Why the Bank of Italy Wants to Change the Subject
Ever since it took over from national authorities as the euro zone's supervisor-in-chief, the European Central Bank has prided itself on taking a tough stance when it comes to bad loans. But has the ECB neglected other risks in the financial sector?
This is the thesis of a curious paper published by the Bank of Italy at the end of December. The Italian central bank, which teams up with the ECB in the Single Supervisory Mechanism (SSM), argues that the euro zone should be much more careful about so-called "Level 2" (L2) and "Level 3" (L3) assets. These are financial instruments that are not traded in active markets and, for this reason, are typically opaque and hard to value. "The current regulatory reporting standard is not sufficient to make a comprehensive assessment of the overall risks stemming from L2 and L3 instruments," the Bank of Italy paper says.
The study is the latest twist in a longstanding argument between the ECB and the Bank of Italy. The BOI fears that the ECB's tough hand on nonperforming loans is unduly penalizing Italian lenders vis-à-vis their European competitors in France and Germany. The Italian banking system accounts for around a quarter of the euro zone's stockpile of NPLs -- a consequence of Italy's prolonged recession and a string of poor lending and supervisory decisions. Conversely, German and French banks have few bad loans, but their balance sheets are full of "Level 2" and "Level 3" assets: Together, they account for nearly three-quarters of the euro zone total.
The Bank of Italy is right to remind supervisors of the riskiness of these opaque instruments. As the paper recalls, since these assets are not traded, banks have plenty of room to manipulate their values on their balance sheets. Supervisors should therefore enforce especially tough auditing standards, for example being strict on the internal models used by euro zone banks to determine their capital requirements. The SSM has recently launched a "Targeted Review of Internal Models" (TRIM), which will be finalized in 2019. Provided it leads to fairer and more prudent valuations, it is certainly a step in the right direction.
However, the comparison between the riskiness of NPLs and of "Level 2" and "Level 3" assets is misplaced. There is nothing wrong with banks holding illiquid assets, such as interest rate swaps: Provided they are properly accounted for, most of them are just part of a bank's normal business. But there is no reason why a lender should be keeping significant amount of nonperforming loans on their books, especially during a recovery. This is a problem not only for the stability of the banking system, but also for the dynamism of the economy as a whole: It means banks use up capital to keep "zombie" companies alive, as opposed to supporting their competitors.
The Bank of Italy gets two cheers for reminding the ECB of the risks hidden behind complex financial instruments. Now, back to the business of reducing NPLs -- at this phase of the cycle, it remains the euro zone's most urgent task.
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Therese Raphael at email@example.com