|
The Italian banking system faces complex challenges as it restructures in preparation for complete or partial privatization. A recent report by US credit-rating agency Standard & Poor's (S&P) points to profitability and capitalization problems that partly result from much of the industry being directly or indirectly state-controlled and partly from fragmentation. It notes that although there has been economic recovery in the past two years, Italy's banks are still dogged by the low profitability that emerged at the beginning of the decade because of recession and deteriorating asset quality. This stagnation, the report adds, reflects "tougher competitive pressures on operating margins and insufficient cost controls".
Capitalization is another peculiarly Italian problem. Whereas banks in most other European countries have strengthened their capital bases in recent years, in Italy, the S&P report notes, these have declined "because of poor earnings retention and ambitious acquisition strategies".
Low profitability and weak capitalization have adversely affected Italian banks' credit ratings. The S&P report notes that Italy is near the bottom of the EU pile, with its "12 largest institutions having an average rating at the low end of the 'A' category".
Italian banking's sorry state is to a large extent a result of its history. Until recently it was hemmed in by a banking law drawn up in 1936 which severely restricted the services particular categories of banks could provide. In many ways banks seemed trapped in a centrally-planned economy rather than enjoying the opportunities of an open market.
The curious ownership structure of many of Italy's 1,000-plus banks has exacerbated their problems. Although privatization has begun, many banks are still either directly state-owned (effectively controlled by the Italian treasury) or under the control of charitable foundations that are themselves government-supervised.
"Foundations," explains the S&P report, "are non profit-making bodies whose goal is to promote public and social interests with particular regard for the development of scientific research, education, the arts, social welfare and other charitable concerns." At the end of 1995, foundations and associations still controlled over half of Italian banks.
This structure is in itself not particularly conducive to profitability and the problem has been compounded by severe overstaffing. Italy is highly unionized (40% of the labour force) and labour laws are legendary for their inflexibility, so most Italian banks have more personnel than they need or indeed can afford. Banks are traditionally higher payers than other Italian industries and this has meant strikingly low return on equity (ROE) ratios compared with European competitors. Goldman Sachs figures indicate that at the end of 1995 average ROE for European banks was 12.8%, with the UK at the top of the list with 21.1%; Spain and the Netherlands at 12.6% and 11.7% respectively, in line with the average; France on 6.2%, considerably below the average; and Italy trailing with 4.13%.
Belated change
Change is late in coming. But recently privatized banks have started speaking a new language. At Credito Italiano, for example, managing director Alessandro Profumo, a recent recruit from consultants McKinsey, has publicly announced that his bank is seeking to lift ROE from 3.3% in 1995 to a lofty 11% in 1998. Few analysts share Profumo's bullishness. For example, Stefano Alberti, head of research at Intermobiliare Securities in Milan, suspects that 9% would be a more realistic target. The important point though, say Alberti and other observers, is that Italian bankers are starting to use and to understand terms such as ROE. "Three or four years ago the only people in the banking industry who were talking about ROE were foreign banks such as ourselves," says Alessandro Massarelli, director at Citibank's Milan-based global relationship banking department.
Banks such as Credito Italiano or Banco Ambroveneto which posted a 1995 ROE of 8% and is projecting at least 10% in 1996 are, however, very much the exception. At the other end of the spectrum are institutions like Banco di Napoli, which reported 1995 losses of around $2 billion (the worst result in Italian banking history). In between lie more than 900 other banks, 827 of which have assets of less than L1,500 billion ($1 billion) and are categorized as being "minor" by the Bank of Italy. It's small wonder Claudio Costamagna, vice-chairman of the Goldman Sachs Sim (investment bank), describes Italy as "easily the most fragmented banking industry in Europe".
These daunting problems an opaque ownership structure, undistinguished ROEs and absurd fragmentation have convinced most Italian bankers that wholesale restructuring must precede widespread privatization. The impetus for change, they say, comes from three related sources. First and foremost, the regulatory authorities are seeking to bring Italian banking practices into line with those elsewhere in Europe. As a result, the Bank of Italy has dictated that foundations must reduce their banking stakes within the next five years. It has also given its public blessing to hostile bank takeovers. This would have been considered unthinkable five years ago, say local bankers.
Second, adds Angelo Papa, head of financial products at Deutsche Bank in Milan (which is widely cited by its competitors as by far the most successful international bank in Italy), pressure for change has increasingly been brought to bear by Italian industry through pressure group Cofinindustria, which has concluded that inefficiencies in Italian banking now threaten the long-term viability of Italian manufacturing.
A particular problem is that lending policies have had much more to do with politics and relationships than with balance sheets or fundamental analysis. A recent report from credit-rating agency Moody's Investors Service noted that "the depth of loan quality problems has been exacerbated by generally unsophisticated credit approval, review and monitoring systems". The report also points out that the Italian Bankers' Association has drawn attention to "unsystematic ad hoc lending criteria, a superficial due diligence approach, insufficient awareness about cross-group borrowing risks and undisciplined loan-monitoring
procedures".
A third impetus for change is increased European integration and the threat of greater competition from foreign banks. This is already evident in investment banking. Italian government bond trading is dominated by foreign houses, with JP Morgan, Morgan Stanley and Salomon Brothers the leaders. In the first half of this year, JP Morgan led more Eurolira bond issues than Credito Italiano, the leading Italian house, with a market share of more than 15% in volume terms. In no other Eurocurrency (apart from the recently established Czech koruna market) do foreign houses enjoy such dominance as lead managers.
Goldman Sachs's Costamagna reckons that to be overconcerned about investment banking is to miss the point about foreign competition. "I would look at the retail side, which is really the crucial point," he says. "Up until now the retail banking sector has been heavily protected. Very few foreign banks have entered the market in a massive way, with the possible exception of Deutsche Bank. Looking forward, I'm not sure that the system will be able to sustain that in the context of an
integrated Europe."
If and when that protection evaporates, international banks are expected to home in on Italian savings, which are second in volume to those in Japan and larger than any other European country's. Deutsche Bank has already made substantial inroads and is now the ninth-largest fund manager in Italy. US investment management company Puttnam has recently indicated its interest in signing a joint venture with the regional bank Cassa di Risparmio di Brescia in Lombardy.
International interest in investment management in Italy is sure to gather momentum for two reasons. First, the long-awaited development of a private pension fund industry as government provision is reduced will attract international fund managers with proven track records. And second, though Italians are prodigious savers, the products on offer to them are for the most part unsophisticated.
Michele Calzolari, director general at the investment bank Caboto Sim (100% owned by Banco Ambroveneto), points out that only around 25% of Italian savings are managed professionally. The rest is channelled into government bonds, real estate or bank deposits or kept under the mattress.
Cost-cutting and diversification
The restructuring of Italian banking will need to take place on two fronts. First, it will have to involve dramatic cost-control measures allied to diversification of products, and geographical penetration aimed at bolstering ROEs and making Italian banks attractive to equity investors. Second, there will need to be a restructuring of ownership and extensive concentration if Italian banks are to become big enough to compete internationally. Neither process is going to be easy.
Banks are already attempting to cut staffing costs or at least, as an initial move, to make better use of staff. A palliative was provided by a Bank of Italy decision to remove an outdated law preventing banks from opening new branches without its approval (which was seldom given). Several banks are taking advantage of their freedom by opening smaller branches to which they are relocating excess staff. Banco Ambroveneto, for example, is opening some 30 to 35 new branches a year, most of which are breaking even within one to two years, says Gigliola Zecchi, head of the bank's international division.
But banks cannot go on opening new branches forever. As the S&P report warns: "The traditional commercial banking market will soon be close to saturation." Jobs will have to go altogether, rather than being moved from one pocket to another. Kevin Tempestini, Italian equity strategist at Salomon Brothers in London, says that the Italian banking industry's 330,000-strong workforce needs to be reduced by at least 10%. "I would expect this to cost at least around L50 million up-front on average for each employee," he says, "which in total comes to L1.5 trillion (or $1 billion)."
What is more, he points out, banks unlike industrial companies with more than 5,000 employees are not entitled to government financial support for redundancy payments. "As we have a centre-left government whose number one priority is to reduce unemployment, political support for this is unlikely to be very visible," he says.
Many banks are addressing the problem through early retirement schemes, some with a surprising degree of success. According to a recently published Morgan Stanley research bulletin, San Paolo Bank, Italy's largest in terms of assets, recently called for 600 employees to accept early retirement: in the event, 900 volunteered to leave.
Productivity is the other face of cost-cutting and analysts argue that more should be done through the adoption of such measures as Anglo-Saxon style performance-related pay. San Paolo is another pioneer here, having introduced an incentive-based salary plan for management. There's a long way to go, though, to match standards elsewhere. Gregorio De Felice, head of the research department at Banca Commerciale Italiana (BCI) in Milan, notes that the "variable" (or performance-related) share of personnel costs in Italian banking is still only around 2% or 3% of the total, compared with anything up to 30% or 40% in the US or the UK.
A radical shift in the product range offered by Italian banks to increasingly sophisticated and demanding local customers is an even more important priority. "In the Italian banking industry about 80% of total revenues are generated from lending," says Deutsche Bank's Papa. "Much too little comes from commission or other fee-based income. The banking system here has to work on the development of alternative products rather than relying on what seems to be an ever-dwindling spread in the lending market." He suggests that Deutsche's Italian operation, which derives roughly half its income from non-lending activities, could act as a "model" for other Italian banks.
As examples of potential growth areas, Papa cites credit cards, bancassurance, custody services and payment systems. "The concept of the back office as a profit centre has rarely been explored in Italy," he says. "Foreign exchange dealing, for example, has been seen purely as a service to the branches rather than as a profit centre in its own right."
Asset management is the most important area for diversification. Although international banks would hardly regard this as ground-breaking, in Italy, it would involve a marked cultural change. "Don't forget that until very recently the banking industry was actually afraid of asset management," he says. This was simply because asset management was seen as a dangerous new-fangled competitor to familiar bank deposits.
Alongside product restructuring goes geographical restructuring. Traditionally, Italian banking has been strongly regionalized in three distinct areas: north, central and south. Historically, banks that have attempted to expand much beyond their local franchise have met with a chilly response and have often been forced to withdraw, licking their wounds and counting their non-performing loans.
The south where compared with the north the economy is weak, staff costs are high and the ratio of bad debts is some three times higher has historically been considered perilous territory for northern-based banks. But those with franchises in the south are also said to have struggled to do well in the north. Stefano Marsaglia, director at Rothschild Italia, which is working with JP Morgan on restructuring Banco di Napoli, explains that the southern bank's ill-fated forays into the north accounted for "huge losses". With only a 1% market share in the north, the bank was forced to lend to take on relatively risky borrowers in its endeavours to expand a move doomed to failure.
Today, however, a number of the stronger banks Ambroveneto is the best example are seeking to expand by acquisition into previously unexplored regions. Although risks are higher in the south, so are potential rewards, given the relative lack of sophistication of industries and investors there.
According to figures published by the Bank of Italy, the surplus of deposits to loans in the south is much higher than in the north. At the end of 1995, deposits totalled L473,000 billion in the north, with a 15% surplus over loans of L413,000 billion. In the south, deposits totalled L176,000 billion, compared with total loans of L111,000 billion a surplus of 59%.
North-south divide
Ambroveneto believes that in spite of the risks involved in the south, the region's potential in such sectors as agriculture and tourism justifies expansion there, effectively making Italy south of Naples, say, the equivalent in global banking terms of an emerging market for institutions located primarily in the north. "We've been acquiring practically one bank per year, mainly in the south, because our aim now is to become a strong national bank rather than one which is strong only in the northern region," says Zecchi.
As a result of initiatives by Italy's top banks to cut costs and restructure their product ranges, international analysts are now starting to regard them as heavily undervalued stocks with recovery potential. To date this year, Morgan Stanley has published "strong buy" recommendations on San Paolo; commented on Istituto Mobiliare Italiano (IMI) as "1995 problems solved, ready to roar"; and described Banca Popolare di Milano's performance as "a true turnaround".
Morgan Stanley is not necessarily implying that these largely northern-based banks are the acme of efficiency and profitability. Its view is rather that the best Italian banks should not be valued at a discount to what is already Europe's cheapest equity market in Europe on a price-to-cash-earnings basis. According to the Morgan Stanley calculations, IMI stands at a 26% discount to the market on this basis, while Banca Popolare di Milano's discount is closer to 50%. Both discounts appear to be unjustifiably wide.
Analysts consider that concentration among Italy's banks needs to be accelerated. So far the majority of mergers have involved very small players. The exceptions have been the creation of the new Banca di Roma through the merger in 1991 of Banco di Roma, Cassa di Risparmio di Roma and Banco di Santo Spirito; and, more recently, the acquisition by Credito Italiano of Credito Romagnolo, which was subsequently merged with Carimonte Banco to create one of the largest private regional banks in Italy, Rolo Banca 1473.
Some analysts express astonishment at the price Credito Italiano was prepared to pay for Credito Romagnolo. One competitor in Milan scoffs that "Credito Italiano paid more [over two times book value] for Rolo than [state holding company] IRI generated from the privatization of Credito Italiano in the first place, which is a nonsense".
The pricing problem is one of the biggest obstacles to further banking consolidation. Rothschild Italia's Marsaglia points out that "Italy is probably the most expensive place in Europe to buy a bank. Typically acquirers would have to pay more than two times book value."
There are sound reasons for these distorted prices, say Milan-based bankers. First, given that the obstacles to opening new branches have been removed only recently, one of the few viable ways to grow was through acquisition. Banks quoted on the stock exchange have typically been cheap trading at around 0.7 times book value but have also been unattractive and usually unattainable acquisition targets. Low returns on equity plus with extensive cross-holding ownership structures (and, in the case of Credito Italiano, an in-built poison-pill mechanism) have combined to rule out publicly-quoted banks as acquisition targets.
The cost of consolidation
This has left the smaller, regional banks as potential prey. However, few of these offer acceptable levels of profitability, so demand for those that do far exceeds supply. As a London-based investment banker explains, a small, regional Italian bank that is profitable may attract 15 or more bidders, while a larger, "available" institution would be unlikely to attract more than three at the most.
The London banker says two further complications impede mergers. "The first problem," he says, "is that if you're a large listed bank and your shares are trading at 0.7 times book value, it is enormously dilutive to fund an acquisition through the equity market if you're buying a bank at 2.5 times book value."
A second obstacle, he says, derives from Italy's labour laws. In most friendly bank mergers in Italy, he explains, the acquirer will have to sign contracts pledging to protect jobs in the newly-merged bank. "That means that in the concentration process which we have seen so far very little added efficiency has been created. Shareholders of listed or even unlisted banks are unlikely to support bids when they do not believe in the ability of the merged banks to deliver immediate returns in terms of higher efficiency. So it's a difficult puzzle and I wonder if we will see the sort of concentration among the banks which some people expect and which this market so desperately needs."
Others share this concern. Deutsche Bank's Papa says: "Consolidation is the only way forward if we are to create large banks which can compete in a meaningful way internationally. But unfortunately I don't see the likelihood of big mergers among the top banks which would create five or six genuinely large players, rather than 25 or 30 medium-sized banks."
Rothschild Italia's Marsaglia is more sanguine. "I wouldn't be surprised if we were to see a big merger within two years. We will have to, if Italian banking wants to avoid being marginalized internationally. After all, if you're five times smaller than Deutsche Bank, what sort of role can you expect to play internationally?"
At the moment Italian banks have virtually no international presence. One of the few exceptions is BCI, which in May 1994 raised to almost 100% its holding in Grupo Sudameris, which consists of more than 30 banking and finance companies in Latin America with some 250 outlets and 6,000 employees. However, as a recent report published by London-based credit-rating agency IBCA notes, BCI may be the fifth-largest bank in Italy in terms of consolidated assets, but ranks a modest 80th in the world.
Far from seeking to expand internationally, a number of other Italian banks are closing down their limited foreign operations to cut costs. "What is very clear and in many ways very sad is that Italian banks have basically disappeared from the international scene," says a representative of a US investment bank in Milan. "For example, 20 years ago the likes of BCI were able to compete overseas with SG Warburg or Deutsche Bank. Today they most obviously cannot."
Whether or not this matters is a moot point. Some Italian bankers argue that international expansion has hardly been spectacularly successful for some of the world's most deep-pocketed banks and that Italy's banks have a fairly impregnable hold on the local retail market, which is where the serious money is to be made. Others, however, suggest that Italian banks' lack of international expertise will mean that they are less well placed than their foreign competitors to benefit from structural changes to the Italian financial services industry.
Corporate bond market
One of these changes, several Milan-based bankers suggest, will be the introduction and rapid evolution of a corporate bond market, the impetus for which is expected to be the recent changes to fiscal legislation that reduce the attractiveness of certificates of deposit as a means of raising bank funding.
The Bank of Italy has indicated in its latest annual report that it would like to see a bank bond market develop which could later act as the benchmark for a corporate bond market. This in turn would present Italian banks with both opportunities and threats. For the stronger players, it will offer further opportunities for product diversification, allowing banks to act as issuers, distributors and market-makers; for the weaker institutions an active bond market would simply add yet another source of funding to compete with bank deposits.
But the development of a corporate bond market if it evolves in tandem with a more sophisticated institutional investor base in Italy would also benefit international banks in Italy that have a proven track record in fixed-income markets elsewhere in Europe.
Market observers seem agreed that the formidable restructuring challenges which lie ahead for Italian banking will make the eventual privatization process a delicate one.
Currently on the agenda, and originally scheduled for the second half of 1996, are the partial sales of stakes held by controlling foundations in Bancario San Paolo di Torino and savings bank CARIPLO.
In both sales, say investment bankers in London and Milan, the selling foundations will need to pursue a phased approach, beginning with stakes of perhaps 20% and being satisfied at least in the initial tranches with very low prices.
As a London investment banker uncompromisingly puts it: "Investing is the art of pricing. Everything has a value and everything is a good investment at the right price. In the case of the Italian banks, that price is currently well below book value. So the foundations will have a choice either to sell cheaply, or not to sell at all.
|