Italian Banks Outperform Peers
European banks will be happy to put 2008 behind them. From the $48 billion in writedowns suffered by Swiss financial giant UBS (UBS) to the €4.9 billion ($6.3 billion) trading scandal that rocked France's Société Générale (SOGN.PA), the Old World's banking sector has been at the center of the global financial crisis this year. Indeed, European financial institutions have booked $1.2 trillion in mark-to-market losses since the credit crunch began—not far short of the $1.6 trillion loss recorded by U.S. banks, according to the biannual Financial Stability Report from the Bank of England.
To make matters worse, analysts don't expect Europe's financial-services sector to pick up until the second half of next year at the earliest. Yet despite the bleak outlook, one European country has bucked the trend of multibillion-dollar writedowns and government bailouts: It's Italy, Europe's fourth-largest economy, whose banks have outperformed larger continental rivals over the past 18 months.
Don't attribute it to management foresight, sharper risk analysis tools, or fatter coverage ratios, though. Italian banks such as Intesa Sanpaolo (ISP.MI) and UniCredito Italiano (CRDI.MI) have outpaced European heavy hitters such as Barclays (BCS) and BNP Paribas (BNPP.PA) primarily due to their extremely conservative business models. The Italians steered clear of securitized assets and subprime loans, forgoing the windfall profits that boosted rivals' balance sheets in the salad days, but also avoiding the huge losses that later ensued.
Instead, Italian banks have remained squarely focused on traditional retail operations and corporate lending, relying on customer deposits to fund day-to-day operations. Even when the country's banks expanded to other countries, they moved mainly into nearby Eastern European markets that have outperformed Western European economies since the mid-1990s. "They don't make the same level of money as other European banks, but their business model certainly isn't broken," says Credit Suisse (CS) analyst Andrea Vercellone. "Italian banks didn't get into the securities business in a major way because frankly they just didn't understand it."
Back to Basics
While this conservatism and lack of global ambition were previously seen as major weaknesses, analysts now applaud Italian banks for their focus on traditional ways. Indeed, banks around the world are following suit and going back to basics. One result is that while Italian banks have seen their share prices plunge this year, the damage is less than average. The DJ Euro Stoxx Banking index, for example, is down 64% so far this year, but shares in Italy's largest bank, Intesa Sanpaolo, have dropped 57%. Italy's mid-cap banks have done better: Milan-based Unione di Banche Italiane (UBI.MI), for instance, has lost just 40% of its value since the start of the year.
(One exception is Verona-based Banco Popolare (BAPO.MI), which has cratered by nearly 69% year-to-date. The bank's chief executive, Fabio Innocenzi, stepped down on Dec. 8 due to rising costs associated with one of the bank's leasing businesses. Innocenzi will be replaced by Pier Francesco Saviotti, currently vice-president for Europe at Merrill Lynch (MER).)
The importance of greater investor confidence shows up clearly in market capitalization. Intesa, for instance, with 2007 net income of just under $8 billion, is now worth $33 billion. That's more than the value of Barclays, even though the British bank had posted profits of $34 billion last year. "[Intesa] has a strong balance sheet and a defensive business mix," says Citigroup (C) analyst Jeremy Sigee.
The combination of a strong cash base and conservative lending practices should help Italy's banks weather the current financial storm. According to Dresdner Kleinwort (AZ) analyst Arturo de Frias, the country's eight largest financial institutions will have an average core capital ratio—the most widely followed measure of a bank's financial strength—of 7.11% by the end of the year. That's roughly in line with the European average but is based on the banks' own cash reserves, not on multibillion-dollar government recapitalization packages that have been announced across Europe (BusinessWeek.com, 10/6/08).
Two Major Risk Factors
Indeed, UniCredito Italiano is the only major Italian bank to announce a plan to boost its core capital. Yet unlike other European institutions, the bank hasn't turned to the government for help. Instead, it funded the €6.5 billion ($8.5 billion) package through a €3 billion ($3.9 billion) convertible bond and a plan to pay its 2008 shareholder dividend in shares, not cash—a kind of share rights offering on the sly.
To be sure, Italian banks could still come under financial pressure if the global economic picture darkens, notes Dresdner Kleinwort's de Frias. "The first action is very likely to be dividend cuts, which would free up a significant portion of capital," he says. But he doesn't think government help will be necessary.
Still, there are two major sources of risk facing Italian banks. The first is their exposure to Central and Eastern Europe. Currently, UniCredito and Intesa generate 33% and 10%, respectively, of their annual net income from the region, which had been growing quickly until the credit crunch hit. Now countries from the Baltics to the Balkans are facing their own economic slumps (BusinessWeek, 10/23/08). A prolonged downturn in Central and Eastern Europe certainly could hurt Italian banks; indeed, one reason UniCredito shares have underperformed the market is its large exposure there.
Fortunately, the bulk of the investments made by UniCredito and Intesa are in countries such as Poland and Croatia that have fewer macroeconomic problems than others in the region. Both banks' Eastern European businesses are also self-funding and shouldn't need bailouts from their parent institutions. "We believe [Central and Eastern Europe] remains a key long-term competitive advantage," says Credit Suisse's Vercellone.
The second concern for Italian banks is the domestic economy. The International Monetary Fund predicts Italy's gross domestic product will contract 0.1% this year and a further 0.2% in 2009. That will put a strain on the banking industry's domestic operations as both companies and consumers struggle to repay loans. The country's real estate market, though by no means as inflated as those of Ireland or Spain, has also begun to slow. According to Italian economic research institute Nomisma, home price increases slowed to 4.2% in the first half of 2008, compared with a 6.1% jump in 2007.
A slowdown in Italy now seems inevitable as European economies fight to stay afloat. Analysts say the country's banking sector eventually will feel some pain. But by pursuing a more conservative business model than their foreign competitors, Italian banks should remain among the best performers in Europe's hard-hit financial-services sector.