The Italian Banking Sector: a Decade of

UNCLAS ROME 004194

SIPDIS


DEPT FOR EUR/WE, EUR/ERA, EB/IFB/OMA
PARIS ALSO FOR USOECD
TREAS FOR OASIA HARLOW, STUART
STATE PASS CEA
STATE PASS FRB FOR GUST
FRANKFURT FOR WALLAR
USDOC 4212/ITA/MAC/OEURA/CPD/DDEFALCO

E.O. 12958: N/A
TAGS: ECON EFIN ELAB IT KPRP
SUBJECT: The Italian Banking Sector: a Decade of
Privatization and Consolidation

Summary
--------------


1. Since the mid-1990s, the Italian banking sector has
undergone significant consolidation through mergers and
acquisitions among major banks. The consolidation was the
largest in Europe in terms of assets, and was driven in
large part by domestic privatization efforts, Italy's entry
into the European Monetary Union (EMU),and reforms to
thwart monopolies. (See para three below). The end result
has been four large banking groups (Banca Intesa,
Unicredito, Capitalia, San Paolo-IMI) and two medium-sized
banking groups (Monte dei Paschi di Siena and Banca
Nazionale del Lavoro). Consolidation should make the
Italian banking sector even more competitive in the single
European market in coming years.


2. Privatization/consolidation has also reduced the
formerly dominant state role. To replace government
funds/capital, Italian banks have issued bonds as an
alternative source of capital.


3. There has also been reform of monopolies, as EU
competition policy and the Italian Antitrust Authority have
pushed for more competition and transparency. Former
Finance Minister Tremonti introduced a tough financial
market oversight bill in response to the USD 18 billion
Parmalat fraud. The original bill has been watered down,
leaving the Central Bank's powers largely intact. The
current draft of the law would strengthen the powers of the
Companies and Stock Exchange Commission (Consob),Italy's
securities markets regulator, by increasing its staff,
giving it greater investigative powers and stiffening
penalties for financial crimes. These changes will be
incorporated into the bill that transposes the EU directive
on market abuses into Italian law. The Central Bank's
oversight authority will remain largely unchanged. Two
separate bills will make additional changes to Italy's
financial market regulatory framework, addressing such
issues as bond issuance.

Consolidation In the Banking Sector
--------------


4. Until fairly recently, the Italian banking system was
highly fragmented and inefficient, with high operating
costs and excessive dependence on interest rate spreads for
income. Restructuring, modernization, and privatization in
the last decade have improved the efficiency of the banking
sector. Consolidation stemmed principally from two factors
- 1) privatization as a result of the GOI selling off
public bank assets to ease the government's debt; and 2) EU
regulations that encouraged liberalization.

Privatization: Amato/Ciampi Laws Weaken Banking Foundation
-------------- --------------


5. Until the 1990's, public institutions controlled more
than 75 percent of the Italian banking sector, either
directly by the GOI or through public banking foundations.
The Italian banking foundations were more philanthropic
than commercial in nature when they were first developed in
the fifteenth century. In the early nineteenth century,
the foundations established savings banks, which loaned
money in their local regions, with profits remaining in the
community. In the 1990's, the Amato and Ciampi banking
reform laws privatized the banking foundations and
separated their commercial and charitable roles. Private
investors were then allowed to buy shares of the banks.


6. The Amato Law (218/1990) separated the functions of the
philanthropic foundations and banks, and also encouraged
the conversion of banks into joint stock companies. The
foundations were each divided into two independent units, a
commercial joint-stock bank, and the foundation as owner of
the bank. Foundations were required to own a majority
share of the affiliated bank. The Ciampi law (Law
461/1998) then required foundations to sell their dominant
ownership and limit it to ten percent by 2005 (recently


postponed to 2006). The process produced four large
banking groups (Banca Intesa, Unicredito, Capitalia, San
Paolo-IMI) and two medium-sized banking groups (Monte dei
Paschi di Siena and Banca Nazionale del Lavoro).

European Monetary Union (EMU) Encourages Consolidation
-------------- --------------


7. Italy's archaic legal framework and banking supervision
structure prior to EMU entry would not have allowed the
Italian banking system to remain competitive within a
unified European financial market. The process of entry
into the EMU further consolidated the Italian banking
system in the last decade and encouraged more efficiency.
Thus, the first years of European Monetary Union (1998-
2001) coincided with further consolidation among the
largest Italian banking groups. Marcello Messori at the
University of Rome Tor Vergata, told us that without this
second wave of consolidation, the Italian banking groups
would have been too small to compete in the future European
market.

The Italian Banking System Today
--------------


8. From 1994 to 2003, mergers and acquisitions decreased
the number of banks from 994 at the end of 1994 to less
than 800 by the end of 2003. The process of consolidation
in the last decade was the largest among European countries
in terms of assets; about 60 percent of total Italian
banking assets were involved. At present, Italy still has
almost 800 banks with over 30,000 branches. However, as a
result of consolidation, the top five Italian banks now
control 54 percent of total bank assets in Italy, similar
to France and Spain, but more concentrated than in Germany
and in the United States. Nevertheless, Italy's banks are
still small relative to other banks in Europe and other
OECD countries. Consolidation is likely to continue as the
Italian banking sector seeks to become more competitive in
the global market.


9. The Bank of Italy (BOI),Italy's central bank, is
generally considered to play an impartial role in Italian
economic policy and supervision. The BOI's primary
responsibilities are monetary management, financial
supervision, and bank note authorization. As a result of
the 1993 banking law, the banking system makes no
distinction among commercial banking, investment, or
savings banking, as it once did. The banking system is
comprised of:

-- Joint stock companies (called Societ per Azioni, or SPA
244 at the end of 2003 with 23,617 branches in Italy),
that provide credit to commercial entities and to private
e
citizens nationwide.

-- Community or Peoples' banks (Banche Popolari 38 at
end-2003 with 3,471 branches in Italy) that provide the
same services as joint stock companies, but the capital of
which is provided by a group of people wishing to open a
bank. These banks are generally smaller than joint stock
companies, ad operate mostly at a regional level. Some,
eQpecially in northern Italy, have important relaQionships
with industrialists in their district, tend to have more
personal connections wih their customers, and have been
expanding raidly. (Note: Banche Popolari Unite is Italy's
hnargest number of banks in pe single branch banks witphin their
small banki@ have historically


served Italy's many small and medium enterprises, and are
less likely to be subject to consolidation.

-- Subsidiaries, branches, or representative offices of
foreign banks.


10. Rank ordered by total assets, the major banks in Italy
are: Banca Intesa, Unicredito, San Paolo, Banca Di Roma
(Capitalia),Monte di Paschi di Siena, and Banca Nazionale
del Lavoro (BNL). BNL is the only bank that has not been
part of a recent merger or acquisition; while at the end of
the 1990's BNL was the largest bank in terms of assets, it
has now dropped to sixth.


11. The major Italian banks, like many large Italian
companies, tend to have a pyramid-like ownership structure,
with inter- and intra-group cross-shareholdings (as exists
with Capitalia, Banca Intesa and Unicredito) allowing
control over subsidiaries and other holdings despite
directly owning only a small share of the controlled
entity. These pyramid holdings allow a bank with a
minority stake and relatively small capital in a major
company to take control through its relationship with
companies in the layers of the ownership pyramid.


12. About 61 foreign banks offer services in Italy, through
branches, subsidiaries, or representative offices. The
largest block of foreign banks are from the UK, Germany,
France, Luxembourg, Belgium, the Netherlands and the United
States. U.S. banks with offices in Italy include Chase,
Citigroup, Morgan Guaranty Trust, Bank of New York, Bank of
America, Mellon and Morgan Stanley.


13. Since northern Italy is more industrialized than the
south, most foreign bank branches, subsidiaries, and
representative offices are located there (83 percent),with
67 percent in Milan. There is only one foreign bank branch
in the entire south (Mezzogiorno),located in Bari.
Moreover, institutions headquartered in the North control
the great majority of bank branches in the South.

Privatization Brings More Capital to Banks . . .
-------------- ---


14. After privatization began in the late 1990's, Italian
banks issued stocks and bonds as an alternate source of
capital to government funds. This development increased
bank ownership by individuals and companies, and GOI
holdings decreased proportionately.

...But also Broken Bonds
--------------


15. In addition to selling bonds to raise their own
capital, Italian banks also began to offer brokerage
services to corporations by selling corporate, foreign or
government bonds. There have been several financial
scandals recently that have raised questions about the
banks' management of this process. Many investors claim
the banks misled them by selling these bonds without
explaining the associated risk. Argentina's default in
2001 affected 400,000 Italians holding euro 14.7 billion in
Argentine bonds; food processor Cirio's collapse in 2003
hurt 30,000 Italian savers holding euro one billion in
Cirio bonds; and in 2004, the dairy group Parmalat's
insolvency affected 100,000 small investors holding euro
1.9 billion in Parmalat paper. Bankers have denied
culpability and have been generally unrepentant about the
damages caused to investors.


16. Many banks have thus been reluctant to settle with
bondholders, but there have been some banks such as San
Paolo IMI who have reimbursed their clients. Capitalia,
Italy's fourth largest bank has compensated either fully or
partially its 3,800 clients holding bonds of Cirio,
Parmalat and another distressed company, Giacomelli.
Despite the compensation, many Italians are now suspicious
of bonds and the banks that sold them.

Interrelationships Between Banks and Companies
-------------- -


17. The Bank of Italy (BOI) retains significant authority
over bank mergers and acquisitions, and rigid controls
restrict ownership relationships between banks and
corporations. For example, Bank of Italy authorization is
required for both domestic and foreign non-banking
companies to acquire more than five percent of a financial
institution's capital (or to gain effective control of a
financial institution, regardless of the amount of capital
acquired). The BOI must also approve the acquisition by
banks of more than five percent of a company. The pyramid-
shaped ownership system is the banking sector's response to
BOI supervision and control. Moreover, the BOI encouraged
some banking mergers while discouraging others.


18. According to Silvano Carletti, Manager of Banking
Competition at Rome's Banca Nazionale del Lavoro, Italian
banks can be shareholders of non-financial companies
providing the following three conditions are met:
- A bank's investment in non-financial companies cannot
exceed fifteen percent of total shareholder funds;
- Investment cannot exceed fifteen percent of the capital
of the non-financial company; and
- Any single investment must be less than three percent of
the banks market capitalization.


19. Over the last decade, BOI governor Antonio Fazio has
made clear his goal to first consolidate internally Italy's
banking sector before opening it to outside competition.
Despite these limitations, foreign banks have established a
stake in Italy's largest banks and have increased their
total stake in the Italian banking sector from 7.1 percent
in 1997 to 12.3 percent in 2002. Credit Agricole and
Commerzbank control fifteen percent and 4.3 percent,
respectively, of Banca Intesa, Italy's largest bank.
Santander Central Hispano and Deutsche bank control 9.7
percent and 2.5 percent, respectively, of San Paolo IMI.
Banco Bilbao Vizcaya controls fifteen percent of Banca
Nazionale del Lavoro, and ABN Amro holds nine percent of
Capitalia and twelve percent of Banca Antonveneta, Italy's
ninth largest bank active in the north. ABM Amro considers
Italy its second domestic market and, like the Spanish
banks Banco Santander Central Hispanico (BSCH) and Banco
Bilbao Vizcaya (BBVA),has been frustrated with the
investment caps. These banks continue to press for the
elimination of the BOI 15 percent limit imposed on foreign
shareholders.


20. Comment: While BOI restrictions on ownership between
companies and banks prevent excessively cozy relationships
between banks and corporations, the restrictions also limit
foreign investment that could bring new technology and
innovation to the Italian banking sector. Some critics
also believe the limitation on foreign investment in local
banks has inhibited Italian banks from joining larger
international groups that are more competitive within the
single EU market. End comment.

Banking and Financial Supervision
--------------


21. Both the 1993 Banking Law and the 1998 Consolidated
Law on Financial Intermediation (the Ciampi law) delineate
BOI supervisory objectives, including management of
intermediaries and capital adequacy, ensuring compliance
with credit regulations, and securing a competitive and
efficient system. The BOI also collaborates with the
European Commission to ensure compliance with EU
directives.

The Role of the Antitrust Authority
--------------


22. Both EU liberalization directives and the Italian
Antitrust Authority have helped push Italian banks towards
competition and transparency. The Antitrust Authority was
created under a 1990 law and has oversight of the


following:

a) agreements that impede competition in the market,
b) abuses of dominant position, and
c) mergers and acquisitions which create or strengthen a
dominant position to eliminate or restrict competition.

The Authority also enforces provisions of a 1992 law on
misleading and comparative advertising. However, according
to Professor Messori at the University of Rome Tor Vergara,
the BOI still maintains primary supervisory/regulatory
authority over the banking system.

Foreign Exchange Controls
--------------

23. In conformance with EU directives, Italy has no foreign
exchange controls. There are no special exchange rates,
and currency transfers are freely permitted. Similar to
the U.S., banks and authorized intermediaries must submit
data on any foreign exchange transaction exceeding euro
10,329 to the Bank of Italy.
The Basel Accord and Italian Banks
--------------


24. European Central Bank President Jean-Claude Trichet
describes the Basel Accord as "enhancing banks' safety and
soundness" by establishing, inter alia, capital
requirements according to individual bank risk and the
credit-worthiness of their loans. Basel Accord capital
requirements are also flexible enough to relax capital
requirements for low-risk banks with a good credit history.


25. Observers here generally see Basel Accord capital
requirements as potentially freeing up capital and
encouraging lenders to lend more efficiently and with
less risk to stimulate stronger economic growth in Italy.
While in the past, Italian banks had based much of their
lending on personal relationships with local firms, the
Basel Accord has encouraged Italian banks to seek more
creditworthy clients and not just service clients well
known to management.

Comment: Where are Italian Banks Headed?
--------------


26. As a result of new EU regulations and new Italian
deregulating provisions such as the Ciampi law, we expect
to see more competition in Italy's banking sector, despite
the limitations on bank ownership. (See para 6 above). An
increase in mergers and acquisitions and more foreign
competition will push consolidation as it leads to a more
competitive and efficient banking system. We expect to see
the implementation of some measures strengthening financial
l
market oversight, but we do not expect to see a revival of
efforts to transfer competence over banking competition
regulation from the BOI to the Italian antitrust authority.
Such a transfer was proposed in former Finance Minister
Tremonti's draft savings oversight bill, which has been
watered down by the Parliament and GOI. BOI Governor Fazio
can be counted on to stoutly resist any effort to weaken
BOI authority.

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2004ROME04194 - Classification: UNCLASSIFIED