Italy's Banks Sail in Choppy Waters

WSJ Europe (Free pass)

By SABRINA COHEN

Europe's banking emergency room has a new patient: Italian lenders.

Investors have focused on their poor performance since banking shares fell by as much as 10% in a single day late last month, a decline triggered by negative reports on the lenders by credit-rating companies. In reality, though, Italy's banking sector has been in the doldrums since March, when the first news of a new Greek crisis started to circulate.

Stocks of the largest five Italian banks have lost around 27%, on average, since the beginning of the year. Concern over contagion risks from other European countries' sovereign-debt problems has weighed heavily on investors' minds, even though the exposure of the country's five leading banks to Greece stands at a relatively low €2 billion ($2.9 billion).

The sluggish economic recovery in Italy, mirrored by the banks' own balance sheets, has also done little to assuage concerns.

At the end of March, several Italian lenders announced so-called rights issues—plans to sell stock to existing shareholders—to raise capital ahead of European-wide stress tests.

The move was taken after Bank of Italy governor Mario Draghi, who is soon to be president of the European Central Bank, urged lenders to strengthen their balance sheets.

Analysts say political uncertainty during talks over key government budget measures worsened the situation at an inopportune time. Marcello Zanardo, a senior banking analyst with Sanford C. Bernstein & Co. in London, said the sector has been battered but isn't broken.

"Italian banks suffered more than other European banks mainly because of their lower profitability and country risk, which led to right issues, but their fundamentals remained sound," Mr. Zanardo said.

In the last two years, while large lenders were busy strengthening their capital ratios in order to comply with European rules on bank capital, small banks offered better pricing to their clients, gaining market share.

"Given the aggressive pricing done by smaller banks in Italy, leading to market-share gains, I believe in today's difficult funding environment they will have no choice but to slow down, with bigger and recapitalized lenders finally starting to grow again," Mr. Zanardo added.

The fall in stocks on June 24 was prompted by credit-rating companies Moody's and Standard & Poor's putting the outlooks on Italy and 16 of its domestic lenders under review.

In the last two quarters, the profitability of Italian banks has come under pressure because of an age-old Italian problem: an inability to cut costs and boost efficiency. Italy's banking system has expanded in the last five years from 31,400 branches to 33,600, due in part to the arrival of foreign lenders such as BNP Paribas SA, Crédit Agricole SA and Barclays PLC.

But given the cost of cutting jobs, and the difficulty of negotiating layoffs with Italy's powerful unions in the wake of the global downturn, banks found it difficult to streamline their operations, getting rid of some of their 325,000 staff.

Italian mutual bank Banco Popolare on Thursday became one of the first institutions to bite the bullet. Having secured a €2 billion capital injection through a rights issue at the start of 2011, it announced plans last week to close 140 of its 1,992 branches and cut costs as part of an updated three-year business plan.

Still, more trimming needs to be done by the sector before the outlook can turn more rosy. The chief problem has been the multi-billion-euro rights issues most banks have been forced to seek.

Unlike most European-based lenders, Italian lenders didn't benefit from a government bailout during the height of the economic crisis. Instead, several Italian lenders used expensive government-sponsored bonds, named "Tremonti bonds" after Finance Minister Giulio Tremonti, to strengthen their capital ratios.

It was the Italian government that benefitted the most, gaining around €200 million from interest on those bonds, according to a study by Mediobanca.

In early 2011, Banco Popolare, UBI Banca SpA, Intesa Sanpaolo SpA and Banca Monte dei Paschi di Siena SpA, had to announce rights issues valued at a total of around €10.4 billion to strengthen their capital ratios and, in some cases, repay the same bonds.

Market participants believe the sector will improve once the impact of the rights issues passes.

Giuseppe Vegas, chairman of Italy's market watchdog, Consob, said last week that he expects European-wide stress results this month to give Italian banks a seal of approval.

Antonio Guglielmi, an analyst based in London with Mediobanca Securities, believes that an increase in interest rates by the ECB may have a negative impact on the cost of funding, but will still help Italian banks' net interest income.

Italian bank stocks may be in need of some aid, but at the least, a corner has been turned.

Write to Sabrina Cohen at sabrina.cohen@dowjones.com