Key takeaways:

• NUS-CRI Agg 1-year (median) PD reflects the impact of increasing domestic sovereign risk on Italian banks, signifying their correlation owing to substantial government debt holdings
• Stress test using BuDA suggests that the rising rates environment could worsen the credit quality of vulnerable Italian banks as local corporates face heightened credit risk on the back of the rising cost of financing

The ECB is set to start hiking interest rates in Jul-2022 after winding up its longstanding Asset Purchase Programme (APP), which was introduced in support of EU member states hit by the 2011 sovereign debt crisis^[1]. As one of the hardest-hit member states during the crisis, Italy was one of the main benefactors of the APP and has the highest debt level^[2] in the region as of Dec-2021, and thus will likely be affected by the withdrawal of favorable ECB policies. A substantial portion of these government debts is held by Italian banks, exposing them to sovereign risk. For most of 2021, NUS-CRI Aggregate 1-year (median) Probability of Default (Agg PD) for Italian banks has been hovering steadily within the A- Upper Bound range when referenced to PDiR2.0 bounds (See Figure 1a). However, the supply chain disruptions caused by the Russia-Ukraine war^[3] triggered the uptrend in the Italian banks’ credit risk. For highly leveraged EU member states like Italy, the impending monetary policy tightening in response to soaring inflation could potentially result in an increase in overall credit risk and NPLs for Italian corporates. In such an unfavorable economic environment, Italian banks’ median credit health may be expected to further deteriorate and marginally advance towards the upper quartile as shown in the NUS-CRI Agg (median) Forward 1-year PD (Forward PD^[4]) (See Figure 1b).

Figure 1a (LHS): NUS-CRI Agg (median) 1-year PD for Italian banks from Jun-2021 to Jun-2022 with the 25th and 75th percentiles of the Italian banking industry, with reference to PDiR2.0 bounds^[5]; Italian 10-year Sovereign Credit Default Swap (CDS) Mid Spread from Jun-2021 to Jun-2022. Figure 1b (RHS): NUS-CRI Agg (median) Forward 1-year PD for Italian banks as of Jun-2022 with the 25th and 75th percentiles of the Italian banking industry, with reference to PDiR2.0 bounds. Source: NUS-CRI, Refinitiv

Yields on Italian sovereign bonds across all tenors^[6] have shifted upwards in 2022 compared to 2021 levels, and the rising borrowing costs were realized in the country’s most recent debt issuance, triggering speculations that the credit risk associated with the Italian government might have increased, as demonstrated by the recent uptick in the country’s 10-year CDS spread (See Figure 1a). Italian banks, which collectively hold around 38.1% of domestic sovereign bonds as of Mar-2022^[7], will likely feel the impact of the increased sovereign risk through the elevated capital charge^[8] required to buffer potential losses. Nonetheless, as of Dec-2021, the industry’s average Common Equity Tier 1 ratio of 15.3% is well above the regulatory requirements and should provide an adequate buffer against additional potential losses.

Government aid and moratoria have contributed to the reduction of Italian banks’ non-performing loans (NPL) to around 0.92% of the total loan portfolio. As these expired in Jun-2022, Italian banks may see an uptick in NPLs going forward. In the face of surging inflation^[9], which enhances the case for aggressive monetary tightening, Italian banks’ asset quality might further deteriorate as businesses’ repayment capacity is strained owing to higher operating and borrowing costs^[10]. Moreover, the increasing share of the government’s ongoing public guarantees on the Italian banks’ balance sheets further increases the industry’s exposure to sovereign risk. The correlation between the sovereign and banking industry’s credit risk has already invoked caution from the market, pushing stock valuations down and making it costly for Italian banks to issue equity in lieu of debt, amid high borrowing costs, should they require additional financing.

Figure 2a (Top Left): Stressed NUS-CRI Agg (median) 1-year PD of Italian banks based on historical 10-year sovereign CDS mid spreads, and corporate credit risk cycle indices (CCI) from 2011-2013, adjusted for the imminent increase in interest rates by the ECB (base case) with the 25th and 75th percentiles of the Italian banking industry, with reference to PDiR2.0 bounds. Figure 2b (Top Right): Stressed NUS-CRI Agg (median) 1-year PD of Italian banks based on successive quarterly 25bps rate hikes while holding other variables constant. Figure 2c (Bottom Left): Stressed NUS-CRI Agg (median) 1-year PD of Italian banks based on a uniform 50% increase in monthly CDS spreads while holding other variables constant. Figure 2d (Bottom Right): Stressed NUS-CRI Agg (median) 1-year PD of Italian banks based on 50% uniform increase in CCI, representing the potential adverse effects of an economic slowdown, while holding other variables constant. Source: Refinitiv, NUS-CRI, BuDA v3.3.0

Using the NUS-CRI Bottom Up Default Analysis toolkit’s (BuDA) stress scenarios to simulate the occurrence of a similar debt crisis as 2011 and measure its effect on Italian banks, stressed PD for the most vulnerable banks in the industry is seen to rise rapidly over the BB+ upper bound in the short to medium term in response to the shock before converging towards the median (Figure 2a). Despite the sharp increase in the short term, Italian banks exhibit a lesser vulnerability to adverse economic conditions like that seen in 2011, in general, with the resulting stressed median PD (base case) remaining significantly lower than the peak of 55bps as seen in the previous crisis. Nonetheless, each of the variables in isolation is analyzed to determine its impact on the Italian banks’ PD. As shown in Figure 2b, successive interest rate hikes would flex the trajectory of the stressed PD of the vulnerable banks upwards as the high-interest environment impedes loan portfolio growth while concurrently increasing their cost of funding. Additionally, with the ECB actively instituting measures against taking advantage of rising interest rates, the Italian banks’ earning potential could remain capped, hindering the resultant growth in NIMs. In comparison, the worsened credit profiles of Italian corporates, which could signify operating and financing difficulties affecting their repayment capacity due to higher borrowing costs, results in a steeper rise in Italian banks’ stressed PD (See Figure 2d). This suggests that an increase in the credit risk of Italian corporates may weaken the asset quality for Italian banks, especially for the vulnerable banks considering their likely weaker fundamentals. On the other hand, while the most and least vulnerable Italian banks appear to be indifferent to an increase in the perceived level of sovereign risk when compared to the base case (See Figure 2c), the upward shift in the median PD emphasizes the overall increase in the industry’s credit risk. Such movement is potentially reflective of the substantial sovereign exposure of most banks in the industry who haven’t yet completed their government debt offloading.

Going forward, the deterioration of Italian banks’ credit health might be dependent on the realization of the expected unfavorable impact of monetary tightening on the Italian economy. Even the ECB recognizes the possible whiplash of aggressive rate hikes to weaker economies, and has committed to instituting preventive and supportive measures. Notwithstanding, a comparison of the Italian banks’ Forward PD and the resulting stressed PD (base case) suggests that Italian banks appear more resilient, potentially owing to better asset quality and stronger capital position to absorb unexpected losses, as well as the availability of regulatory support.

1. The EU debt crisis was set off by the member states’ (Portugal, Ireland, Italy, Greece, and Spain) high levels of public debt. ↑

2. Italian government debt is at 150.8% of its gross domestic product (GDP) as of Apr-2022, surging recently because of the pandemic. ↑

3. Among EU member states, Italian banks have the highest exposure to businesses directly affected by the Russia-Ukraine war. ↑

4. The Forward PD estimates the credit risk of a company in a future period, which can be interpreted similarly to a forward interest rate. For example, the 6-month Forward 1-year PD is the probability that the firm defaults during the period from 6 months onwards to 18 months – this is conditional on the firm’s survival in the next 6 months. ↑

5. The Probability of Default implied Rating version 2.0 (PDiR2.0) provides a more familiar interpretation through mapping the NUS-CRI 1-year PDs to the S&P letter grades. The method targets S&P’s historical credit rating migration experience exhibited by its global corporate rating pool instead of relying solely on the reported default rates. ↑

6. The 10-year government bond yields reached an 8-year high of 4.17% in Jun-2022. ↑

7. Domestic government bond holdings decreased by 9.9% from its 48% peak in 2014 because of post-crisis prudential initiatives, such as portfolio restructuring, to reduce exposure to sovereign risk. ↑

8. Capital is expected to be affected by approximately 20 to 25bps. ↑

9. EU’s inflation recently hit a new record in anticipation of energy price increases following Russia’s reduction of gas exports. ↑

10. Lending rates have been generally increasing since Jan-2022, especially for long-term loans. ↑

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Contributing Editors: Raghav Mathur, Wang Anyi