cflp project

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THE SHARE OF OUTSTANDING LOANS BY NBFCS VIS-A-VIS THE

OUTSTANDING LOANS BY BANKS IN ITALY - FINANCIAL ASPECTS

(Term paper towards partial fulfillment of project in the subject of Corporate Finance

Law, Policy and Practice)

Submitted by Submitted to

Amritambu Satyarthi (Roll no. 811)

Anusha Nagoji (Roll no. 813)

Aratrika Chakraborty (Roll no. 814)

Diva Devarsha Srivastava (Roll no. 822)

Mohit Maheshwari (Roll no. 828)

N. S. Tanvi (Roll no. 829)

Dr. Rituparno Das

Mr. Prateek Deol

Faculty of Law and policy sciences

NATIONALLAWUNIVERSITY,JODHPUR

OCTOBER,2014

(Number of words: 11280)


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CONTENT

Content .......................................................................................................................................1

Introduction ................................................................................................................................4

Italy: An Economic Overview .................................................................................................4

Commercial Banks in Italy ......................................................................................................4

STRUCTURE OF THE ITALIAN BANKING SECTOR: THE MAIN PLAYERS .................7

ITALIAN FINANCIAL SITUATION .....................................................................................7

Actions needed in the Italian Financial Sector .........................................................................8

REGULATIONS FOR NON BANKING FINANCIAL INSTITUTIONS IN ITALY ..................9

The Italian Non-Financial Sector ........................................................................................... 10

Italys New Rules to Facilitate Direct Lending...................................................................... 10

Regulatory Changes .............................................................................................................. 11

Lending Deregulation ........................................................................................................ 11

Insurance Companies......................................................................................................... 11

Securitization SPVs ........................................................................................................... 12

Exemption from withholding tax ........................................................................................... 12

Substitutive tax on loan transfers ........................................................................................... 13

Issue of Bonds ................................................................................................................... 14

Possible Further Measures ................................................................................................. 14


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Loans by NBFIs .................................................................................................................... 15

Banking and grant of loans in Italy ............................................................................................ 15

REGULATORY ARCHITECTURE: OVERVIEW OF BANKING REGULATORS AND KEY

REGULATIONS....................................................................................................................... 16

RECENT REGULATORY DEVELOPMENTS ........................................................................ 17

BANK GOVERNANCE AND INTERNAL CONTROLS ........................................................ 19

Distinction between control and management functions of bank ............................................ 20

Loans by banks and NBFCs .................................................................................................. 23

Regulatory Requirements for Mortgage Lending ................................................................... 24

New lending opportunities in Italy for non-bank lenders ........................................................ 26

Paving the way for lending by debt funds .......................................................................... 26

Exemption from withholding tax ....................................................................................... 27

Substitutive tax on loan transfers ....................................................................................... 28

Investing in Non-Performing Loans in Italy ........................................................................... 29

NPL portfolios ................................................................................................................... 29

A window of opportunity................................................................................................... 29

Outstanding loans in Italy .................................................................................................. 30

COMPARISON OF OUTSTANDING LOANS BY NBFCs AND BANKS .............................. 31

Reasons for rise in Non-Banking Financial lending ............................................................... 33

Distinction between loans provided by Non-Banking Financial Institutes and loans by Banks

.............................................................................................................................................. 34


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Conclusion ................................................................................................................................ 36

BIBLIOGRAPHY ..................................................................................................................... 37


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INTRODUCTION

ITALY:AN ECONOMIC OVERVIEW

The global financial crisis didnt spare Italy. Economic and political turmoil over recent years

has put the country and wider Eurozone at risk. The macroeconomic environment has negatively

affected the countrys public finances, with the deep recession and the complex financial

situation presenting Italian governments with a series of problems. Despite interventions from

both the Italian government and European institutions, public debt has escalated substantially in

the last five years and the situation remains critical.

During the second half of 2011, the government passed a series of three austerity plans to

balance its budget and decrease public debt:

June 2011 Italy approved the first austerity package of US$68 billion, which was meant to

reassure the international financial markets and reduce the Italian budget deficit.

September 2011 Silvio Berlusconis US$74 billion new package was approved by the Italian

Parliament to reduce the deficit.

December 2011 The Senate voted for Mario Montis austerity plan of US$39 billion, which

aimed at mitigating the debt with actions such as spending cuts, tax rises, and pension reform.

European Central Bank (ECB) intervention to help financial institutions at both the European

and the Italian level has put a lot of pressure on the country.4

By the end of 2012, Italian banks had borrowed 268 billion from the ECB. This funding may

have helped prevent Italian banks from going bust, but risks remain very high as profits remain

low and the quality of loans is still deteriorating.

COMMERCIAL BANKS IN ITALY

According to theBank of Italy, there were 841 banks in the country at the turn of the 21st

century, one third of them being in banking groups. The statistical data demonstrates that 240

banks have been incorporated as stock-exchange-listed companies, these accounting for about


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eightypercent of the sectors total assets, while the shares of savings banks and mutual banks are

respectively 12 percent and 4.4 percent of the assets.1

Historically, the Italians can be proud of having the oldest bank in the world.Monte dei Paschi di

Siena(locally named Il Monte) has been a banking institution since 1472, twenty full years

before Christopher Columbus discovered America! Interestingly enough, the oldest bank in the

world was originally formed as a charity granting loans for the poor in Siena and benefiting the

citys economy. Today, the bank is a part of MPS Group (publicly traded as BIT, BMPS)2 ,

which holds the largest share of the domestic market. The bank has 32,870 officials working in

over 1,900 branches throughout Italy and in the some of the worlds biggest financial centers.

Through its subsidiaries (MPS Finance, Banca Toscana, and Antonveneta), Il Monte has

developed a wide range of banking activities, including everyday banking solutions, bank loans,

asset management, insurance andinvestment banking. After the acquisition of Banca

Antonveneta in 2007-2008, Monte dei Paschi di Siena became Italys third largest bank

afterUniCreditandIntesa Sanpaolo.

UniCredit SpA (stock exchange symbols FWB: CRI, BIT: UCG) is the largest banking group

based in Italy (headquartered in Milan) and one of the ten largest groups in the world. UniCredit

Group started its existence in 1473, just a year after the establishment of Il Monte, as Intesa

Sanpaolo, then in 1870 it changed to Banca di Genova and subsequently to Credito Italiano(1895). Today, the organization has 177,571 employees and a network of offices in twenty-two

countries across Europe, serving more than forty million costumers. To their individual clients,

the devoted team of UniCredit Group is proud to offer a rich variety of everyday banking

services such as current and savings accounts, credit and debit cards, consumer and mortgage

loans, online banking solutions, and insurance services, while the business clients of the bank

may choose from a set of tailored banking solutions, including investment advisory and

management, asset management, assistance on EU projects application, project financing, and

direct banking solutions. The corporate and institutional clients of UniCredit are offered risk

1 E. Polovedo, 2011, Italy approves an austerity package, The New York Times.http://www.nytimes.com/2011/07/01/world/europe/01italy.html

2Id.
http://www.nytimes.com/2011/07/01/world/europe/01italy.htmlhttp://www.nytimes.com/2011/07/01/world/europe/01italy.htmlhttp://www.nytimes.com/2011/07/01/world/europe/01italy.html


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management solutions, business loans, realty investment solutions, merger and acquisition

advisory, etc.

Intesa Sanpaolo Group (listed on the Italian Stock Exchange as ISP) is the second strongest

player in Italys banking sector. Headquartered in Turin, Italy, the group started its existence

after the merger of Banca Intesa and Sanpaolo IMI in 2007. ISP now has over 108,000

employees, working in a network of offices in Italy, Central and Eastern Europe, and the

Mediterranean region. Banca Intesa S.p.A. has developed its activities in four main business

areas. The banks retail banking business serves individual clients, small and medium-sized

businesses, as well as non-profit organizations, offering them a package of integrated banking

services, including investment banking and advisory, wealth management, business projects

financing and industrial loans, while the corporate division of Banca Intesa caters for the

interests of large corporations, financial institutions and institutional clients, offering them

merger and acquisition advisory, asset management, capital market and merchant banking, etc3.

Banca Nazionale del Lavorois the sixth largest bank in Italy. The bank was founded in 1913 in

Rome. The structure was nationalized in 1929 and then went private again in 1998. The bank

existed independently until it was acquired by FrancesBNP Paribasin 2006.

Banca Popolare di Milano, listed as PMI, is Italys second corporate bank (the first being Banca

Popolare di Lodi). Founded in 1865 in Milan, the bank has about 8,000 officials and a network in710 branches in Italy and abroad. The groups one and a half million clients can choose among a

large selection of banking services and solutions, including online banking and everyday banking

solutions, property management and brokerage, mutual funds management, and

merchantbanking.

As a whole, the banking sector in Italy has been hard hit by the global economic crisis.

According to a 2009 report of the International Monetary Fund, Ireland is the only economy in

the Eurozone that is currently doing worse than Italy.

3BBC News, Italy senate passes Montis austerity package. http://www.bbc.co.uk/news/world-europe-16301956,2011


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STRUCTUREOFTHEITALIANBANKINGSECTOR:THEMAINPLAYERS

The gap between the top 10 players in the Italian banking sector market and the remaining banks

is extremely wide. According to the European Banking Federation, Italy is home to the fourth

largest banking market in Europe (after Germany, the UK, and France) with total asset value

estimated at 4,042 billion at the end of 2011. This accounts for approximately 9% of total

European banks assets, with the main players being Unicredit, Intesa San Paolo, and Monte dei

Paschi di Siena.Italy has up to 72 foreign financial institution subsidiaries and banks among

which, two figure in the top 10 Italian banking groups. The largest entities are BNL (part of BNP

Paribas), Cariparma (part of Credit Agricole), and Deutsche Bank. Other banks usually have a

single branch representation or subsidiary, providing investment banking/corporate finance

services.

ITALIANFINANCIALSITUATION

Before the 1990s, the state owned more than 70% of Italys banking assets, but a wave of

privatisations changed the scene. Since 2006, the global economy has gone through three

different phases of the financial downturn: first, the subprime mortgage crisis; second, the near-

collapse of financial institutions which started with the Lehman Brothers bankruptcy; and

finally, the ongoing debt crisis.

The first phase of the crisis did not hit the Italian market thanks to its traditional commercial

banking business model. The impact on personal lines was limited, as the Italian population

doesnt have a culture of high personal debt.

However, phase two didnt follow suit. The crisis started impacting Italian financial institutions

and as a result, between 2008 and 2010, Italian banks suffered losses (devaluation and loss of

credit) equivalent to around 38 billion.4

As the financial market worsened around Europe, Italian banks lost their credibility, accumulated

more debts, suffered downgrading by Standard & Poors, and faced increased constraints on

4Id.


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accessing government funds and foreign markets.5Moreover, the gloomy picture has been made

worse by the political instability and the scandals that hit many financial institutions.

In early 2012, the ECB started its Long-Term Refinancing Operation (LTRO), from which

Italian banks benefited around 250 billion, which was mainly used to acquire government

bonds. This arrangement seems to be temporary and not sufficient to recover from the deep crisis

that affected the Italian financial sectors. Further solutions are necessary for a long-term

stability.

ACTIONS NEEDED IN THE ITALIAN FINANCIAL SECTOR

The Bank of Italy is the central bank of the Republic of Italy and is part of the European System

of Central Banks (ESCB) and also the Eurosystem. The Bank is working to enhance Italianfinancial sector efficiency and flexibility by reaching economic stability, cutting costs within the

financial institutions, increasing banks transparency, and providing less rigid financial solutions

to stimulate growth.6

These actions are needed and seem to provide some relief to the heavily indebted financial

institutions. For example, Italian banks, as of January 2013, held circa 350 billion o f Italian

debt, a number that has rocketed in the last couple of years. A slow and slight improvement in

the banking system has been registered in the past year.

Even if 2013 seemed to be slightly better, last year the top 10 Italian banks incurred financial

losses of approximately 1 billion, a figure that will present the market with a tough challenge.7

5ECB funding to Italian banks fall in March, Reuters.http://uk.reuters.com/,2013 article/2013/04/08/italy-banks-ecbidUKL5N0CV14H20130408

6 V. Proskurovska, 2012, European Banking Sector Data and facts 2012. http://www.ebf-fbe.eu/uploads/FF2012.pdf7Id.
http://uk.reuters.com/http://uk.reuters.com/http://uk.reuters.com/http://uk.reuters.com/


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REGULATIONS FOR NON BANKING FINANCIAL INSTITUTIONS IN ITALY

In Italian legislation, banking activity consists in the dual task of accepting deposits and other

repayable funds from the public, and of exercising of credit. Banks accept repayable savings and

liquid funds in the form of deposits and in other forms. In keeping with European legislation,

banks can also engage in any other financial activity excluding those reserved to non-bank

entities. Thus, the Italian financial system is dominated by banks. Banks balance sheets reflect

their traditional banking model of providing loans with customer funding. The expanded ECB

monetary policy framework has also contributed to shielding Italian banks against market

shocks.8

Part of the difficulty of assessing the impact of Non Banking Financial Institutions (NBFIs) on

financial stability is the wide range of institutions involved. The sector of NBFIs is defined as

including insurance undertakings, pension funds and other financial intermediaries (OFIs). The

latter group includes financial institutions engaged in the securitisation of assets, securities and

derivatives dealers (operating on own account) and specialised financial institutions (e.g., hedge

funds, venture capital firms, etc.).

All financial institutions and quasi-institutions which are principally engaged

in financial intermediation by incurring liabilities in forms other than currency,

deposits and/or close substitutes for deposits from institutional units other than

monetary financial institutions, or insurance technical services.9

Sergio (1996)10 in a study of non-performing loans in Italy found evidence that, an increase in

the riskiness of loan assets is rooted in a banks lending policy adducing to relatively unselective

and inadequate assessment of sectorial prospects. Interestingly, this study refuted that business

cycle could be a primary reason for banks NPLs. It takes a different approach than the solvency

and liquidity stress tests by assessing the financial soundness of the main borrowers of the

Italian banking systemhouseholds and the non-financial corporate sectorand quantifying the

8Italy: Financial System Stability Assessment, IMF Country Report No. 13/300, September 20139Other financial intermediaries, insurance undertakings and pension funds as defined in Council Regulation (EC)

No 2223/96 will be considered in this study. Alternative definitions, if used due to data limitations, will be referredto explicitly.10 Sergio, M.,(1996). Non-performing bank loans: Cyclical patterns and sectoral risk. Review of EconomicConditions in Italy.


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potential impact from macroeconomic shocks. It relies on various sources of information,

including aggregate statistics and more granular information from household surveys and

corporate balance sheet databases.11

THE ITALIAN NON-FINANCIAL SECTOR

In Europe, a wide range of non-bank institutions have the potential to act as direct lenders to

mid-market companies. The most obvious are insurers and pension funds, but sovereign wealth

funds and hedge funds could also be attracted to this market. European non-bank institutions

could also lend direct to larger mid-market companies without a formal credit rating, as in a US

private placement or a German Schuldschein loan. Standard & Poors launch of a service

offering creditworthiness opinions to mid-market companies is an indicator of the potential

growth in this area. The debt burden of the corporate sector is moderate, but leverage is high.

Corporate balance sheets, made fragile by the prolonged recession, are weighed down by a

historically high level of debt in relation to both value added and equity. Leverage has increased

during the crisis, though mostly reflecting a decline in the value of equity. On average, Italian

firms leverage is among the highest in theeuro area. SMEs are more highly leveraged than other

firms.

ITALYS NEW RULES TO FACILITATE DIRECT LENDING

On June 24, 2014, the Italian Government adopted Law Decree no. 91 (the Decree) 12 that,

among other things, introduced various measures aimed at stimulating the Italian economy. This

memorandum outlines some of the measures contained in the Decree designed to increase the

availability of non-bank debt financing to Italian companies and lifting certain tax obstacles to

the access by non-listed companies to the international debt capital markets. Decree 91 amends

the definition of Undertaking for Collective Investment ("UCI") to include those who invest in

credit, including credit made available by utilisation of the UCIs' own assets.

11Technical Note On The Financial Situation Of Italian Households And Non-Financial Corporations And Risks ToThe Banking System, IMF Country Report No. 13/348, December 201312The Decree was published in the Official Gazette on June 25, 2014, date as of which it is effective. It will have to

be converted into law by Parliament within 60 days, otherwise it will lapse on a retroactive basis. Amendments tothe Decree could be passed during the conversion process.


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REGULATORY CHANGES

Lending Deregulation

In Italy lending activity (including issuance of guarantees) has been traditionally reserved to

banks and those financial intermediaries enrolled in a specific register held by the Bank of Italy

that are subject to regulatory and prudential provisions broadly mirroring those applicable to

banks (the 106 Intermediaries).13

In order to facilitate Italian companies access to non-bank debt financing, the Decree expanded

the scope of the entities that are allowed to carry out lending in Italy by including Italian

insurance companies and Italian securitization vehicles (Securitization SPVs).14

Insurance Companies

With respect to insurance companies, the Decree directly amends Art. 106 of the Italian Banking

Act in order to add a specific carve-out from the general prohibition on lending activity for any

lending (other than the issuance of guarantees) carried out by Italian insurance companies other

than to natural persons and so-called micro-enterprises.15

The regime applicable to the abovementioned lending activity will be specified by implementing

regulations to be issued by the competent authorities. Specifically, the Italian banking regulator

(Banca dItalia) has been given authority to identify the reporting requirements applicable to

Insurance companies engaged in lending as well as the manner of their inclusion in the Italian

centralized credit risk database (Centrale dei rischi). Similarly, the Italian insurance regulator

(IVASS) has been authorized to establish limits and conditions applicable to such lending by

insurance companies in accordance with the following principles:

borrowers will be selected by a bank or a 106 Intermediary; such entities should retain a

significant economic interest in the transaction;

13See Art. 106 and ff. of Legislative Decree No. 385 of September 1, 1993 (the Italian Banking Act) 14Securitization SPVs are established under Art. 3 of Law No. 130 of April 30, 1999 (the Securitization Law). 15As defined by EU Commission Recommendation 2003/361/EC


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- the insurance company will be adequately capitalized and have an internal control and

risk management system which allows the insurance company to manage the risks

typically related to the lending activity.

Securitization SPVs

The Decree also contains provisions enabling Securitization SPVs to carry out lending in Italy,

other than vis--vis natural persons or micro-enterprises.16

The Decree further specifies the conditions applicable to such lending by Securitization SPVs.

Like for insurance companies, banks or 106 Intermediaries must select the borrowers and retain a

significant interest in the transaction. In addition, the Decree provides that the securities issued

to finance such lending may be purchased only by qualified investors.

17

It is not clear whetherthe restriction on identity of the initial purchasers also entails a restriction on re-sales to entities

other than qualified investors.

EXEMPTION FROM WITHHOLDING TAX

The new rules also include striking developments in the rules on taxation of loans to Italian

borrowers, which may have even more of an immediate effect in practice.

By way of background, Italian withholding tax is generally levied at 26% of the amount payable

by way of interest or financial remuneration, after subsequent increases from 12.5% and then

from 20% over the last few years. This rate is subject to any treaty against double taxation

between Italy and the lenders' home jurisdiction.

The good news is that Decree 91 exempts from withholding tax interest and other proceeds

having a financial nature payable in respect of medium to long term loans (i.e. loans for a term in

excess of 18 months) by Italian borrowers to (i) credit institutions based in a EU Member State,

(ii) insurers regulated under the law of a EU Member State, or (iii) UCIs which are not leveraged

16Somewhat confusingly, instead of introducing a further carve-out in Art. 106 of the Italian Banking Act, where thegeneral prohibition is contained, the Decree amends the Securitization Law to provides that Securitization SPVs areallowed to carry such lending.17The definition of qualified investor mirrors that of professional client provided for under the MiFID regimeand includes, among others, banks, investment firms, insurance companies, collective investment undertakings,

pension funds, broker dealers and other institutional investors as well as large corporations.


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funds and are organised in a EU Member State or a EEA State included in the Finance Ministry's

white list.

SUBSTITUTIVE TAX ON LOAN TRANSFERS

Imposta sostitutiva is the incentive tax regime available for medium-long term loans documented

in Italy, and consists of a one-off levy payable on utilisation or availability of credit facilities, at

the rate of 0.25% of the principal amount of the facility.

It is called a "substitutive" tax because, where it is payable, the credit and security documents are

exempt from registration and other indirect taxes. The measure is beneficial for secured

transactions, which, depending on the circumstances, may trigger registration tax at 0.5% of the

amount of the secured claims for each security document, or mortgage tax in respect of land orproperty charges, at 2% of the amount of the secured claims. It is a one-off tax because it will

cover subsequent amendments, restatements and adjustments to the finance documentation but,

so far, not the transfer of the lenders' rights thereunder or the contractual relationship as a whole.

However, Decree 91 provides that the regime will now also cover post-closing transfers of the

loans, as well as the related security and contract documentation. Previously, the unavailability

of imposta sostitutiva for such loan transfers had meant that the transfer of a secured loan would

trigger substantial tax burdens, in form of all the indirect taxes payable on the security interests

under the ordinary regime. This development is another important contribution to the

improvement of the liquidity of the Italian market, at a time when Italian credit institutions are

pressed to sell on their loans for supervisory capital concerns, as well as to release capacity for

fresh lending.18

Whilst these new developments mark a significant step forwards towards a more efficient and

liquid Italian loans market, it remains to be seen how the market will react. It would appear that

opening up the loan markets to non-bank Lenders may well encourage the development of

alternative financing structures for Italian borrowers, including unitranche transactions.

18Supra at 3


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Issue of Bonds19

Other measures have also been taken to encourage the issuance of bonds by non-listed

companies, and in particular private placements (non-listed bonds subscribed by qualified

investors). In fact, Article 21 of the Decree extends the application of the so-called 239

regime[1] to non-listed bonds if they are held by one or more qualified investors (as defined by

the Italian Financial Act in line with the Prospectus Directive), the listing of bonds being no

longer a requirement in order to benefit from such a favorable regime.

In addition, a blanket exemption from withholding tax will apply to private placements where the

bonds are subscribed by domestic or European investment funds or Italian securitisation vehicles

provided that the following conditions are met: (i) at least 50% of their assets are invested in

such bonds; and (ii) the units of the investment fund (or the bonds issued by the securitisation

vehicles) are fully owned by qualified investors.

Possible Further Measures

In our view there are at least three items which are missing from the described picture. The first

item is real estate investment funds, where legislation has rapidly evolved in past years, but is

still linked to views on the real estate business which are now too formal and traditional in

respect of what a post-crisis market expects.

The Italian government has in fact promised to investors that a reform on real estate funds and

the real estate market will be enacted soon. The second item relates to the granting of loans by

investment funds. As mentioned, a reference to the right of Italian closed investment funds to

grant loans is made in the Decree even though a more explicit legislative coordination would be

invaluable. In this respect, it is also worth mentioning that the financial intermediaries

regulation framework is still awaiting implementing measures. Hopefully, this will be the

occasion to coordinate the relevant legal frameworks.

Till now as we know that various financial institutions have provided loans in Italy. For instance,

ICG made its first investment in Italy by providing a mezzanine loan for acquisition finance of

19 Italy Introduces Measures To Facilitate Alternative Funding, July 07, 2014; Available athttp://www.paulhastings.com/publications-items/details/?id=b185e169-2334-6428-811c-ff00004cbded
http://www.paulhastings.com/publications-items/details/?id=b185e169-2334-6428-811c-ff00004cbdedhttp://www.paulhastings.com/publications-items/details/?id=b185e169-2334-6428-811c-ff00004cbdedhttp://www.paulhastings.com/publications-items/details/?id=b185e169-2334-6428-811c-ff00004cbded


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Instrumentation Laboratories to support Citicorp Italia/CH Werten. Aart from that SMEs also

seem to have been turning to retail bonds to raise money. Known as mots, these bonds are well

established in Italy, where they have traded on Milans Borsa Italiana since 1994.20

LOANS BY NBFIS

Loan assets expanded relatively significantly in 2006. Short-term loan assets expanded more

than long-term loan assets on a proportionate basis. However, this occurred more due to

valuation changes than active loan expansion activity by NBFIs. The key consequence of the

crisis on loan assets was a reduction in asset growth.21

BANKING AND GRANT OF LOANS IN ITALY

The modern Italian banking system has its origins in the 80s. During these years, two important

innovations were introduced.

The first was the change in the attitude to banking supervision. Under the new model, Italian

authority had the power to deny authorization for the opening of banks if it deemed that a new

bank was not necessary to satisfy market needs. For the same reasons, banks did not have the

power to decide their territorial expansion independently, as the opening of new offices was also

subordinated to Bank of Italys discretionary approval. This authority to control market structure

has been repealed in the current new model.

The second innovation was the privatization of banking sector that started with the so-called

Amato law (i.e. Law 218/1990). Indeed, until then, the most important Italian banks were

directly or indirectly state controlled as it was commonly felt that that banking activity had to be

regarded as an activity of public interest.

Since the 90s the banking system has undergone significant changes, most of which have been

introduced also as a consequence of legislation of European Union (EU). The ban on banks

acquiring shareholding above given thresholds, in companies operating in the

20Alternative Capitals Critical Role in Rebuilding Europes Economy for the Long Term, May 15, 2014; Availableathttp://www.kkr.com/sites/default/files/KKR-1404-Alternative-Capital-Europe.pdf21Non-bank financial institutions: Assessment of their impact on the stability of the financial system, EconomicPapers 472, November 2012; Available athttp://ec.europa.eu/economy_finance/publications/economic_paper/2012/pdf/ecp472_en.pdf
http://www.kkr.com/sites/default/files/KKR-1404-Alternative-Capital-Europe.pdfhttp://www.kkr.com/sites/default/files/KKR-1404-Alternative-Capital-Europe.pdfhttp://www.kkr.com/sites/default/files/KKR-1404-Alternative-Capital-Europe.pdfhttp://ec.europa.eu/economy_finance/publications/economic_paper/2012/pdf/ecp472_en.pdfhttp://ec.europa.eu/economy_finance/publications/economic_paper/2012/pdf/ecp472_en.pdfhttp://ec.europa.eu/economy_finance/publications/economic_paper/2012/pdf/ecp472_en.pdfhttp://www.kkr.com/sites/default/files/KKR-1404-Alternative-Capital-Europe.pdf


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commercial/industrial sectors, has been abolished. Today the Italian supervisory model is based

on three pillars of Basel II, and bank of Italy has made efforts to simplify the administrative

proceedings governing banking activities. In order to improve competition in the financial sector,

a ban on interlocking directorships among financial entities who are competitors have been

introduced.

Banking regulation is influenced by the directives and regulations of EU, and by the standards

adopted by the Basel Committee and the Financial Stability Board/Forum. In this context, the

Italian authorities have been favorable to the principle that the financial industry should be able

to adopt suitable self-regulation. This attitude helped the banking system absorb the first

financial crisis in 2007-08 with the Lehman Brothers insolvency.

REGULATORY ARCHITECTURE: OVERVIEW OF BANKING REGULATORS AND

KEY REGULATIONS

The fundamental source of law governing banking activity is the legislative decree No. 385/1993

(i.e the consolidated law on banking) which lays down the architecture of the system by

regulating: (i) bodies responsible for supervising and regulating banks and other entities

operating in the banking system, (ii) entities operating the banking system; (iii) provision of

banking services; and (iv) banking crisis management.

The main authorities in charge of banking regulation are the CICR (i.e. Interdepartmental

Committee for credit and savings), the ministry of economy and finance (MEF) and bank of

Italy. Just like the MEF, the CICR is also a political body which rules, after having reviewed the

bank of Italys proposals. Bank of Italy is the supervising authority for banks and other entities

operating in the banking system.

The rules implementing the provisions of the Consolidated law on banking are contained in the

CICRs resolutions, in the MEFs decrees, and in a large number of regulations issued by the

Bank of Italy. The hierarchy between such sources of laws are: the CICR resolutions and MEF

decrees must be compliant with the provisions of Consolidated law on banking, whilst bank of

Italys regulations must be compliant with all. The following is the distribution of regulatory

powers:


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a) CICR: (i) cases where deposit taking activities do not constitute banking activities (ii)

banking services which are subject to publicity content and advertising; (iii) criteria to

be complied with when determining the amount of commission to be payable on

facilities and overdrafts; (iv) content and means of periodic communication to clients,

etc.

b) MEF: It has powers in the management of bank crises and it regulates inter alia, (i)

requirements of reputation that must be owned by the shareholders of banks and (ii)

requirements of reputation, experience and independence that must be owned by the

executives of the bank

c) Bank of Italy: on the basis of guidelines issued by the CICR, it regulates (i)

authorization proceedings for acquisition of direct and indirect shareholdings in banks,

(ii) issuance of bonds by banks, (iii) maximum amount of mortgage loans and content of

relevant contracts; (iv) capital adequacy and risk containment of banks; (v) corporate

governance, internal control systems, remuneration and incentive system of banks (vi)

operation on conflict of interest; (vii) definition of banking group, etc.

Amongst the most important regulations that have been adopted by the Bank of Italy in relation

to banks, the following can be mentioned:

Circular no. 229 of 1999 containing supervisory instructions for banks as amendedfrom time to time.

Circular no. 263 of 2006 containing the new provision on prudential supervision for

banks

Regulation on transparency requirements applicable to banking services

RECENT REGULATORY DEVELOPMENTS

Since 2004 Italian corporate law has contemplated three different governance and supervision

structures that stock corporations may choose from and adopt in their by-laws:

(i) The traditional Italian model, comprising a board of directors and a board of statutory auditors

(collegio sindacale) composed of independent members performing oversight functions;


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(ii) A one tier model, consisting of a board of directors, including a management audit committee

(comitato per il controllo sulla gestione) composed of a majority of independent directors; and

(iii) A two tier model comprising a supervisory board (consiglio di sorveglianza) and a

management board.

In March 2008, the Bank of Italy issued a supervisory regulation regarding banks internal

organization and corporate governance (the New Regulation),1 which implements the general

guidelines set forth by Decree No. 200 of the Minister of Economic Affairs of August 2004 (the

Treasury Decree) on the principles to be followed by banks and other financial intermediaries

adopting governance systems alternative to the traditional one.2 In line with better regulation

standards, the New Regulation is divided into general principles and implementing guidelines.

The principles set forth the organizational and governance goals that banks are free to achieve in

the manner they choose depending on their characteristics, whilst the guidelines are intended to

facilitate the implementation of the general rules in specific areas.

The New Regulation applies to both banks and bank holding companies (capogruppo)

incorporated in Italy and sets forth the essential features that a bank or bank holding company 22

(hereinafter, collectively referred to as banks) must adopt in its corporate governance system to

ensure the sound and prudent management of the bank.

The New Regulation uses the concepts of (i) strategic supervision, (ii) management, and (iii)

control to identify the functions with which corporate bodies or their members need to be

entrusted. This approach focuses on the powers and duties that are relevant for supervisory and

corporate law purposes.

The New Regulation seeks primarily to draw a clear distinction between the control and

management functions and clearly define each of them. In particular, the New Regulation

addresses those situations where, depending on the governance system implemented in a banks

by-laws, the same (management or control) function is performed by more than one corporate

22Bank holding companies are, in particular, responsible for the overall consistency of the corporate governance at agroup level and the creation of adequate connections between bodies, areas and functions (control functions in

particular) at the various group member companies.


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body, or a single corporate body performs various functions. Indeed, the confusion generated by

such situations could jeopardize a banks sound and prudent management.

The principles set forth by the New Regulation are particularly relevant for the two tier

governance system (as outlined in the Italian Civil Code), in which the risk of overlaps between

the governing bodies is particularly acute.

BANK GOVERNANCE AND INTERNAL CONTROLS

According to the New Regulation, banks shall choose the corporate governance model which is

most likely to ensure the efficiency of operations and the effectiveness of controls, taking into

account the costs involved in each model. The choice should be made on the basis of a self-

assessment process, considering:

(i) The banks ownership structure and its recourse to the equity capital markets;

(ii) The banks size and the complexity of its operations;

(iii) The banks medium- and long-term strategic objectives; and, if applicable,

(iv) The organizational structure of the group to which the bank belongs.23

Banks will have to (a) adopt, by June 30, 2009, (b) update upon the occurrence of any

significant organizational change, and (c) file, upon request, with the Bank of Italy, a corporate

governance plan,24. The corporate governance plan will need to be approved by the corporate

body in charge of the strategic supervision function and adopted with the favorable opinion of

the body entrusted with the control function.

23According to the Speech, Once the rules have been issued, banks will be expected to make, in accordance withthe principle of proportionality, a detailed self-assessment to verify the compliance of their corporate governancesystems with the new rules. A suitable transition period will allow intermediaries [i.e., banks] to make anyadjustments that may prove necessary.

24In its paper illustrating the outcome of the public consultation on the draft New Regulation (the Paper) the Bankof Italy clarified that each bank is free to decide whether to publish in whole or in part the corporate governance planor classify it as confidential and deliver it only to Bank of Italy. See http://www.bancaditalia.it/vigilanza/banche/documcons/consnorm/resoconto_040308.pdf.


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Each banks corporate governance plan will need to detail (i) the reasons why the corporate

governance model chosen by the shareholders is the most suitable to ensure efficient

management and control, and (ii) the choices made with respect to the organizational structure of

the bank (e.g., tasks, powers and composition of the governing bodies; delegated powers;

accounting audit system; incentive and remuneration schemes; and information flows),

shareholders rights (e.g., withdrawal rights and quorums for shareholders meetings to vote on

resolutions and for challenging shareholders or board resolutions), financial structure ( e.g.,

classes of shares and limits to their transfer, other equity-like securities, and segregated assets),

and procedures for handling conflicts of interest (e.g., related-party transactions, directors

obligations).

For banking groups, the plan prepared by the group parent company (capogruppo) will have to

illustrate the measures adopted to ensure the adequacy of the management and control systems

and the organizational choices made with respect to the banks belonging to the banking group.

Group holding companies will need to detail the measures in place to ensure the interaction

between the corporate bodies and functions of the various companies making up their group, in

particular as regards the control systems. Banks belonging to banking groups are exempted from

drafting a corporate governance plan if their organizational choices are reflected in the plan of

their group parent company.25

DISTINCTION BETWEEN CONTROL AND MANAGEMENT FUNCTIONS OF BANK

The Bank of Italy has articulated a number of innovative positions with respect to the internal

corporate governance of Italian banks, in particular when they adopt the two tier governance

system. The level of detail and the prescriptive nature of the provisions concerning the internal

organization and powers of banks corporate bodies have been criticized by commentators

25The corporate governance plan also needs to be filed at the time of (i) the establishment of a bank, and (ii) achange of the existing corporate governance model. Mutual banks (banche di credito cooperativo) adopting thestandard by-laws prepared by their association and reviewed by the Bank of Italy will not be required to prepare acorporate governance plan.


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because of certain significant restrictions imposed on banks ability to fully implement the

governance systems provided for under the Italian Civil Code.26

The New Regulation requires that, where the strategic supervision and management functions are

assigned to different bodies, the tasks and responsibilities of each body be clearly identified, with

(i) the strategic supervision body being responsible for deciding the banks strategy and

monitoring its implementation, and (ii) the management body being in charge of the banks

management.27

Similarly, the New Regulation requires that a clear distinction be drawn between powers and

roles of the individuals within the corporate bodies to which both supervisory and management

functions are entrusted. In particular, the chairman of the board of directors is supposed to have a

key role in fostering debate within the board and ensuring an adequate balance of powers in a

manner consistent with his or her duty to organize the work of the board and guarantee that the

board members receive an adequate information flow.

The New Regulation requires that a similar function be vested in banks that adopt the two tier

modelin the chairman of the body in charge of strategic supervision. If the strategic function

has been entrusted to the supervisory board, the chairman of the supervisory body must ensure a

neutral stance among the functions attributed to him or her, so as to guarantee their objective and

impartial integration (see below regarding the means to ensure neutrality).28

26The Bank of Italy in its Paper addresses these criticisms, stating that it has been delegated sufficient powers (bythe Italian Banking Act and Treasury Decree No. 200 of 2004) to enable it to influence, in the interest of the soundand prudent management principle, the contents of bank by-laws, including by way of restricting the choices grantedto companies by the Civil Code.

27In the Speech, the Governor confirmed the rationale for this provision: The supervisory board can combine andin fact usually does combine guidance functions, typical of the shareholders meeting, strategic supervisionfunctions, vested in the board of directors, and control functions, characteristic of the board of auditors

28For example, the Chairman of the Supervisory Board of Mediobanca Banca di Credito Finanziario S.p.A.,despite being empowered by the current by-laws of the bank to participate in the meetings of th e banksManagement Board (the bank adopted the two tier system in June 2007), has informally agreed with the Bank ofItaly that he would delegate such power to another member of the Supervisory Board, who is also President of the

banks Internal Audit Committee.


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In order to implement such principles, the New Regulation requires, inter alia:

(i) That the scope of delegated powers of the members of the management body be set out in a

clear and precise fashion, especially with regard to quantitative limits, as well as the manner in

which such powers should be exercised;

(ii) That certain activities in addition to those set forth by the Italian Civil Code not be

delegated to individual members or committees (e.g., strategic guidelines and transactions,

preparation of business and financial plans and appointment of the general manager, amendment

of key internal policies, choice of the head of internal control and compliance functions);

(iii) That the simultaneous presence within a board of directors of an executive committee and

one or more chief executive officers be justified by the size and complexity of the banksoperations;

(iv) That the chairman of the board of directors and, in the two tier model, the chairman of the

management board when the supervisory board does not perform the strategic supervision

function, have a non-executive role and not be involved, even de facto, in the current business of

the company, except for exceptional circumstances, and provide a balance of power vis--vis the

CEO or other executive directors; and

(v) That the entrustment to the supervisory board of strategic supervision not lead to the

involvement of the supervisory board in the management of the bank, thus changing its nature as

a control body and limiting the independence of the management body.29

29The New Regulation provides for a number of measures to be included in the by-laws of banks that have adoptedthe two tier system in order to ensure an adequate balance between the strategic and management functions. In

particular, the New Regulation and the Paper require that banks by-laws, among other things:

(i) clearly set out the functions of the supervisory and management boards, respectively, and exclude the possibilityof expanding such functions on a case-by-case basis, (ii) identify the nature and content of the decision-making

powers entrusted to the supervisory board, compared to the powers entrusted to the management board, and (iii) setout the key strategic transactions in connection with which the supervisory board may formulate its guidelines to themanagement board.


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23

LOANS BY BANKS AND NBFCS

The laws on banking and credit matters have been brought together in Legislative Decree

385/1993, as amended, generally known as the Consolidated Law on Banking. This law

establishes principles and assigns powers; it lays down the basic rules and defines the tasks of the

credit authorities (the Interministerial Committee for Credit and Savings, the Ministry for the

Economy and Finance and the Bank of Italy). In particular, it assigns the power to issue

secondary legislation on technical matters and interventions of a prudential nature.

The laws on financial matters have been brought together in Legislative Decree 58/1998, as

amended, generally known as the Consolidated Law on Finance. Other important rules for the

organization, powers and functioning of the Bank of Italy and of other supervisory authorities are

contained in the articles 19 to 29 of the Law 262/2005 ("Measures for the protection of savings

and discipline of the financial markets").

Total bank assets in Italy stand at a relatively modest 2.6 times GDP, compared with 3.2 times in

the whole of the euro area. Italian banks generally shunned the sorts of toxic financial

instruments that brought down banks in America and Germany. And the country has not

experienced a housing bust on a par with that in Ireland or Spain.

Yet for all their sobriety, Italian banks are struggling amid a mountain of bad debts from Italian

businesses, big and small. These are rising by about 20% a year and now stand at more than 8%

of all bank loans, or almost 17% of GDP. The euro-area average is 11%, although Italy uses a

slightly stricter definition of souring loans.

The main culprit is Italys economy, which has been shrinking for more than two years. In

addition, a slow legal system makes it difficult for creditors to recover money owed to them. In

many cases banks simply keep on extending loans to firms that have no hope of repaying them.

Alberto Gallo of Royal Bank of Scotland reckons that some 30% of Italian firms owe five times

or more than their annual earnings before interest, tax, depreciation and amortisation, a ratio that

would make a private-equity firm blush

Italys bankers are also contributing to a dangerous downward spiral by withholding credit from

firms that are growing. Faced with the prospect of large write-offs, bankers are generally


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retreating from risk. Holdings of government bonds as a portion of total assets are among the

highest in Europe. This leaves Italian banks dangerously susceptible to a sudden jump in yields

on Italian government debt.30

Meanwhile, the number of companies saying that access to finance is their biggest problem has

been increasing over the past two years, even as it has been falling in places such as Germany.

Some members of Confcommercio, a business association, have had their overdraft limits halved

overnight. It reckons only about 10% of members applied for loans last year; only a quarter of

those applications were approved. For the economy as a whole lending to non-financial firms fell

by almost 9% over the two years to December, according to the European Central Bank (ECB).

For the minority of small Italian firms that do manage to get finance, the rates they pay are about

two percentage points higher than those charged to firms elsewhere in the euro area. That is

partly due to the risks involved in lending to firms in a sluggish economy. But it is also a

reflection of Italys dysfunctional banks, many of which also struggle to borrow money from

bond investors or in capital markets. One measure of this is the reliance on the ECBs Long -

Term Refinancing Operations (LTRO), an emergency source of funding put in place when it

seemed the euro area might break up. Fitch, a ratings agency, points out that last year Italy

overtook Spain to become the largest user of LTRO funding.

There is some hope of change. The ECBs impending inspection of the balance-sheets of banks

across the euro area is prompting some to write down bad debts and raise capital now, to avoid

humiliation. Intesa and Unicredit, Italys two biggest banks, earlier this year posted combined

losses of almost 19 billion ($25 billion) in part due to write-downs. In April they struck a deal

to pool some of their bad debts and have them managed by KKR, an American private-equity

firm31

REGULATORY REQUIREMENTS FOR MORTGAGE LENDING

The regulatory requirements for mortgage lending promulgated by the bank of Italy and

emanating from basel II recommendations. The rules for prudential vigilance apply to the

30GIOVANNI LEGORANO , Loans Sour for Italy's Banks, The Wall street journal, Nov. 13, 201331 Investing in Non-Performing Loans in Italy: latest trends and investment opportunities, available athttp://www.gop.it/doc_pubblicazioni/339_7qiu886bf6_ita.pdf


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screening process for new loans and the procedures for monitoring existing mortgage exposures.

In particular, the rules focus on the operational limits (i.e., the loan-to-value ratio) and the

acceptance of mortgages as credit risk mitigation instruments. As in the U.S., the term real estate

mortgage loan (credito fondiario) refers to a written loan agreement securitized by a mortgage on

a real property used as collateral for borrowed funds. Such a loan enjoys privileged tax and

regulatory treatments due to the social relevance of property investments. The purpose of the

borrowed funds is to buy, build or renew a real property .In order to be classified as a real estate

mortgage, thepromissory note must contain the following provisions:

a.Maturity: The loan must have a medium- or long-term maturity (i.e., have an average duration

of more than 18 months). With residential mortgages, the amortization term is usually between

eight and 30 year.

b.Mortgage: A so-called first grade or senior mortgage is a pledge of property as collateral for

the payment of the debt. Subordinated liens may also be accepted, but the loan-to-value ratio

stated for regulatory purposeswhich defines the maximum credit amountmust be calculated

considering both the amount of the new loan to be granted and the residual amount of any

previous mortgage.

c. Loan-to-Value Ratio: As described in detail next, the maximum loan amount is set by the

Central bank as a percentage of the current market value of the real estate pledged as collateral

for the loan. Additional securities may lever the loan-to-value ratio under specific circumstances.

If these provisions are fulfilled, the mortgage loan enjoysas a medium- to long-term loana

reduced substitute tax of 0.25 percent calculated on the borrowed amount; the substitute tax

is levied in place of the ordinary, higher indirect taxes related to the cadastral (land) register and

mortgage taxes. In addition to other favorable legal standards, mortgages pledging property are

not subject to bankruptcy claw-back actions if they have been recorded at least 10 days prior to

the bankruptcy declaration of the mortgagor. Also, a mortgage holder cannot terminate the loan


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agreement and initiate foreclosure unless the borrower fails seven times, at several points in time,

to make interest and principal payments when due under the promissory note.32

NEW LENDING OPPORTUNITIES IN ITALY FOR NON-BANK LENDERS

The Italian government recently published long awaited legal reforms, designed to improve the

competitiveness of Italian businesses and the economy in general: Law Decree No. 91/2014 of

24 June 2014 ("Decree 91") is now in full force and effect after publication on 20 August 2014

of the conversion law No. 116 of 11 August 2014.

The reforms include some of the boldest changes seen by the Italian loan market for years, and

are expected to facilitate credit conditions and to diversify the offering from foreign investors

and non-bank lenders.

However, at this stage there remains substantial uncertainty on the wider implications of the new

measures, and it will be interesting to see how these measures will be implemented.

Paving the way for lending by debt funds

Decree 91 amends the definition of Undertaking for Collective Investment (" UCI") to include

those who invest in credit, including credit made available by utilisation of the UCIs' own assets.

This change in law dovetails with the Finance Ministry's proposed new regulation on criteria for

investment by UCIs, mandated under article 39 of Legislative Decree 24 February 1998 No. 58

(the "Finance Act"), by way of implementation in Italy of Directive 2011/61/EU (AIFMD).

UCIs are now permitted to engage in lending in Italy subject to the conditions set out in the draft

Bank of Italy Regulation on Collective Investment Schemes. Amongst other things, the new

rules require UCIs investing in credit receivables to participate in the Bank of Italy's Centrale dei

Rischi, the Bank's central credit information system, and the Bank of Italy may require the

information flow with theCentrale dei Rischi to be intermediated by a licensed bank or registered

financial institution. It is expected that, to engage in direct lending, UCIs will be required to put

in place appropriate mechanisms and models for the evaluation and managment of credit risk.

32MASSIMO BIASIN; AND HALBERT C. SMITH, CRE EMERITUS, The Valuation of Mortgage Security byItalian Banks


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Certain additional limitations will also apply which we will be able to expand upon once the

results of the relevant open consultations are known. It would also appear that additional

conditions may still be enacted because certain aspects relating to how such financings will be

regulated have not yet been addressed in full.

In particular the definition of UCIs in the Finance Act does not contain any jurisdictional

limitations on where a UCI should be organised in order to be a permitted lender. As a result, the

requirements for foreign UCIs are unclear. Initial views suggest that EU UCIs authorised to lend

in their home jurisdiction are permitted to carry out this activity in Italy as well if the Alternative

Investment Fund Manager (AIFM) is passported into Italy, even though such requirement is not

expressly stated. Accordingly we recommend that until the specific rules and common practice

are established, any AIFM should engage in preliminary consultations with the Bank of Italy

before making any significant Italian loan investments.

Exemption from withholding tax

The new rules also include striking developments in the rules on taxation of loans to Italian

borrowers, which may have even more of an immediate effect in practice.

By way of background, Italian withholding tax is generally levied at 26% of the amount payable

by way of interest or financial remuneration, after subsequent increases from 12.5% and then

from 20% over the last few years. This rate is subject to any treaty against double taxation

between Italy and the lenders' home jurisdiction. As a result, in the past fronting bank and other

financial structures have been commonly used to facilitate non-Italian lenders advancing funds to

an Italian borrower in order to structure around the application of Italian withholding tax.

The good news is that Decree 91 exempts from withholding tax interest and other proceeds

having a financial nature payable in respect of medium to long term loans (i.e. loans for a term in

excess of 18 months) by Italian borrowers to

(i) credit institutions based in a EU Member State,

(ii) insurers regulated under the law of a EU Member State, or


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(iii) UCIs which are not leveraged funds and are organised in a EU Member State or a

EEA State included in the Finance Ministry's white list.

This development should facilitate syndication and secondary market transactions, as before now

borrowers have been understandably reluctant to allow (or bear the increased costs ensuing from)

inclusion of foreign credit institutions. 33

Substitutive tax on loan transfers

Imposta sostitutivais the incentive tax regime available for medium-long term loans documented

in Italy, and consists of a one-off levy payable on utilisation or availability of credit facilities, at

the rate of 0.25% of the principal amount of the facility.

It is called a "substitutive" tax because, where it is payable, the credit and security documents areexempt from registration and other indirect taxes.

The measure is beneficial for secured transactions, which, depending on the circumstances, may

trigger registration tax at 0.5% of the amount of the secured claims for each security document,

or mortgage tax in respect of land or property charges, at 2% of the amount of the secured

claims.34

It is a one-off tax because it will cover subsequent amendments, restatements and adjustments to

the finance documentation but, so far, not the transfer of the lenders' rights thereunder or the

contractual relationship as a whole.

However, Decree 91 provides that the regime will now also cover post-closing transfers of the

loans, as well as the related security and contract documentation. Previously, the unavailability

of imposta sostitutivafor such loan transfers had meant that the transfer of a secured loan would

trigger substantial tax burdens, in form of all the indirect taxes payable on the security interests

under the ordinary regime.

33 Carlo Massini, Jeffery Greenbaum and Fulvia Astolfi, Hogan Lovells ,New lending opportunities in Italy,particularly for non-bank lenders, Italy, September 11 2014

34Ibid


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This development is another important contribution to the improvement of the liquidity of the

Italian market, at a time when Italian credit institutions are pressed to sell on their loans for

supervisory capital concerns, as well as to release capacity for fresh lending.

INVESTING IN NON-PERFORMING LOANS IN ITALY

NPL portfolios

Latest trends and opportunities According to the most recent data released by the Bank of Italy,

non-performing loans (NPL) in the balance sheets of Italian banks totaled around Euro 160

billion in January 2014, rising nearly by 25% compared to a year ago. The factors leading to this

increase depend mainly on the contraction of gross domestic product and in the increase of the

unemployment rate.Italian banks are now addressing the issue with more decision, due to theupcoming asset quality reviews and stress tests operated by the European Central Bank. During a

recent speech in front of the Italian Banking Association (ABI), the Governor of the Bank of

Italy, Mr. Ignazio Visco, stressed that NPLs are still very heavy on national banks balance

sheets and it is therefore necessary an intervention on several grounds. On one hand, banks need

to continue to raise financial hedges and to allocate funds proportionally to the risk degree of the

assets owned; on the other, they need to make internal management procedures more effective or

otherwise make use of operators specialized in the recovery of problematic loans. Some of them

will have to sell at least part of their NPL portfolios to investors.

But if the large amounts of NPLs in the Italian banks balance sheets constitutes an issue for the

banks, at the same time they represent a very attractive opportunity for investors. Italian banks

have been very cautious and relatively few transactions have taken place in Italy compared to the

aggregate size of NPLs. Other European countries, notably Spain and Ireland, have been much

faster in tackling the issue. Now it seems it is Italys much awaited turn. In fact, after a calm

period of several years, more and more funds and specialized investors are now becoming active

on Italian NPL portfolios.

A window of opportunity

Due to the banks need to sell their distressed credit portfolios in order to get fresh liquidity and

comply with the banking authorities requirements, it is now possible for investors to buy NPL


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portfolios at a fraction of their face value. Prices have been very low until now, due to the

negative evaluations of Italys economy by international investors and rating agencies. Now

prices negotiated for portfolios are going up, reflecting an improvement of Italian economys

perception. Clearly the discount rate to be applied is becoming more negotiated, as the vendors,

due to the increasing market demand, are gaining negotiating power. Still, the aggregate size of

NPL portfolios to be sold is such that the market should still remain attractive for some time.

Inviting opportunities can still be found in different categories, such as consumer loans,

corporate loans and asset-backed loans. Another category to be looked at is past-due receivables

guaranteed by the state or other governmental entities

Outstanding loans in Italy

Italian banks' bad loans started to decline as a proportion of overall lending in the first quarter of

this year, although they are still rising in absolute terms, the Bank ofItalysaid on Friday.

"The deterioration in banks' loan asset quality has eased," the central bank said in its twice-yearly

Financial Stability Report.

"The flow of new bad debts as a ratio to outstanding loans stabilised in the fourth quarter of 2013

and preliminary data indicate that in the first quarter of 2014 it declined," the report said.

"However, the volume of non-performing loans is still growing."35

A gradual easing of credit contraction and the decline in net non-performing loans (NPLs) are

among several signs that Italy is gradually emerging from a two-year long recession.

Italian banking association ABI said last month that net NPLs had fallen to 78.2 billion euros

(64.43 billion pounds) in February from 79.2 billion euros in January.

Gross NPLs topped 162 billion euros in February, ABI said, up from 160.4 billion.

35Italian banks' bad loan problem is easing - central bank, Reuters, May 2 , 2014
http://uk.reuters.com/places/italyhttp://uk.reuters.com/places/italy


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The Bank of Italy report said Italian banks are gradually repaying the money they borrowed from

the European Central Bank during the height of the euro zone debt crisis, but at a slower rate

than elsewhere in the currency bloc.

Last month 38 of the 112 Italian counterparties that had taken part in the ECB's 3-year

refinancing operations had paid back 79 billion euros, or 31 percent of the original borrowing,

compared with 62 percent in the other euro zone countries, the Bank of Italy said on Friday.

COMPARISON OF OUTSTANDING LOANS BY NBFCS AND BANKS

A bank is an organization that accepts customer cash deposits and then provides financial

services like bank accounts, loans share trading account, mutual funds, etc. A NBFC (Non

Banking Financial Company) on tthe other hand is an organization that does not accept cash

deposits but provides all financial services except bank accounts. The key points of difference

between the two are:-

a) While a bank directly interacts with customers, NBFCs interact with banks and governments.

b) A bank indulges in a number of activities relating to finance with a range of customers,

NBFCs on the other hand are mainly concerned with the term loan needs of large enterprises.

c) While a bank deals with both internal and international customers, NBFCs are mainly

concerned with finances of foreign companies.

d) While a banks main interest is to help in business transactions and savings/ investment

activities on the other hand NBFCs main interest is in stabilization of the currency.

There is significant difference between the interest rates of banks and NBFCs.

Compared to the peak of EUR 4.6 trillion reached at the beginning of 2009, the volume ofoutstanding loans has decreased by more than 9% to EUR 4.2 trillion in the Euro area till

October 2013.36 On balance, the reporting euro area banks have further tightened their credit

standards to non-financial corporations (NFCs). As stricter regulations were being applied by

36Helmut Kraemer- Eis, Salome Gvetadze, European Small Business Finance Outlook, European Investment Fund(December 2013)


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banks of Europe there was a surge in non banking financial corporations especially in Italy.

Since these NBFCs were involved in high amount of lending there has been a steady decline in

the amount of STRs(Suspicious Transaction Reports) filed by banks has mostly as a result of the

surge in the STRs filed by the Italian Post Office and by Non-Banking Financial Companies.37

These reports are indicators of more outstanding loans being provided by NBFCs in recent years

as compared to Italian Banks.

The surge in NBFCs in Italy has led to more lending to Small and Medium Sized Enterprises

(SMEs). Loans are increasingly being granted not by banks but by alternate providers of finance

in Italy and other European Union countries as banks in Italy and other countries of Europe are

not feeling robust unlike the banks of United States.38 Banking industry of Italy and other

European countries has been influenced by impressive growth of US business development

companies (BDCs) which now boasts assets in excess of $1.2 trillion- at the last count in summer

2013.39Now European banking industry and Italian banking industry is trying to replicate the

model by boosting companies access to credit, especially for smaller groups for whom access to

bond markets, or even pooled vehicles such as collateralised loan obligations is tough. Frances

Tikehau, a fast expanding alternative finance boutique, is looking at just such an initiative in its

domestic market. In Italy, meanwhile, Andrea Beltratti- an academic and former chairman of

Intesa Sanpaolo- is plotting something similar.40While this may be beneficial for the economy it

has also accounted for outstanding loans to a great extent in the Italian market.

A further sign of an appetite for financial risk is the willingness of investors to buy loans with

minimal protection in the case of a deterioration in the debtors financial positionso-called

covenant-lite loans. More than half of loans sold by non-bank lenders in January 2014 were

covenant-lite, the highest proportion ever.41This again has led to an increase in outstanding loans

by NBFCs.

37 Italy FATF Mutual Evaluation(February 2011), available at http://www.fatf-gafi.org/media/fatf/documents/reports/mer/First_Biennial_Update_Feb2011_Italy.pdf38 http://www.ft.com/intl/cms/s/0/146eb00c-7c69-11e3-9179-00144feabdc0.html#axzz3GSjBoXCZ39Ibid.40Supra Note 341 http://www.economist.com/news/briefing/21575773-central-banks-have-cushioned-developed-worlds-economy-difficult-period-they-have-yet


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Non-bank lending need not constitute a direct challenge to European banks. There are increasing

signs that banks are willing to work with a range of alternative lenders to meet their clients

needs and relieve the strain on their own balance sheets. In our view, the potential benefits to

both borrowers and lenders are compelling.

REASONS FOR RISE IN NON-BANKING FINANCIAL LENDING

European small and medium-sized businesses were increasingly wishing to invest for future

growth, but European banks remained under pressure to reduce their levels of leverage. Raising

capital or restructuring liabilities was not enough to prevent the banks from reducing net new

lending. As a result many non banking corporations were created to fill the void in the lending

market.42

Institutions with capital to invest were increasingly interested in the possibilities of direct

lending. Hence many non- banking institutes mushroomed in Italian markets which lend loans to

small and medium sized companies alongside commercial banks.43

Demand for credit among European SMEs kept growing as the regions economies recovered

after recession. The Italian lending market needed to expand capacity as firms were seeking to

meet rising customer demand. Demand for credit received an additional boost from the hangover

of the credit boom that ended in 2008. A large proportion of the credit raised by European SMEs

between 2004 and 2007 is due to be refinanced by 2017, but many of the markets which were the

source of this finance are either closed or operating at reduced capacity. Unfortunately as

European businesses demand for credit increased, European banks ability to lend declined.

European banks have been under pressure to reduce balance sheet leverage since 2008, and this

trend is likely to continue for several years. Italian firms struggled to fill this gap using other

existing sources of credit.

Boom in small to medium scale enterprises in Europe and Italy attracted many non banking

financial institutes such as insurers, pension funds, sovereign wealth funds and hedge funds to

42 Increasing European SME Access to Credit with Non- bank Lenders, PwC (April 2014), available athttp://www.pwc.com/en_GX/gx/banking-capital-markets/pdf/pwc-increasing-european-sme-access-to-credit-with-non-bank-lenders.pdf43Ibid.


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European market. Wide range of non banking institutions had the potential to act as direct

lenders to mid-market companies.

DISTINCTION BETWEEN LOANS PROVIDED BY NON-BANKING FINANCIAL INSTITUTES AND

LOANS BY BANKS

Following are some points of distinction between loans provided by NBFCs and loans provided

by Banks44

1. Italian and European non bank institutes can lend loans to large mid market companies

without a formal credit rating. Same is not true for Italian and European banks which can lend

loans to companies with a formal credit rating.

2. While Italian banks face tough regulatory capital requirements, there are no such tough

regulatory measures on non banking institutes and they are likely to get more risk adjusted

returns than for banks.

3. European and Italian Non-bank institutions do not have the treasury functions to provide

revolving credit facilities and assets with fixed duration offer the best fit while lending loans.

Italian Banks on the other hand do have treasury functions to provide revolving credit facilities

while lending loans.

4. Non banking financial institutions (NBFIs) lend loans of high amount with a typical loan

falling somewhere between 10m and 50m. Below that band, loans are too small to attract non

bank institutions, on the other hand banks provide loans at all kinds of amounts.

5. Non-bank institutions acting as lenders lack the right supporting structures and capabilities.

Generally such institutions lack in-house lending facilities and credit risk management expertise

which are there with banks. NBFIs outsource loan administration and other back office work to a

third party service provider.

44Supra Note 7


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6. Non banking financial institutions are more likely to face problem of outstanding loans as

European and Italian regulators are clearly sensitive to levels of leverage among non-bank

institutions. Such lack of regulatory measures is not there with the banks.

7. Non bank lenders are usually willing to lend for a fixed period. Such limitations are not there

on banks which are better able to manage revolving credit. However some banks also prefer to

retain short term lending for the opportunity it offers to cross-sell services such as foreign

exchange, cash management and trade finance.

8. Italian NBFIs as compared to banks are found to have better exposure to small and medium

enterprises while lending loans.

We believe that co-lending, where banks and non-banks lend alongside each other, represents themost promising model for non-bank lending. In most cases, commercial banks will retain the

primary customer relationship and continue to provide less capital intensive products and

services. However private banks and investment banks could also use non-bank lending partners

to meet their customers credit needs without using up precious capital. For banks, the effect

would be to move their corporate lending function closer to a debt capital markets model.

Since recession in 2008 the capabilities of banks have been reduced to a great extent.

Henceforth, it is the present need of the hour for non banking institutes to go mainstream and

provide high amount lending in order to revive the economy again. The fact is that lending to

non-financial companies in Europe has increased last year. According to new data from Allen &

Overy, the law firm, new loans were up globally by an average of 30 per cent.

US non banking financial institutes have thrived in recent years. The Italians are trying to

emulate the same model. However there are a few caveats to heed.

First, the US structuresin place for 30 yearshave only thrived thanks to generous tax breaks.

If a European BDC (business development companies) industry is to take off, politicians would

probably need to grant it similar concessions. Second, regulators must find a way to monitor the

sector. Despite its vast size in the US, it is obscure and only lightly supervised.


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CONCLUSION

Italian banks' bad loans started to decline as a proportion of overall lending in the first quarter of

this year, although they are still rising in absolute terms, the Bank of Italy said on Friday. The

deterioration in banks' loan asset quality has eased. the central bank said in its twice-yearly

Financial Stability Report.

Theflow of new bad debts as a ratio to outstanding loans stabilised in the fourth quarter of 2013

and preliminary data indicate that in the first quarter of 2014 it declined. the report said.

However, the volume of non-performing loans is still growing.

A gradual easing of credit contraction and the decline in net non-performing loans (NPLs) are

among several signs that Italy is gradually emerging from a two-year long recession. Italianbanking association ABI said last month that net NPLs had fallen to 78.2 billion euros (64.43

billion pounds) in February from 79.2 billion euros in January.

Gross NPLs topped 162 billion euros in February, ABI said, up from 160.4 billion. The Bank of

Italy report said Italian banks are gradually repaying the money they borrowed from the

European Central Bank during the height of the euro zone debt crisis, but at a slower rate than

elsewhere in the currency bloc.

Last month 38 of the 112 Italian counterparties that had taken part in the ECB's 3-year

refinancing operations had paid back 79 billion euros, or 31 percent of the original borrowing,

compared with 62 percent in the other euro zone countries, the Bank of Italy said.


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