DBRS: Italian Guarantee Scheme for NPLs Adds Pressure for Balance Sheet Clean Up

• Guarantee scheme is an additional tool to expand the market for NPLs
• Pricing is key as the current bid offer pricing gap remains high
• Banks may be reluctant or delay using GACS to avoid losses and pressure on capital
• Increased market and regulatory pressure may test the voluntary nature of the scheme

On January 27, 2016, the Italian Ministry of Economy and Finance (MEF) announced a scheme to support the disposal of non-performing loans (NPLs or sofferenze). The scheme will provide a State guarantee for securitized transactions of NPL assets (“GACS” or Garanzia Cartolarizzazione Sofferenze). In DBRS’ view the GACS scheme will provide Italian banks with an additional tool to manage asset quality and reduce the high stock of NPLs over the medium term, and could prove a catalyst for some banks to clean-up their balance sheets.

Total gross NPLs reached historically high levels of EUR 201 billion in November 2015, corresponding to 10.4% of total lending in Italy. Even after adjusting for provision coverage of c. 56%, net NPLs remained elevated at EUR 89 billion. DBRS notes that although the scheme is voluntary, stronger pressure from investors and regulators could prompt banks to accelerate NPL sales via GACS. Likewise, the scheme could help to establish a consistent structure for selling various NPL classes to investors. The Italian GACS scheme is different from government-funded “bad banks” established in some other EU countries as it does not provide any State aid component.

Via GACS, banks can securitise existing NPL portfolios at market prices. Only senior debt tranches with investment grade ratings will be eligible for the government guarantee, and only if the related junior notes are also sold. The cost of the guarantee will be calculated on a basket of single-name credit default swaps (CDS). The CDS basket will be linked to Italian companies (financial and non-financial) with ratings similar to those of the senior notes.

In DBRS’ opinion, pricing is key. Based on current levels of provisions and market expectations, the bid offer pricing gap for Italian NPLs remains high. The scheme might be able to reduce the pricing gap only marginally via lower funding costs. Pricing will also depend on individual factors such as geography, sector and NPL vintage. In addition, there should be some benefit for banks via reduced administration costs for NPLs sold. Nonetheless, banks using GACS are likely to incur losses and this may add to capital pressure, especially for weaker institutions. Specific capital implications are also likely to differ across institutions on the basis of risk-weighting models.

It is difficult to predict the success of GACS. Although the scheme provides a consistent structure and could help to expand the market for NPLs in Italy, its usage may be limited for a number of reasons. Some banks may already be in the process of considering sales independently. Others may choose to delay NPL sales with the expectation that future collateral values may improve due to pending Italian solvency reforms or a more favourable economic environment. Nonetheless, DBRS expects that banks will be challenged and the voluntary nature of the scheme could be tested by increased market and regulatory pressure for balance sheet clean-up.

Note: All figures are in Euro (EUR) unless otherwise noted.