The deteriorating growth outlook has heightened financial tensions - The worsening of the outlook for the growth of the world economy has heightened fears for the soundness of heavily indebted borrowers, public and private alike. The strains have affected the international banking system and given rise to risks to global financial stability. Within the euro area the sovereign debt crisis has spread to Italy and Spain. The difficulties encountered by the authorities in implementing suitable countermeasures against the crisis have played a part.
There are fears that the cyclical weakness may persist ... Fears are emerging that the phase of weakness for the global economy will persist, with possible repercussions on consumption and investment decisions.
... as a consequence of the necessary corrective measures for the public finances ... The main advanced countries are stepping up the necessary effort for the adjustment of their public finances. In the absence of structural reforms to boost expectations of future incomes and sustain demand, however, fiscal consolidation measures applied simultaneously in a number of countries could trigger a downward spiral of declining economic activity and deteriorating public finances.
... of deleveraging in the private sector ... The leverage of households and firms is decelerating or decreasing, especially in economies where debt is at high levels. If excessively rapid and widespread, this trend - necessary though it is - also threatens to depress demand.
... and of the difficulties of the banking sector - In the euro area, the sovereign debt tensions are having repercussions on banks' market evaluations and their ability to raise medium- and long-term funds. In the short term, funds from the Eurosystem allow banks to cope with the illiquidity of the wholesale funding markets, but protraction of the tensions entails the risk of shrinking banks' balance sheets and tightening credit supply conditions.
The debt crisis is the main macroeconomic risk - The debt crisis in Europe is the main risk for the world economy. The scenarios set forth in this Report take account of the aggravation of the crisis in recent months; they posit that the countermeasures already taken, or those to be decided in the future, will prevent the materialization of the worst cases.
Europe needs an overall strategy to resolve the crisis - Towards the end of 2008 and in the early part of 2009 the European authorities intervened successfully to recapitalize banks and guarantee their fund-raising. In today's circumstances the scope for action by the public sector is limited. The banks' difficulties are strictly linked to those of sovereign borrowers. The measures decided by the European Council in October tackle both problems at once by strengthening the European Financial Stability Facility's capacity for action, adopting a new programme for Greece, and preparing a plan for the recapitalization of the largest banks and guarantees for banks' bond issues. The procedures for the implementation of these measures, now being defined, will be of the greatest importance.
The Italian economy has weaknesses, but important strengths as well - In investors' assessments Italy is penalized by its high public debt and above all by slow growth. However, Italy also has strengths, notably the small budget deficit, the low debt of the private sector, the soundness of the banks, and limited foreign debt. The Government forecasts debt to GDP will be reduced significantly. If the fiscal consolidation targets are met, our calculations indicate that the ratio should come down or stabilize even if interest rates on government securities were to undergo significant increases.
The permanent reduction of sovereign risk will nonetheless require measures to increase the potential for growth, which in the present phase are closely linked with financial stability. Italy's European commitments for effective reform must be swiftly implemented.
The improvement in the condition of firms has come to a halt - Firms are being affected by the weakening of economic activity. Business surveys point to expectations of a decline in levels of activity and a worsening of the terms for access to credit. If these expectations materialize, the financial condition of many firms could worsen in 2012.
The financial condition of households is solid - On the whole Italian households are financially sound. Their indebtedness is modest; their substantial wealth consists largely of low-risk assets. Our analysis indicates that the risk of a significant increase in interest expense is limited. Strains could arise for lower-income households, which hold a very limited portion of bank loans.
The banking system is being affected by the sovereign debt crisis - The difficulties with which the Italian banking system must now contend did not originate within the system. Italian banks' exposure to the countries for which financial support programmes have been instituted is very low in both securities and CDS markets. As in other banking systems, the asset share made up of domestic government securities is significant. In part for this reason the banks' CDS spreads have been following the rising trend of those for Italian sovereign debt.
Credit to the private sector should continue to expand in 2012 - Our estimates, which assume the gradual passthrough of the recent rises in government securities yields to banks' lending rates, suggest that the current strong expansion of credit to non-financial firms would weaken slightly in 2012; the rate of growth in lending to households would remain unchanged. If banks' difficulty in accessing the wholesale funding market were to persist, the credit slowdown could become more pronounced.
The new bad debt ratio declines - The flow of new bad debts is decreasing in proportion to outstanding loans, albeit slowly. The outlook remains uncertain, however, with the risk of an upturn, especially in respect of lending to firms.
Italian banks have reduced their foreign exposure; within this aggregate there has been a shift towards the countries of Central and Eastern Europe, which have good growth prospects but also high macroeconomic risk.
Retail funding has increased but wholesale funding has declined - Italian banks' retail fundraising continues to expand at a steady rate, but the illiquidity of the international capital markets is affecting their overall funding capacity. Their ability to cope with these strains is underpinned by the large share of highly stable retail funding, the absence of maturing government-guaranteed securities, and a balanced, though diminishing, liquidity position.
The sovereign debt tensions have had repercussions on liquidity ... In the absence of a revival in the wholesale funding markets, Italian banks' recourse to Eurosystem refinancing - which, like that of banks in other leading European countries, has already increased in the past few months - will inevitably expand further. The Italian banking system as a whole can count on very substantial assets eligible as collateral with the central bank.
... and on banks' profitability - Banks' profitability is stable, but the prospects are clouded by developments in the real economy and the strains in the financial markets. The containment of costs will have to play a key role in recouping profitability.
Further capital strengthening is under way - Italian banks have boosted their capital bases significantly this year thanks to their capital increases and retained earnings. This action will continue, as part of European initiatives. Stronger capital buffers will enable Italian banks to withstand shocks and maintain a sound capital position and reactivate wholesale funding.
In the money market, collateralized transactions and those intermediated by the central counterparty predominate - Interbank trading has contracted and been concentrated on the contract types best able to contain counterparty and liquidity risk. For the most part funds are traded through collateralized operations with the interposition of the central counterparty. Within the uncollateralized segment banks continue to have substantial recourse to the OTC market, which handles most of Italian banks' transactions with foreign counterparties.
The government securities market has lost liquidity but has continued to operate regularly - The liquidity of the secondary market in government securities has diminished significantly during the periods of tension. On the primary market the placement of Italian government securities has proceeded smoothly. The cover ratio of demand to supply has consistently been above one, with only occasional slight dips.
The payment and securities settlement systems have operated regularly and with full business continuity.
