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Italy : Challenges faced by the European banking sector.

Let me start by thanking the Italian Banking Association for inviting me to participate in this important event Euro area banks have faced a number of headwinds since the financial crisis. As a result, euro area banks have raised significant amounts of capital which have led to a substantial strengthening of solvency ratios: average common equity tier 1 capital (CET1) increased from 7% in 2007 to 14% at present. The solvency position of European banks is thus robust. The lingering concerns about their condition relate primarily to their low profitability, an issue that has already lasted several years.

The subdued profitability is reflected in depressed bank valuations. Despite a broad-based improvement in bank valuations in recent quarters, a wide dispersion persists between euro area and U.S. banks valuations. While euro area banks price-to-book ratios have recovered from the lows of mid-2016, the gap between euro area and U.S. banks valuations remains significant, with an average price-to-book ratio of 0.77 against 1.26 for U.S. listed banksThe large cross-sectional variation of price-to-book ratios within the euro area partly reflects cyclical factors, as the pace of economic recovery varies across countries, but possibly also differences in the progress made by institutions in tackling structural challenges. To give you an idea, average price-to-book-value is 0.94 for Spain, 0.75 for Italy, 0.76 for France and 0.42 for Germany.

In the euro area, listed banks aggregate return on equity (ROE) stood below 3% in 2016, a slight decline from the previous year. In international comparison, euro area banks financial performance continues to lag behind that of most of their global peers: in 2016, U.S. average ROE stood at 8% with Nordic banks above 9%, led by Swedish banks with 12% ROE, a notable performance in a country where key official interest rates are negative and much lower than in the euro area. Regarding cross-country differences, listed Italian and German banks recorded negative average ROE in 2016 which, in the case of Italy was due to sharp increases in loan impairment charges at some banks, mainly linked with increased efforts to clean up their balance sheets. In other large euro area countries, French and Spanish listed banks recorded a ROE of 5% and 7%, respectively.

The continued weakness in bank profitability reflects a number of cyclical and structural factors. A key cyclical challenge is linked to the difficulties in increasing revenues in a low nominal growth and low interest rate environment and a relatively flat yield curve. As a matter of fact, net interest income declined somewhat in 2016, as the compression of margins was only partly offset by increased credit growth albeit still at moderate levels. While profitability headwinds stemming from cyclical factors should abate as the economic recovery progresses, structural challenges remain and need to be tackled. These include the large stock of non-performing loans (NPLs), a legacy of the 2008 financial crisis, cost inefficiency and excess capacity. Let me address each of these factors in turn.

A large stock of legacy NPL in some euro area countries continues to dampen profitability prospects. The average NPL ratio for euro area banks at just above 2% in 2007, reached 8% in 2013 and stands now at 6%. For the six high-NPL national banking sectors, the averages went however from 5% in 2007 to 23% last year. 1 Elevated loan impairment costs remain an important driver of low profitability in high-NPL countries. Indeed, following the capital and provision increases since the financial crisis, the NPL issue does not primarily concern solvency but rather banks profitability. The coverage of NPLs by provisions and collateral is, on average, 82% in the euro area and 80% in Italy. Net NPLs are therefore reassuring, from a solvency perspective. Profitability however, is affected by the lower returns provided by the NPLs, given the weight of gross exposures in total assets. The share of total assets that generates lower revenues than full performing loans is a considerable European problem: gross NPLs represent 4% of total assets of euro area banks against only 0.8 % for U.S. banks. The figure for Italy however stands at 11%, thereby with an unavoidable significant impact on profitability, despite the visible reduction in the NPL ratio for the system since the peak in 2013. Naturally, high NPLs also tie up capital, erode funding, as well as operational capacity, thereby constraining banks ability to support the economic recovery. Despite a visible reduction in system-wide NPL ratio in Italy, progress in reducing stocks of high NPLs to manageable levels remains insufficient.Amid continued difficulties in boosting revenues, remaining cost-inefficiencies also weigh on banks profitability. On aggregate, euro area banks cost-efficiency has deteriorated somewhat since 2010, based on both a cost-to-income and a cost-to-assets basis and compares unfavourably with some international peers, most notably the Nordic countries.

Against this background, for many euro area banks, a return to sustainable profitability is increasingly dependent on improvements in operational efficiency. A cross-country comparison suggests that the relative importance of physical versus digital distribution channels may be one of the differentiating factors across countries in terms of cost efficiency, as illustrated by the positive correlation between branch network reduction since the late 90s and the usage of internet banking in EU countries.

Structural challenges to profitability in some banking sectors are also linked to industry structure and excess capacity. In addition to banks efforts to improve operational efficiency via cost-cutting, consolidation could bring some profitability benefits at the sector level.

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Publication:Mena Report
Date:Jun 15, 2017
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