The Asset quality review on non-performing loans conducted by the Bank of Italy: Main features and results

Introduction

In the last few years the Italian economy has been under considerable strain. Between 2007 and 2012 GDP fell by a cumulated 7 percentage points in real terms. Industrial production fell by a quarter. This environment has given rise to a large increase in non-performing loans (NPL), whose ratio to total loans went from 4.5% at the end of 2007 to 12.3% in June 2012. Over the same period the level of the related provisions as a ratio to total loans (the so- called coverage ratio) fell by 12 percentage points, from 49.4% to 37.7%.

For a proper assessment of the current levels of NPL and of the coverage ratio characterizing Italian banks, over time as well as in the cross-country dimension, several facts must be taken into account.

1. The definitions of non-performing loans in the EU are highly heterogeneous, and the one adopted by Italian banks is particularly ample. In particular, over the last few years Italian banks have called for more collateral and reduced loan-to-value ratios. Applying the definition of non-performing loans adopted by leading European banks, which excludes fully collateralized positions, the coverage ratio of the Italian banking system would be much higher, and increasing over the last three years.
2. Four of the twelve percentage points decline in the coverage ratio recorded between 2007 and 2012 reflect a composition effect.
3. Italy is characterized by long judicial procedures for credit recovery actions. This induces banks to build the outstanding amount of provisions gradually; it also entails a relatively high steady state level of the NPL ratio.

The Bank of Italy constantly monitors the evolution of credit risk and banks’ provision policies. Asset quality reviews (AQR) are carried out on a regular basis, as a part of the Supervisory Review and Evaluation Process (SREP), in order to assess the current and perspective exposure to credit risk of each institution, according to the reference framework provided by the Bank’s Supervisory activities guidelines.

This note presents the main methodological aspects and the key results of an initiative focused on coverage ratios and provisioning policies launched by the Bank in 2012. Section 2 briefly illustrates the general approach adopted by the Bank in its supervisory activity focused on asset quality. Section 3 describes the specific features and the results of the AQR carried out in 2012-13. The forthcoming supervisory actions are described in Section 4.