Italy’s Financial System Stabilized, Still Vulnerable

Low profitability, deteriorating loan quality remain key vulnerabilities

Risk monitoring and financial sector oversight are strong

Reforms needed to improve bank governance

Italy is one of the major 25 financial sectors that must undergo a review of its financial health every five years as part of the IMF’s surveillance. The latest assessment under the Financial Sector Assessment Program is the country’s first since the global economic crisis. The IMF also released its annual report on the health of the Italian economy.

The IMF said the Italian financial system has shown remarkable resilience in the face of a severe and prolonged recession at home and a major crisis in Europe, but the baseline outlook for the economy remains weak and the financial system is still vulnerable.

“If downside risks to this baseline materialize, the impact on banks could be significant, albeit substantially cushioned by their own capital buffers and the availability of liquidity from the European Central Bank ,” said Dimitri Demekas, an Assistant Director in the IMF’s Monetary and Capital Markets Department and head of the team that conducted the assessment.

The IMF assessment recommends a variety of measures to the Italian authorities. Those measures will have to be complemented at the euro area level with steps to strengthen the banking union.

Main risks

Banks have strengthened their capital position in the last years, but remain vulnerable to several key risks, in particular:

• The lackluster economic outlook and the large exposure to the highly-leveraged Italian corporate sector that keep credit risk rising and put pressure on bank profits. The ratio of non-performing loans (including past due, restructured, doubtful, and defaulted loans) to total loans has almost tripled since 2007 to 13.4 percent.

• The weak governance in some categories of banks—notably cooperatives and banks under significant influence of banking foundations— that fare noticeably worse in the stress tests.

• The large holdings of government bonds that leave banks exposed to losses and higher funding costs if yields on government bonds surge again. The yields on Italian government bonds have declined substantially from...