and growth is picking up at a similar pace to the rest of the euro area. The gradual removal of the monetary stimulus provided by the European Central Bank’s asset purchase programme would signal the materialisation of sizeable and self-sustainable improvements in inflation and economic activity. As such, this would be good news for both the euro area and Italy.

An increase in interest rates accompanying a strengthening of economic activity is fully sustainable and would not impair Italy’s access to capital markets. In terms of debt-to-GDP dynamics, Italy’s public debt has a long maturity and any rise in yields will be transmitted only slowly and gradually to the cost of debt refinancing. The high level of the debt ratio is nonetheless a source of vulnerability and the credibility of the commitment to reduce it remains crucial.

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: Italy is to be congratulated on its economic recovery, especially over the last nine months. But how much of it should Italy take credit for — and how much is down to the broader upswing in Europe?

Economic developments in Italy are closely connected to those in Europe, due to similar economic structures, close trade ties and common factors underlying GDP growth. Over the past few years, the economic recovery has greatly benefited, both in Italy and in the rest of the euro area, from favourable financial conditions and considerable monetary policy support. In Italy growth has also been spurred by government measures providing incentives to employment and capital accumulation. As a result, the ratio of machinery and equipment investment to GDP has returned to near pre-crisis levels; between 2015 and 2017 cumulative employment grew by 3%. According to our projections, economic activity will continue to expand in 2018 at a similar pace to that observed last year. The gradual unfolding of the effects of the various structural reforms enacted in recent years will keep sustaining Italy’s GDP growth over the medium term.

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: One criticism of Italy is that it has traditionally grown more slowly than other European economies in the good times and shrunk further in the bad times. Have enough reforms been enacted to avoid repeating this unwanted tradition?

Since 2011 Italy has undertaken a vast programme of structural reforms, aimed at creating a growth-friendly environment. Legislators have approved, in various steps, measures to reduce red tape, improve the efficiency of the judicial system, prevent and fight corruption, foster competition in key service sectors, stimulate innovation, and achieve a more flexible and dynamic labour market.

The positive effects of these reforms are unfolding, but economic activity is still hampered by the rigidities and inefficiencies affecting the business environment and by weak productivity growth. The reform process must therefore continue. Its success depends on a shared commitment, far-sightedness and measures to mitigate the costs of the transition.

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: Italy is also to be congratulated on the reforms put in place over the last six years. But is there a danger that the economic recovery will lessen the appetite for further reforms?

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Reforms typically entail widespread benefits that take time to become visible, but their costs are often immediate and concentrated in specific segments of the population. Therefore, there is always the concrete risk that pressure mounts on the government to reduce the pace of reform or, worse still, to overturn previously implemented reforms. I do not believe, however, that these risks are higher in Italy than elsewhere. And I am convinced that the benefits from reforms are still palpable in Italy: an economy which has the potential to reduce the growth gap, as it is populated by firms that are on the cutting edge of technology and are competitive on a global scale.

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: Should Italy be a special case regarding bank resolution regulation? Should it be exempt or should the regulations change, and if so, how?

No exception. As I have said elsewhere, it would have been preferable to have had a transition phase before the new resolution framework was introduced in the EU, and the bail-in should have been applied to newly issued instruments. Before the new rules became applicable, banks should have had time to build up adequate amounts of new bail-inable buffers.

One outstanding issue that warrants further reflection is how to manage crisis in small banks, for which no resolution procedure is envisaged under the new EU resolution framework, given the absence of a ‘public interest’ justification for intervention. The new framework, coupled with the restrictive current interpretation of state aid rules, has disqualified instruments that were successfully used in the past to solve small institutions’ crises. Recourse to these instruments (such as interventions from deposit guarantee schemes in “purchase and assumption” transactions) should be given consideration in the forthcoming BRRD review.

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: Should other bank regulations be changed or softened? If so, which?

The recent approval of the Basel III reforms is a milestone in the process of profound change in financial regulations spurred by the global financial crisis. The finalisation of the reform package dispels any residual regulatory uncertainty about the international banking sector. What we need now is to pause for a while, in order to let authorities and banks implement and apply the new rules.

At the same time, I see merit in devising ways of reducing the burden of reporting and disclosure requirements for smaller institutions, provided that basic and sound safeguards remain securely in place. Europe, where Basel rules are applied to all banks, has moved in this direction, and I welcome this development.

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: How will the ECB’s Targeted Longer Term Refinancing Operation funding be replaced by Italy’s banks, among its biggest beneficiaries? With the TLTRO repayments, MiFID II’s impact on retail investors, and potentially more expensive and volatile debt markets as a result of QE tapering, is there a danger that Italy’s banks will face a funding problem?

Recourse to Eurosystem refinancing by counterparties operating in Italy has been substantial. Following the last TLTRO2 in March 2017, it peaked at almost €260bn (10% of total liabilities) and declined slightly thereafter. Nevertheless, I do not envisage risks for the funding of Italian banks related to TLTRO2 repayments or to the end of QE.

First of all, retail funding has been increasing, driven by deposits. Combined with weak credit growth, this has brought the funding gap (the share of loans not covered by retail funding) to historical lows (4% in September 2017). The overall funding needs of Italian banks are also diminishing, as holdings of government securities are being reduced. Excess liquidity has been rising since mid-2016, including for small banks. Moreover, in the second half of 2017 Italian financial intermediaries have placed large amounts of uncovered securities on international markets and net issues have been positive for the first time since the beginning of 2015. 

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: Italy’s retail investors have been important players in the country’s capital markets. Are they being squeezed out by regulation and if so, where should they invest instead, and where should the country’s borrowers turn for investment?

In the past few years, Italian households have replaced their holdings of government securities and bank bonds with investments in asset management instruments (mutual funds, insurance policies and retirement products), increasing portfolio diversification. Disinvestments in bank bonds have been influenced not only by the changes in bank regulation implemented after the crisis, but also by a rise in tax rates (now at standard level, after a long period of reduced taxation). More recently, the marked rise of investment fund subscriptions was favoured by the introduction of long term individual savings plans (PIR, Piani Individuali di Risparmio). In this way, the portfolios of Italian households increasingly resemble those of euro area households, even though holdings of asset management instruments remain limited by international standards. 

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: The ECB has put forward, then appeared to retreat from, plans to make banks increase their provisioning against non-performing loans. What is the best approach to this question?

I have said on several occasions that measures to favour the clean-up of banks’ balance sheets in the wake of the crisis are welcome. The so-called “calendar provisioning” is no exception, provided that it is adequately and appropriately calibrated. But supervisors should beware of approaches which would de facto impose blanket sales of NPLs on banks. In the current circumstances this would lead to a fall in the market price of NPLs. This type of policy would erode banks’ own funds at a time when raising capital can still be difficult, thereby putting the ongoing recovery at risk. In this field, any policy action needs to strike a delicate balance between the goal of speeding up the resolution of the NPL problem and that of preserving financial stability.

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: What is the solution to Italy’s NPL problem? Is there a danger that it will keep coming back to bite the banking sector every time there is a downturn?

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There is no silver bullet to solve the NPL problem, which is the legacy of the severe double-dip recession that hit Italy between 2008 and 2013. In any recession a build-up of NPLs is unavoidable: in these circumstances firms shut down and workers lose their jobs, which is what leads to NPLs in the first place. Banks, supervisors and policymakers are working hard to reduce the stock of these assets in banks’ balance sheets. Progress is tangible: as a share of outstanding loans, new NPLs have regained the levels prevailing before the crisis; as for the stock, the NPL ratio has declined significantly since 2015, and will continue to do so, also thanks to large transactions that are currently being finalised. Work is also being done to make sure that any build-up of NPLs in the future is effectively limited by safe and sound practices. In some EU countries, including Italy, more needs to be done on the speed of recovery procedures. This may require legal reform but also actions to improve the efficiency of courts. 

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: Is more work needed to develop a unified strategy on dealing with unlikely-to-pay loans? Also, what are your thoughts on the development of a speedier foreclosure process in Italy along the lines of the EU’s NPL action plan?

Bankruptcy and foreclosure procedures, which in Italy take much longer than in other developed countries, are the main reason behind the “persistence” of NPLs in banks’ balance sheets. I have often mentioned that had recovery times in Italy been in line with the average observed in the other large European countries, the bad loan ratio would have been half of what we have instead observed. The reforms of the judicial procedures implemented in 2015 and 2016 have certainly gone in the right direction. But more work is needed, for instance in terms of the specialisation and organisational efficiency of the courts. There is no doubt that the EU action plan on this issue presents an opportunity.

Banks have their role to play. Our analyses have often found evidence of poor management of NPLs, especially when it comes to prompt availability of detailed information on the state of the recovery procedures. A more pro-active stance by banks, then, is clearly needed, also on the unlikely-to-pay category. More efforts are needed to increase the cure rate (the percentage of NPLs that go back to performing). The reforms approved in 2015 contain important new rules on this front. A new kind of “restructuring agreement” was introduced, aimed at facilitating a more prompt agreement among creditors (the presence of multiple lenders, relatively widespread in Italy, can create perverse incentives among banks). Also, creditors of troubled firms have now the possibility to submit restructuring plans in competition with the one presented by the firm, reducing the possibility of opportunistic behaviour by debtors. However, reforms take time to kick in. This is a complex issue, which we closely monitor. 

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: Does the Bank of Italy regard climate change as a risk to the financial institutions it oversees? What steps, if any, have you taken to address this risk or to make financial firms address it?

We definitely regard climate change as a risk. While we are not environmental watchdogs, we are aware that climate-related natural events, as well as a hasty transition to a low-carbon economy, have potentially far-reaching consequences for the economy. Households and firms are operating in a fragile environment, exposed to floods and landslides whose frequency and intensity is increasing because of climate change. The potential disruption caused by these events can also reduce the value of the collateral of bank loans and, in turn, hamper banks’ borrowing and lending activities.

Our approach to these issues is multifaceted. We contribute to “climate intelligence”, for instance, by investigating how environmental risks can affect the value of firms and spread to the banking sector. Moreover, we provide our view on these risks to inform the debate at the national and international levels. For example, together with the Ministry of Finance, we are currently leading a group established within the National Observatory on Sustainable Finance, to help the financial community manage more effectively the risks that come with climate change.

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: Are Italian banks lending enough to support the corporate sector? Do they need further encouragement?

All in all, the availability of credit is no longer a constraint on economic activity in Italy. The rate of expansion of loans to non-financial corporations is still weak, in part due to the high self-financing capacity of firms, but it is positive in both the manufacturing and service industries. Moreover, banks have progressively eased lending standards, so that access to credit is currently quite favourable, especially for sound larger firms.

To a great extent, these improvements reflect the strengthening of the economic outlook and the effects of the unconventional measures implemented by the ECB. Looking forward, we expect growth in credit demand to gain pace as the economic recovery gains ground. This is why it is essential that monetary policy continues to maintain an ample degree of accommodation.

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: Are you concerned that not enough capital market finance is getting into the SME sector?

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The access of Italian SMEs to capital markets has always been limited due to both demand and supply factors. On the demand side, family entrepreneurs are reluctant to allow their firms to become as transparent as listed companies and to share control with new shareholders. On the supply side, there are fewer investors specialised in less transparent issuers and riskier investment opportunities. We expect that the economic recovery, drawing on the effects of the many reforms introduced in recent years, will facilitate both bond and equity financing of firms, as well as the development of a crowdfunding market. In addition, individual savings plans are helping to channel capital from retail investors towards the non-financial corporate sector, which could further incentivise SMEs to issue market financing instruments.

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: Why aren’t we seeing more mini-bonds?

At the current juncture, firms have ample internal resources and banks are granting new loans at low interest rates, so credit is actually a very attractive alternative to market financing. However, the mini-bond market is still a relatively young segment of the capital market and, overall, there are signs of a positive trend in the number of issuing firms and in the amount of issued securities. The recent case of a basket of mini-bonds issued by a pool of SMEs and subscribed by institutional investors provides a successful example of these developments.

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: How can Italy create a larger group of national champion-sized companies?

Recent work on “frontier firms” by the OECD showed that Italy’s champions are comparable to US champions in terms of efficiency but are much smaller on average. Historically Italian companies have always tended to be small, a characteristic that goes beyond sectoral specialisation. Many factors impede firms’ growth and the reallocation of inputs to the most efficient uses. To tackle this issue, among the reforms often mentioned in the policy debate, I believe that Italy should give priority to: changes in the industrial relations system to favour decentralised wage bargaining with a strong focus on firm-level productivity; the removal of tax and regulatory disincentives to firms’ entry and growth; and increasing the efficiency of the judicial system and the public administration.   

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