Italian Banks - Accelerating the Sales of NPL to Improve Asset Quality

Italian Banks - Accelerating the Sales of NPL to Improve Asset Quality 31 July 2017 Commentary Carola Saldias Senior Director Financial Institutions Analytical Team carola.saldias@dagongeurope.com Evgeni Petkov Associate Director Financial Institutions Analytical Team evgeni.petkov@dagongeurope.com DAGONG EUROPE - www.dagongeurope.com

TABLE OF CONTENTS 1. INTRODUCTION 2. ASSET QUALITY OF ITALIAN BANKS AND COMPARISON WITH EU WEIGHTED AVERAGE 3. REGULATORY INITIATIVES TO ENCOURAGE NPL SALES 4. MAIN ACTIONS UNDERTAKEN BY ITALIAN BANKS 5. EXPECTATIONS ON ASSETS QUALITY, PROFITABILITY AND CAPITAL 2

1. INTRODUCTION During 2016 and 1H17, Italian banks have been under the spotlight following the events related to the liquidation and sale of Banca Popolare di Vicenza, Veneto Banca and the recapitalisation of Monte dei Paschi di Siena. These events highlighted again the main weakness of the Italian banking system, the accumulation of deteriorated loans after the crisis of 2008, which has not been resolved as fast as desired and expected by regulators and market participants. From the most recent data published by the EBA Risk Dashboard, the sample of Italian banks included in the report shows credit quality improving, measured by Non-Performing Loans (NPL) as a percentage over gross loans of 15.3% 1 by 4Q16, compared to 16.4% in 2Q16. The stock of NPL amounted to EUR 349Bn 2 in 2016 (EUR 360Bn in 2015), with an aggregate coverage ratio at 50.6% (45.4% in 2015). Up until 2016, Italian banks have been very reluctant to sell NPL due to their expectations for recovery and also due to the potential effects of additional losses generated by a sale price that could be below book value. In fact, in 2016 a total of EUR 11Bn of bad debt portfolios has been sold, an amount that is still very marginal compared to the total exposure. The purpose of this research is to provide data related to the largest NPL portfolios held by Italian banks, their disclosed information and efforts to reduce them during 2017 and beyond, and analyse the effects that those sales could have on the industry at an aggregate level. Important Note: In this document we use the terms NPL and deteriorated loans interchangeably. Dagong Europe does not have ratings assigned to the banks mentioned in this commentary and comments on the solvency of the entities discussed below is beyond the scope of this document. 1 EBA Risk Dashboard 1Q17, data from EBA Risk Dashboard only available from 2Q16. 2 Bank of Italy, Financial Stability Report No.1/2017 3

2. ASSET QUALITY OF ITALIAN BANKS AND COMPARISON WITH THE EU WEIGHTED AVERAGE Deteriorated loans started to be accumulated by Italian banks after the crisis of 2008, with levels that went above 10% only since 2011. Contrary to what has been implemented by other EU countries soon after the crisis, the Italian banking system did not face the problem through an aggregate solution as it was the case for Ireland and Spain, for example. The Italian government did not promote or implement at that time an industry solution, leaving banks to manage their credit quality by themselves. However, it is worth noting that at the time of the crisis, the asset quality was not under the spotlight due to the relatively low levels of NPL at that time (around 5.0% for the aggregate Italian banking system), therefore, an industry solution was not immediately needed. However, the deterioration of the Italian economy, for a longer than expected period, led to a large deterioration of asset quality, mostly coming from Corporates and SMEs. Economic sector concentration stems largely from real estate and construction, mostly unsecured. In addition, these exposures have been classified as bad debts for an extended period of time. Compared to the EU data for YE16, the Italian banking industry is far above the EU weighted average for NPL, considering that for the past 3 years the EU weighted average has been improving from 6.5% in 2014 to 5.1% in 2016, compared to 17.7% and 17.3%, respectively for the Italian banking industry. Ex. 1: Aggregate Asset Quality Indicators Italian Banking System December 2014 December 2015 December 2016 Stock of Performing Loans EUR 1,694 Bn EUR 1,630 Bn EUR 1,667 Bn Performing Loans (%) 82.3% 82.3% 81.9% Stock of NPL EUR 350 Bn EUR 360 Bn EUR 349 Bn NPL ratio (%)(1) 17.7% 18.1% 17.3% EU weighted average NPL ratio (%)(2) 6.5% 5.7% 5.1% Sources: (1) Bank of Italia Financial Stability Reports, (2) EBA Risk Dashboard 1Q2017 With the release of 1Q17 data from EBA Risk Dashboard 3, we observe the EU weighted average NPL ratio decreasing, from 5.1% by YE16 to 4.8% in 1Q17. In the case for the sample of 15 Italian banks included in the EBA report, we observe also a reduction, from 15.3% by YE16 to 14.8% by 1Q17. Most of the improvement is due to an acceleration of NPL sales following the efforts of the ECB and the national regulator to speed up the reduction of NPL and bring the asset quality closer to the EU average. Ex. 2: NPL for EU countries (2Q16-1Q17) 50.0% June-16 Sept-16 Dec-16 Mar-17 40.0% 30.0% 20.0% 10.0% 0.0% SE LU EE FI CZ GB NO DE NL BE DK LV FR LT SK MT AT EU ES PL RO HR HU BG IE SI IT PT CY GR Source: EBA Risk Dashboard 1Q17. 3 EBA Risk Dashboard: https://www.eba.europa.eu/documents/10180/1898284/eba+risk+dashboard+-+q1+2017.pdf 4

3. REGULATORY INITIATIVES TO ENCOURAGE NPL SALES Financial Institutions ECB Encouraging an Active Strategy for NPL Management We observe an acceleration of NPL sales by Italian banks in recent months, following the publication of the Guidance to banks on non-performing loans, March 2017 4 published by the ECB. The document addresses the concept of high NPL banks as those banks with an NPL level that is considerably higher than the EU average level. The average is disclosed on a quarterly basis through the European Banking Authority (EBA) Risk Dashboard. As stated in the document, the guidance is non-binding, nevertheless, any observed deviations should be substantiated upon request of the supervisor. As indicated by the guidelines, the NPL strategies should be implemented immediately, therefore we expect that the reduction of NPL in the Italian banking industry continues to speed up through larger sales as well as through structured operations as it has been already evidenced by recent transactions. The guidelines are defined as recommendations for all banking institutions, mostly addressed to significant institutions supervised directly by the Single Supervisory Mechanism (SSM), including their international subsidiaries and those with a high level of NPL. The NPL guidance states that it is non-binding in nature, but banks should explain and substantiate any deviations upon supervisory request. The NPL guidance encourages banks to implement strategic objectives for the time-bound reduction of NPL over realistic but sufficiently ambitious time horizon or so called NPL reduction targets. The targets should be established at least along the following dimensions (i) by time horizon, (ii) by main portfolios and (iii) by implementation option. For high NPL banks, the targets should at minimum include a projected absolute or percentage NPL exposure reduction, both gross and net of provisions, not only on an overall basis but also for the main NPL portfolios. If the foreclosures exposure is also material, a dedicated foreclosed assets strategy should be defined or, at least a reduction strategy should also be included in the NPL strategy. The NPL strategy should be implemented over a time horizon of 1 to 3 years, be approved by the management body and reviewed at least annually. Facilitation for Bankruptcy Procedures and New Regulations for NPL Disposal The Italian government has been active in approving new regulation to facilitate bankruptcy procedures, considering that in Italy bankruptcy procedures are complex and take on average a significantly longer period, compared to other EU countries. The average time for enforcement of real estate collateral is estimated at 4.25 years and for insolvency cases 7.5 years 5. However, the complex and not yet unified insolvency frameworks still generate inefficiencies and lengthy processes for commercial and civil litigation. On the other hand, the Bank of Italy has been approving several regulatory modifications to facilitate and simplify the process of NPL sales. Within the most recent modification to law 130/1999 for securitisations of credit exposures 6, the Bank of Italy clarifies that the Special Purpose Vehicles (SPV) that acquire and structure operations of NPL will be able to: i. Grant additional financing alternatives to certain debtors in difficulties or directly acquire participations when it is evaluated as an alternative to improve the recovery prospects of the exposure. ii. Directly acquire and manage the underlying assets or real estate provided as guarantees for the securitisation. 4 https://www.bankingsupervision.europa.eu/ecb/pub/pdf/guidance_on_npl.en.pdf 5 Italy - IMF Staff Report for the 2017 Article IV Consultation July 6, 2017 6 Bank of Italy, http://www.bancaditalia.it/pubblicazioni/note-stabilita/2017-0010/note-stabilita-finanziaria-vigilanza-n-10-ita.pdf 5

The new framework also simplifies the sale or cession of the exposures, from the originator to the SPV, eliminating the obligation to notify the debtor. A new simplified procedure will be applicable also for exposures not individualised. 4. MAIN ACTIONS 7 UNDERTAKEN BY ITALIAN BANKS TO REDUCE THEIR DETERIORATED PORTFOLIOS 8 On an individual basis, the Italian banks that have larger NPL portfolios are those expected to be more active in selling NPL in 2017 and accelerating the clean-up. Among the largest Italian banks with assets above EUR 45Bn, the stock of gross NPL reaches around 40% of the aggregate amount of NPL of the industry. If we would include also the most recent case of banks liquidation 9 with Banca Popolare di Vicenza and Veneto Banca, the stock of NPL from this group of banks would represent EUR 163Bn and almost 48% of the industry s aggregate stock, which we consider the most relevant exposure and the one that will be more actively managed. Ex. 3: Largest Italian banks with total assets above EUR 45Bn as of YE16 YE2016, EUR Mn Total Gross Loans Gross NPL Net NPL Net NPL ratio Coverage Unicredit 478,146 56,342 24,992 5.23% 44.4% Intesa Sanpaolo 394,918 58,137 29,767 7.54% 48.8% Banca Monte dei Paschi 87,060 45,785 20,319 23.3% 55.6% UBI Banca 86,698 12,521 8,055 9.3% 35.7% Banco Popolare 82,117 17,525 11,355 13.8% 35.2% BPER 50,654 11,173 6,197 12.2% 44.5% Banca Popolare di Milano 46,555 6,270 3,484 7.4% 44.4% Sources: Banks annual reports. After the publication of the ECB guidelines, Italian banks started to disclose additional information to the market in terms of their strategies to manage NPL. We expect these initiatives to continue to be disclosed, which will provide visibility to market participants in terms of their potential effects on the banks financial profiles. Below we present the available information related to NPL sales expected for 2017 for the largest Italian Banks: Unicredit The bank has officially disclosed two projects to dispose NPL during 2017: 1. Project FINO: EUR 17Bn of loans to customers held by UniCredit and by Arena One NPL S.r.l. In December 2016, UniCredit S.p.A. (also in its capacity as - Sole Noteholder - of the securities issued by Arena One NPL S.r.l.) signed two Framework Agreements with two separate third-party Investors, designed to define the characteristics of two (or more) proposed securitisation transactions. The transaction has been signed on July 17 th, 2017 through a Transfer Agreement with Pimco and Fortress for a total portfolio of EUR 17.7Bn. Sale price was not officially disclosed by the bank. 2. Project PORTO: The second portfolio refers to non-performing loans that amount to EUR 19.1Bn for a range of gross credit exposures classified as non-performing loans and a range of credit exposures classified as unlikely to pay with a gross value of EUR 16.9Bn. 7 Sources used are only official documents published by each bank in their annual reports or press releases. 8 For the purpose of this document, we include in this section only the Italian banks with deteriorated portfolios above EUR 10Bn as of YE16. 9 Dagong Europe research report on Recent Cases of EU Banking Resolution/Liquidation: One Rule Does Not Fit All : http://www.dagongeurope.com/uploads/rating/1499069477research-bankingresolutioncases03072017final.pdf 6

Intesa Sanpaolo The bank undertook sales of NPL in 2016 for a total amount of EUR and it is in the process to materialise additional transactions. However, public information disclosed by the bank related to NPL sales for 2017 has not been available up to date. Monte dei Paschi The bank is structuring a securitisation that will include a portfolio of NPL for an amount of EUR 26.1Bn (Gross Book Value, GBV) and sale off of EUR 2.5Bn of unsecured exposures related to leasing. The securitisation will be structured to transfer the junior and mezzanine tranches to the Atlante II fund for a sale price at 21% GBV. The transaction is expected to be closed by December 2017. Banco Popolare 10 In 2016 the bank implemented NPL sales for EUR 945Mn. In January 2017, the bank also sold a portfolio of EUR 641Mn and will continue implementing measures to improve asset quality though a strategy for recoveries focused on third party management. Banco Popolare di Vicenza and Veneto Banca With the approval of the resolution and liquidation of both banks in June 26th, 2017, the banks will be liquidated and sold to Intesa Sanpaolo. However the existing deteriorated portfolios of both banks, estimated at EUR 18Bn (nominal amount) will be transferred to the Societa per la Gestione di Attivita S.p.A. (SGA). SGA is a company owned by the Ministry of Economy and Finance of the Italian government, with the purpose of managing and acquiring NPL, as well as to buy participations in other Italian financial institutions. 5. EXPECTATIONS ON ASSET QUALITY, PROFITABILITY AND CAPITAL ASSET QUALITY Expected improvement in asset quality mainly through reduction of the NPL ratios: The data from EBA shows that Italian banks held a NPL ratio at 14.8% for 1Q17 compared to 4.8% for the EU weighted average. We expect a larger reduction of NPL and improvement of the asset quality ratios for the next 2 years following sale processes and alternatively securitisation structures. However, we acknowledge that due to the regulatory and legal differences related to the bankruptcy processes, we should expect that NPL in the Italian banking industry will be at levels above the EU average for a longer period unless the legal framework changes significantly. For now, we see signs of improvement with the implementation of updated laws and regulations, however we are cautious about the change of the business environment towards the facilitation of these processes. Potential improvements also in loan loss coverage ratios: In terms of coverage ratio, Italian banks are well positioned in comparison with the EU average. Coverage of NPL for Italian banks reached 50.6% for 1Q17, compared to 45.2% for the EU weighted average. It is worth noting that Italian banks have been increasing the recognition of provisions, first as it has been encouraged by the regulator and also in order to anticipate any future sale or securitisation without significantly affecting the overall profitability with increases in cost of risk. Therefore, we expect additional improvements of coverage ratios, however those depend on the particularities of each bank s portfolio and their target coverage levels for the performing exposures. 10 Banco Popolare Annual report, not including data from the merger with Banca Popolare di Milano, effective from 1 st January 2017. 7

PROFITABILITY Potential short-term reduction in profitability due to sales of NPL at lower gross book values however, improvements foreseen in the long-term: Italian banks held a RoE ratio at -5.7% 11 (net of write-downs to goodwill) compared to 6.9% for the EU weighted average. Profitability for Italian banks has been significantly affected by the large losses of Unicredit and Monte dei Paschi recorded in 2016. We expect that losses related to the sale of NPL could also be incurred in 2017, however, we expect that the larger provisions were already recognised. If NPL sales are materialised with sale prices significantly below their book value, additional charges need to be accounted, and will affect profitability ratios. However, we remain cautious to the strategies and aggressiveness that Italian banks can follow to faster reduce their NPL in the next couple of years. CAPITAL On one hand, capital levels should benefit from the release of high RWAs: Italian banks held a CET 1 ratio at 11.5% for 1Q17 compared to 13.8% (fully loaded) for the EU weighted average. We expect that with the sale of NPL and securitisation transactions, capital ratios measured based on RWAs will improve due to the release of capital allocated to assets with a high risk weighted component (NPL are typically weighted at 150%). On the other hand, apart from the direct effect through the profit and loss statement, banks using the advanced internal-based method will face increased capital requirements if they sell NPL at prices significantly below book value: The sold NPL portfolios will have to be included in the data sets used for estimating loss given default (LGD), thus increasing the estimated LGD and the risk weighting of assets. 12 This negative effect on capital might outweigh the positive one resulting from offloading high weight NPL. Depending on financials market appetite, potential issuances under MREL to improve capital ratios: In addition, we expect that following the clean-up of asset quality, Italian banks will be more actively looking to increase their capital base through MREL (Minimum Requirements for Own Funds and Eligible Liabilities) 13 issuances, and will be able to do so without being penalized by the market with an above average yield. 11 Bank of Italy, Financial Stability Report, No.1/2017. 12 Bank of Italy, https://www.bancaditalia.it/pubblicazioni/note-stabilita/2017-0006/en_note_di_stabilita_finanziaria_e_vigilanza_n._6.pdf?language_id=1 The paper estimates an increase in LGD of 12% and overall decrease of CET1 in the range of 90-190 bps. We consider the assumptions on which the estimates are based, as very strong and expect the impacts to be significantly more limited. 13 Dagong Europe research report on TLAC and MREL: Global Banks Facing Additional Capital Requirements. http://www.dagongeurope.com/uploads/rating/1441873072commentary-tlac-mrel-10sep2015-eng.pdf 8

DISCLAIMERS NO CONTENT (INCLUDING CREDIT-RELATED ANALYSES AND DATA, VALUATIONS, OR OUTPUT THEREFROM) OR ANY PART THEREOF ( CONTENT ) MAY BE MODIFIED, REVERSE ENGINEERED, REPRODUCED OR DISTRIBUTED IN ANY FORM BY ANY MEANS, OR STORED IN A DATABASE OR RETRIEVAL SYSTEM, WITHOUT THE PRIOR WRITTEN PERMISSION OF DAGONG EUROPE. DAGONG EUROPE DOES NOT INTEND TO ASSUME, AND IS NOT ASSUMING, ANY RESPONSIBILITY OR LIABILITY TO ANY PARTY ARISING OUT OF, OR WITH RESPECT TO, THIS CONTENT. THIS CONTENT IS NOT INTENDED TO, AND DOES NOT, FORM A PART OF ANY CONTRACT WITH ANYONE, EITHER DIRECTLY OR INDIRECTLY. THE CONTENT SHALL NOT BE USED FOR ANY UNLAWFUL OR UNAUTHORIZED PURPOSES. RELATIONSHIP WITH ENTITIES OR INDIVIDUALS DAGONG EUROPE DOES NOT HAVE A FIDUCIARY RELATIONSHIP WITH ANY ENTITY OR OTHER INDIVIDUAL RECEIVING THIS RESEARCH. NOTHING IS INTENDED TO OR SHOULD BE CONSTRUED AS CREATING A FIDUCIARY RELATIONSHIP BETWEEN DAGONG EUROPE AND ANY INDIVIDUAL OR ENTITY RECEIVING THIS RESEARCH. DAGONG EUROPE DOES NOT PROVIDE TO ANY PARTY ANY CONSULTANCY SERVICE, FINANCIAL ADVICE OR LEGAL, AUDITING, ACCOUNTING, APPRAISAL, VALUATION OR ACTUARIAL SERVICES. 2017 Dagong Europe Credit Rating Srl (collectively, Dagong Europe ). All rights reserved. 9

Via dei Bossi 2a, 20121 Milan Italy Tel (+39) 02 72746011, fax (+39) 02 72003544 www.dagongeurope.com