Risks and Perspectives for Italian Banks in the SSM Framework

Supervision, risks and perspectives for Italian banks in the framework of the Single Supervisory Mechanism (SSM) Francesco Masala – Head of EconomicResearchDepartment - ABI Vincenzo D’apice– EconomicResearchDepartment - ABI 17 Novembre 2016

Agenda Distinctive features of the Italian banks The banking context: cyclical & structuralchanges Challenges and prospects for Italian banks Focus on the asset quality issue: Country vs. Bank Determinants of Non-Performing Loans” (Abi research paper)

In Europe different banking business models coexist (1/2) • Business mix1: commercial banks with high loans/assets ratio Fiancialassets/assets Loans (interbankloansexluded)/assets Assetsheld for trading/assets Derivatives /assets Gov. bonds/assets Source : Associazione Bancaria Italiana (reffered to a sample of 132 Eu banking groups)

In Italy traditional commercial banks ... that provide credit, mainly to businesses (and in particular to SMEs) … Breakdown of loans to private customers (June 2015) Large firms SMEs Residentialmortgages to households Otherloans to households 29% 44% 71% 56% Source : Associazione Bancaria Italiana (reffered to a sample of 132 Eu banking groups)

... with low level of financial leverage (or high level of equity/assets) Leverage (attivo/equity) Fonte : Associazione Bancaria Italiana (su un campione di 132 gruppi bancari europei)

Very low State aids … Recapitalisation3measures to supportbanks (€ billion; 2008-2014) Total amounts of European state aid approved1 and used2 (EU-28; 2008-2014) Recapitalisationmeasures to supportbanks (% of 2014 GDP; 2008-2014) *Amounts of aid approved and used are the maximum outstanding (annual) amounts during the period of 2008-2014. (1) Those are data on the maximum amounts of aid, included in the measures adopted by the Member States and authorized by the Commission. In other words, those are the maximum amounts of aid (by aid instrument) that Member States were allowed to grant to financial institutions. However, data on State aid approved represent neither the amounts of aid actually used nor the benefit obtained by individual financial institutions. (2) Those are data on the amounts of aid (by aid instrument) actually given to financial institutions. However, those data do not represent the cost for public finances, resulting from State aid granted to financial institutions. For example, data on recapitalisations do not reflect the fact that some of the capital provided to financial institutions during the crisis has already been repaid. Likewise, the outstanding stocks of guarantees on liabilities reflect risks rather than fiscal costs, as those risks only result in costs if guarantees are called. (3) Data on recapitalisations show the overall amounts of capital, including liquidation aid, provided in a reporting year. Aid repayments are not taken into account. Source: ABI on EuropeanCommission «State Aidscoreboard 2015 – Aid in the context of the financial and econoimiccrisis

Agenda Distinctive features of the Italian banks The banking context: cyclical & structural changes Challenges and prospects for Italian banks Focus on the asset quality issue: Country vs. Bank Determinants of Non-Performing Loans” (Abi research paper)

The banking context evolution: cyclical & structural changes Cyclical trends … … add up to twomainstructuralrevolutions Economic trend Regulatoryrevolution Digital revolution • Operational constraints: capital, liquidity, SREP, ... • Compliance costs: SSM, SRM, DGS ... • Increased competition: even cross-border and cross-sector as well as between banks • Changing consumer behavior: needs and access to banking services • Lowassets/credit growth(poorquality of the demand) • Commercial spread decline • High cost of risk(provisions on loans) Pressure on banks’ profitability Fonte: Abi

For Italy the gap to pre-crisis levels still very wide GDP evolution: from 2008 to 2016 (2Q) GDP evolution: from 19997 to 2007

Investments still much lower than the pre-crisis levels; exports have recovered GDP main component

All in all, the resilience of credit facilities in Italyishigherthan in countriessubjected to similar stress • LOANS TO PRIVATE CUSTOMERS • Loans to non financial • corporations in Europe • (YoY growth rates; May 2009 – September 2016; %) • Loans to households • in Europe • (YoY growth rates; May 2009 – September 2016; %) • Fonte: Elaborazioni Direzione Strategie e Mercati Finanziari ABI su dati BCE • % • % • Source: ABI on ECB

Loansdynamicisdriven by the GDP trend in all the EU countries • ‘Credit per GDP unit’ trend • (Loans to GDP ratio; YoY % change; 2009 Q1-2015 Q4) > 0 = loans increase (decrease) higher (lower) than that of GDP < 0 = loans increase (decrease) lower (higher ) than that of GDP • Source: ABI

The macroeconomic cycle effects on credit quality: inevitable impact in terms of provisions and losses on loans Dynamics of the stock of net bad loans and impact on credit Loanlossprovisions evolution Abi sudati Banca d’Italia (dati di fine anno)

The relevantdecline of commercial spread on traditionallending • Interestrates and commercial spread for Italianbanks • (year end data ifnototherwiseindicated)

With respect to the recent past, Italian banks’ profitability is benefiting from the cyclical recovery… Return On Equity of largestEuropanbanks (sample of 130 banking groups; of which 15 Italians) • Source: ABI on 130 banking groups’ balance sheet data

… even if the most recent quarterly results show a significant decline in the profitability Top 12 Italian banking groups: 3q data ( mln €) • Source: Abi on banks quarterly reports

The economic outlook has weighed heavily on the performance of Italian banks, given the link between economic performance and the banks Relationship between banks profitability (ROE) and the dynamic of the economy (var. Real GDP) (estimated over the 2011-2013 period, sample of 132 European groups *) The sensitivity of commercial banking to the real economy cycle is also confirmed by statistical evidence (referred to a sample of European banking groups*): an increase of 1 percentage point of real GDP growth leads to an increase of 2 percentage points of ROE • Source: ABI (‘'Abi Report on the European banking market' '; Number 1, September 2014); (*) banks under SSM supervision plus some UK and Eu Nordic Countries banks

The ''regulatory revolution'‘ adds pressure and uncertainty New and incomingregulation (exemplification) • Any regulatory act able to affect the supply of credit can be detrimental to the economy, especially in Europe where almost 80% of SMEs funding is based on bank credit rather than on capital market fund raising as it is in US. • Banks need a clear, stable and economic friendly banking regulatory environment, able to help banks to continue to play their key role in supporting firms and households Operational constraints: capital, liquidity, SREP, ... Compliance costs: SSM, SRM, DGS ... Source: Abi

Are we confident that banks are now on the path to better health? • The Italian NPLs tale: is an happy end possible? • Are the banks ready to extend new loans to businesses? • What else needs to be done?

Are we confident that banks are now on the path to better health? • Between December 2007 and June 2016, Common Equity Tier 1 ratio grew from 7,0 % to almost 12,5% in Italy • Nevertheless, especially for commercial banks, to be on track depends on how the economy evolves as a whole Source: ABI on BorsaItaliana and Italian Banks website Source: ABI on Bank of Italy

Some relevant reasons to be confident on the future of the country and therefore of the banks: • flexibility in the Stability and Growth Pact • ECB’s quantitative easing(QE) • Juncker Investment Plan • lower oil pricesand weakereuro • a number of domestic institutional and economic reforms: • the Jobs Act • tax simplification • law to convert cooperative banks into joint stock companies • measures to speed up foreclosures and bankruptcy proceedings • alignment with Europe on fiscal deductibility of loan loss provisions • Progresses confirmed by relevant macroeconomic figures: • Italian real economy is (re)emerging gradually

Nevertheless it doesn’t mean that everything it’s fine • 8 years of recession together with a growing and complex banking regulation have: • squeezed credit demand • aggravated debtors’ repayment difficulties • affected the performance of Italian traditional commercial banks • triggered a polarisation of the domestic corporate sector

The Italian NPLs tale: is an happy end possible? • Physiological outcome of the crisis; NPLs growth lowerthan expected • In Italy 80% of NPLs growth explained by macro/country factors (Real GDP, Enforment procedure length; interest rates spread vs benchmark) as compared to 50% on average in Europe ….. • Comparisons with EU peers unwarranted: i) Italy’s recovery came later than elsewhere, ii) no national bad bank, iii) Italian banks cannot repossess assets (as in Spain) • Gross Bad debt (sofferenze) figures misleading (200 bn €): what really matters is the net value (€ 84.7 bn)1. The issue of impaired loans is not an emergency for the banking system, as most of bad debts is concentrated in banks in good financial condition and only a minor portion are held by significant banks with particularly high levels of non-performing loans and by other intermediaries with low capital ratios2 • Asset quality indicators: i) NPLs2 stock decreasing; ii) NPLscoverageratios4higherthan in mostlargest EU banks; iii) valuablecollateralisation • Recent reforms to speed up credit recovery will lower the Bid/Askprice gap and favour the creation of a NPLs secondary market • GACS (State Guarantee on NPL securitisation) will be of help, atleast for some banks • ATLANTE FUNDis likely favor the development of the Italian NPLs market, helping to bridge the gap between NPLs bid and ask price Causes Currentpicture Expectations (1) Total system, asat August 2016 (2) BadLoans (’’sofferenze’’) + unlikely to pay + past due loans (4) Provisions on NPLs / Total grossNPLs Source: ABI

Asset quality indicators are improving, for both the total Npls… In September 2016 the ratio non-performing loans / loans to households and firms is 23%, about 1 pp less than a year before

… and, for the first time since 208, for the badloansconsidered on standalonebasis September figure confirms the improvement in credit quality trends: at that date the annual change in the NPL ratio was negative for 9/10 of a point (compared to 5/10 in June). For the first time since 2008 the annual dynamics of the loans / loans ratio is negative

The improvement of the NPL ratio isdriven by both the reduction of the numerator (NPLs) and the growth of the denominator (’’performingloans) The improvement in asset quality is due to both the components of the report: in September, non-performing loans decreased at an annual rate of 4.3% (versus a decrease of 2.7% in June), while performing loans increased by 0.8% (against a stationary in June)

Are the banks ready to extend new loans to businesses? • Italian banks not only are ready to increase credit to non financial firms … banks are already increasingloans to enterprises (and to households too). • Since end 2007, banks lending to households and firms grew of around €125 billion up to €1,403 billion at September 2016 • Nowadaysthe YoY rate of change in bank loans granted to households and firms stands at 0,0%; a strong recovery from the recent past (peak: -4,5% in Nov 2013) • Recent positive signals in lending revival: in the first nine months of this year new mortgages grew by 38% compared to the first nine months of a year ago

ECB banks lending survey figures show credit standards on loans to Italian firms continue to ease, especially for less risky firms, while the improvement in lending policies translates into a narrowing of margins on the average loan • Nevertheless, in the new world, more than in the past: • banks will not grant credit to all firms regardless of their strength • lending will probably be much more selective • Due to growing pressure coming from the too pervasive and sometimes chaotic regulation and supervision, banks could find it difficult to grant credit even to those firms not performing as well as the top firms but with a clear recovery potential

What else needs to be done? • Main priority: a more balanced approach between the search for financial stability and the need to promote real economy growth, which is the current real problem faced by Europe • Conditions to succeed in part macroeconomic (exogenous to banking sector) and in part microeconomic (endogenous) • Macro 1: re-gain a sustainable and high gdp growth environment (higher real gdp, inflation back to 2% and consequent rise in interest rates) • Macro 2: pushing in order to prevent regulation from hurting economic growth (with the obsession of financial stability): • make clear how the future regulatory landscape will look as regulatory uncertainty is constraining bank lending.

Too many additional regulatory files still open: I) risk weighting of Sovereign exposure; II) revisions of standardised method for credit risk calculation; iii) IRB models harmonization, iv) national discretions on capital requirements; v) banking structural reforms; vi) TLAC and MREL; …) • avoid the risk to hit the traditional commercial banking activities in favour of other types of financial activities • Micro 1: re-composition of bank services basket especially for SMEs (+ fee income; - interest income) • shift from a bank-centred to a more capital market oriented financial structure: accelerate the radical transformation of Italian non financial firms to increase their competitiveness; the creation of a capital market union is crucial

Micro 2:act to restore profitability by… • … managing the deep changes related to digital revolution by technology / investment in IT • … leveraging on cost containment, to fill the gap between Italian and EU banking groups • … leveraging on revenues upside potential (in Italy there is plenty of room for growth in a number of markets)

Ongoing reorganisation Ongoing efforts by banks Number of branchesatItalianbanks Number of employeesatItalianbanks -35,944 -3,842 Source: ABI on Bank of Italy

Additional cost cutting and reorganisation of the distribution model Ongoing efforts by banks Bank branches per 100,000 inhabitants in Europe (December 2015) Bank branches per 100,000 inhabitants in Italy (Trend, Dec 1999 – June 2016) • +16 branches * 2014 data • Source: ABI on ECB and Eurostat data

Leveraging on relevant revenues upside potential Ongoing efforts by banks Degree of development of some financial products: Italy vs. Europe1 • Asset under management2 • Stock/GDP (%) • Non-life insurance • Non-life insurance premium/GDP (%) • Current accounts/inhabitants • Non-life insurance premium/GDP (%) • Stock/GDP (%) +47% 1.5 4 1.1 +60% 3.4 30 +30% 24.2 2.3 3 0.7 1 25 18.7 20 2 0.5 15 10 1 0 5 Italy EU* 0 0 • Credit cards/ inhabitants Italy EU* Italy EU* 0.8 0.3 • Mortgages • Stock/GDP (%) • Pension funds • Stock/GDP (%) • Life insurance • Technical reserves/GDP (%) +59% 10x 33.8 44.3 51.3 +71% 30 60 50 25 50 40 27.9 20 40 30 15 30.0 30 20 10 20 3.1 10 5 10 0 0 0 Italy EU* Italy EU* Italy EU* • Notes: (2012 Figures) • (1) France, Germany, Spain and UK • (2) Mutual funds; *France, Germany, UK and Spain. • Source: Intesa Sanpaolo on centralbanks, RBR Paymentcards in Europe, business associations, ISTAT, WBI, Eurostat

Leveraging on relevant revenues upside potential Ongoing efforts by banks • A process favored by the recovery • of the asset management market in Italy Flows of net assetsraised (€ bln, quarterly data) Asset Under Management Trend 2003 - 2016 (€ bln, annual data) 1,871 1,834 1,588 1,330 1,195 1,180 1,114 1,131 1007 955 950 938 880 842 • Source: ABI on Assogestionifigures

Exogenous actions taken/to be taken at national level: Civil justice reform and its potential impact on NPLs Bid/Ask spread Askprice* (as a % of outstandinggrossNPLs) 7 6 5 4 3 2 1 2.0% 45 46 47 48 49 50 51 2.5% 44 45 46 47 49 50 51 3.0% 42 44 45 46 48 49 51 3.5% 41 42 44 46 47 49 50 4.0% 40 41 43 45 46 48 50 4.5% 38 40 42 44 46 48 50 5.0% 37 39 41 43 45 47 50 5.5% 36 38 40 42 44 47 50 6.0% 35 37 39 41 44 46 49 (*) = NPLscarryingvalue = NPLs /GrossNpls Bidprice (as a % of outstandinggrossNPLs) 7 6 5 4 3 2 1 8.0% 30 33 36 38 41 45 48 8.5% 30 32 35 38 41 44 48 9.0% 29 31 34 37 40 44 48 9.5% 28 30 33 36 40 44 48 10.0% 27 29 32 36 39 43 47 10.5% 26 29 32 35 39 43 47 11.0% 25 28 31 34 38 42 47 11.5% 24 27 30 34 Hypothesis: ** End 2014 scenario Collateralvalue = 59% of outstandinggrossNPLs Currentaverage time to guaranteesrecovery = 7 years Fees for recoveryprocedures: serviciesfees = 6% + legalfees = 5% Resolution timing: years -35% Discount rate: banks Number of years to resolution (**) NPV= Net Present Value Resolution timing: years Number of years to resolution Discount rate: market Bid-ask spread decreases with resolution time reduction 38 42 47 12.0% 24 26 30 33 37 42 47 • Source: ABI ownestimates

Recent approved measures to reduce resolution time and accelerate the disposal of NPLs Atlante Fund State Guarantee on bad loans securitisation (GACS) Changes in Insolvency & Foreclosure Regulation Changes to the Fiscal Framework • Atlante Fund is a private-capital-funded safety network designed to support banks’ recapitalization and ease the deconsolidation of non-performing loans (NPLs) from banks’ balance sheets • It will be managed by Quaestio Capital Management Company SGR SpA • Its subscribers participate in it on a voluntary basis • Persistency of NPLs also due to a clogged judicial system • August 2015: a bankruptcy reform1 addressing insolvency and foreclosure procedures: • increase speed and efficiency of insolvency procedures and property foreclosures. • Promote higher recovery rates. • May 2016: new measures to reduce debt recovery time.3 • Scheme to enable Italian banks to securitiseand offload bad debts with a State guarantee in a way not considered State aid (27 Jan 2016). • Banks’ participation will be voluntary. • According to some analysts, it could increase bad loans value by up to 5 percentage points • New fiscal treatment of loan-loss charges adopted in 2015 to encourage write-offs and disposal of NPLs: - Loan-loss charges immediately tax deductible in full (instead of pro-quota in a 5Y) - Remove DTAs related to loan-losses charges in 10 years. • Tax for the acquisition of foreclosed real estate assets: from 9% to a €200 flat2. • Notes: 1) DL83/giu-2015/L132/august-2015 -2) To take advantage of the flax tax a buyer must turn around and sell the property within 24 months - 3) DL59/2016 • Source: Abi

Changes in Insolvency & Foreclosure Regulation Law Decree 59/2016 Law Decree 83/2015 Law Decree 83/2015 contains provisions concerning the reform of debt enforcement procedures (in insolvency and on an individual basis) aimed at: • reducing the time needed to collect debts and enforce guarantees; • supporting the satisfaction of creditors, including by enhancing their role in company turnaround processes; • increasing the flexibility of out-of-court restructuring; • introducing mechanisms for expediting forced sales and measures aimed at safeguarding the value of companies in crisis and assets subject to forced sale. The main changes introduced by the very recent Law Decree 59/2016 concerning support for companies and reduction of debt recovery times are as follows: • rules concerning non-possessory pledge; • loans to companies secured by transfer of real property subject to the condition precedent of default by the debtor (Patto Marciano); • register of compulsory property expropriation procedures, insolvency procedures and crisis management instruments; • provisions on forced expropriation; • access of the bodies involved in insolvency procedures to the information contained in the databases; • amendments to the bankruptcy law. • Source: Abi

Consolidation: a possible answer • Recent national reforms are paving the way… Over the last 12 months, the Italian Government introduced a series of systemic reforms aimed at facilitating the consolidation of the sector: Mutual banks ("BCC") reform Cooperative banks (“Popolari”) reform Cap to Foundations investments • Approved in January 2015, to be enacted by year-end 2016 • Cooperative banks (known as “Popolari") with more than €8bn in assets must change their governance structure and become joint stock companies by 31st December 2016 • Approved in February 2016, to be enacted by year-end 2017 • Over 370 small local mutual lenders (known as "BCC") will have to merge into a single, centralised institution with more than €1bn in equity • A few of them (equity > 200 mln €)could opt to remain independent • April 2015 • The Ministry of Finance and ACRI, the association of Italian savings banks and foundations, signed an MoU agreement forbidding Foundations to invest more than 33% of their equity in any single asset class. Source: Abi

Consolidation: a possible answer • …but some factors still discourage it • Some factors still discourage consolidation. Among them a major role is played by: The volatility” on capital (and other) regulation “ A FAQ among bankers today: are supervisors going to ask me a higher capital in case of an M&A deal? The achievement of a regulatory framework more certain, stable, transparent & harmonized will facilitate the consolidation process

Italian banks state of health and prospects at a glance Not an emergency • Source: Intesa Sanpaolo

Agenda 1. Motivation 2. Literature review 3. Data 4. Univariate analysis 5. Multivariate analysis 6. “What-if” Simulations 7. Conclusions

1. Motivation • Since 2008 we have seen a dramatic increase in the non-performing loans.

1. Motivation • In turn, the increase of NPLsreduces credit growth and, so, has a negative impact on economicgrowth. From NPLs to EconomicGrowth Economicgrowth

1. Motivation • Hence, understanding the key drivers of NPLs growth is very important for bank managers, regulators, policymakers. • The well-established literature that focuses on the NPLs determinants points out two different categories of key drivers: country-specific factors (GDP, inflation rate, unemployment, etc.) and bank-specific factors (capitalization, profitability, funding mix, efficiency, etc.).

1. Motivation • Our research is motivated by the fact that these studies analyze just one or few countries and do not include the recent crisis period. • So, we investigate the determinants of NPLs focusing on country vs. bank specific factors. • Our contribution is threefold: • We analyze Single Supervisory Mechanism banks and other large European banks*. • The data covers the period running from 2006-2014*. • We also provide “what-if” simulations to evaluate the impact of country-specific factors on the NPLs*.

Risks and Perspectives for Italian Banks in the SSM Framework