Non-performing exposures (NPEs) have been weighing on Italian bank credit for years. But in a new report, Scope notes that trends have changed and the underlying drivers of asset quality have been improving for some time. From a peak of EUR 344bn in Q3 2015, Italian banks’ gross NPEs fell 20% to EUR 274bn by Q3 2017, due to a combination of pressure from supervisors to conduct more portfolio sales, an active secondary market, and a better macro backdrop.

With the weakest banks liquidated or in State hands, sources of headline risk are limited. All banks of relevant size have increased provisions, and most have seen gross and net NPE ratios decline.

“The recent business plans of most Italian banks include disposals of bad loans in response to supervisory requirements and to reduce downside risk, even if this route may not necessarily maximise shareholder value. From a credit perspective, though, Scope sees this as a positive development and we expect 2018 to be another record year for NPE sales,” said Marco Troiano, bank analyst at Scope and author of the report.

NPE sales are commonly accepted as the fastest way to bring down headline ratios. Scope estimates that most banks should be able to bring their gross ratios down to the mid-to-high single-digit range. Indeed, NPE strategies have converged on market solutions, as a consensus seems to have emerged on best practices to deal with the stock of bad loans. The ECB’s publication of guidance for dealing with NPEs played a part in this, as did the increasingly intrusive SSM supervision into banks’ asset quality.

“Scope’s ratings on Intesa (A, Stable) and UniCredit (A, Stable) acknowledge the better environment as well as individual improvements at both banks. By 2021, we expect Intesa and UniCredit to achieve gross NPE ratios of 5%-6% with high coverage, which should reassure investors,” said Troiano.

Asset quality no longer features at the top of Scope’s systemic risk agenda for Italian banks. In fact, NPE formation trends have been reversing since 2015, in part due to increased supervisory pressure from the ECB/SSM since 2016. Fast forward to 2018 and the picture has improved materially. Current NPL levels in Italy and Europe are a legacy of the last crisis.

Scope considers that bad loans are adequately provisioned for; the current 64.4% coverage ratio looks adequate to cover expected losses. “Barring a relapse of the economic situation, we believe provision accruals going forward should be more contained than in the recent past and we expect asset-quality metrics to continue to improve, supported by favourable macro conditions,” said Troiano.

“We believe that current coverage levels are consistent with expected recovery rates. While economic conditions remain supportive, we do not foresee material additional losses stemming from the current NPE books. However, if the macro backdrop deteriorates, this could put downward pressure on collateral values, recovery rates and, through these, on solvency,” said Troiano. “Time is of the essence. Banks should accelerate their NPE clean-up so when the next economic downturn emerges, they are not bearing the burdens of the old crisis.”