The role of corporate governance in strengthening Italian banks

Nadege Jassaud

30 October 2014

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Background: The recently released ECB balance sheet assessment highlighted nine Italian banks that failed the asset quality review (AQR) and stress tests – before 2014 recapitalisation. Eight of them fall into the categories described in this article (and 14 out of the 15 Italian banks participating in the assessment).

  • In Italy, bank ownership through foundations and bank cooperatives raises specific challenges for corporate governance.

With no shareholders, banking foundations are subject to political influence, which affects the composition of their boards of directors and, in turn, key decisions regarding their activities. In the cooperative banks, restrictions on ownership and voting rights (one member, one vote) weaken market discipline and the bank’s capacity to raise outside capital. Both types of banks tend to have smaller capital buffers and weaker asset quality than other Italian banks. To safeguard the soundness of these banks, regulation and supervision must ensure that any governance weakness are addressed and do not undermine bank stability.

Foundations remain important shareholders in the large Italian banks

  • Italian foundations have played a critical role in the privatisation of community-owned banks.

In the early 1990s, the Italian government privatised the community-owned banks and created foundations to serve as temporary trustees. These foundations became exclusive owners of these banks and have relied on their proceeds (bank dividends) to fund philanthropic projects for the local communities. Foundations have also supported banks during two rounds of consolidation, as well as bank recapitalisation during the recent crisis, providing a quarter of the capital raised by the largest banks from 2008 to 2012.

  • Foundations still remain in control of the largest Italian banks.

The Foundation law (1998) mandated the foundations to dispose of the majority of their ownership stakes in their original banks, including ‘positions of control’, within four years. However, as of March 2014, for 35 banks, accounting for nearly a quarter of the banking system, foundations still accounted for more than 20% of bank capital. In the three largest banks (Unicredit, Intesa, and Monte dei Paschi), foundations are able to nominate the majority of bank board members,1 despite having a minority share, through shareholder agreements (Figure 1). System-wide, foundations also exercise significant influence on the Italian financial system through a complex network of cross shareholdings.

  • Foundations suffer from an opaque and weak governance structure.

Italian foundations usually do not follow uniform accounting standards and their accounts are not certified by an external party. The appointment of their governing bodies is often non-transparent and influenced by local politicians, who can, in turn, influence bank decision-making. For example, local politicians hold 55% of the Board’s seats at Fondazione Cariplo, which de facto controls – with other foundations – the second largest bank, Intesa. Supervision of foundations has also been weak, as the law requiring the Ministry of Economy and Finance to oversee the foundations was partially declared unconstitutional in 2003, and thus, in practice was never applied.

Figure 1. Bank ownership vs. nomination of board directors

Sources: UGC and ISP website; IMF staff estimates.

Notes: As of May 2013. Only foundations with ownership above the 2% reporting thresholds are reported, underestimating the real size of the sector.

  • The financial position of several foundations has weakened, raising concerns about their capacity to provide further bank support.

Revenues for Italian foundations were hit hard by the downturn in banks’ profits, while operational costs and grant payouts have continued to grow. Some large foundations still have portfolios heavily concentrated in their ‘original’ bank, with some stakes reaching 90%. This has raised the pressure on banks to generate dividends to support the weak financial position of the foundations, potentially impeding the build-up of internal capital. For instance, in 2013, some large banks (Intesa, Unicredit) paid out dividends, despite having incurred significant net losses.

  • Banks with foundation ownership tend to feature weaker asset quality than other Italian banks.

Banks with majority foundation ownership have a provisioning coverage ratio about 10 percentage points below the system average. Stress tests run by the Bank of Italy for the 2012 IMF Financial Sector Assessment Program also found that the capital shortfalls for these banks accounted for almost half of the shortfalls of all Italian banks under an adverse scenario.

The cooperative bank models have held back bank growth

  • Cooperative structures are widespread in Europe and have been an important source of credit to local businesses.

Bank cooperatives hold a deposit market share above 20% in Austria, Cyprus, France, Germany, the Netherlands, and Switzerland (European Association of Co-operative Banks). In Italy, the large bank cooperatives, known as Banca Popolare, account for 14% of total bank assets. Due to their geographical remit, cooperatives had limited exposure to the global financial crisis. Since 2008, they have also continued to be the main provider of credit to Italian small and medium-sized enterprises (SMEs) and have increased their capital ratios, mostly through retained earnings and moves to more sophisticated Basel 2 risk models.

  • The cooperative model raises governance issues when banks grow above a certain size.

Cooperative structures impose restrictions on ownership, caps on voting rights, and limits on proxy voting. These restrictions make it difficult for any shareholder, even with a large capital stake, to change the governance structure, replace poorly performing managers, or prevent directors from nominating their successors. These restrictions on ownership also make it virtually impossible to attract strategic investors, given the limited tools for promoting sound management and adequate controls. As a result, these banks rely mostly on internal capital generation or their retail base investors. This raises a multitude of risks, including possible mis-selling of capital to retail investors.

  • Like foundation-owned banks, bank cooperatives have weaker asset quality compared to other banks and are less resilient to shocks.

On average, the largest cooperatives have lower provisioning coverage – 10 percentage points below the system average – and are more vulnerable to adverse shocks in a stress scenario.

Policy considerations

The Bank of Italy has taken several steps to improve bank corporate governance. These include: a ban on cross-appointments in financial institutions, a new related party transaction regulation, and new rules on corporate governance in banks. Building on these steps, further reforms to strengthen the oversight and management of banks should include:

(i) Governance-related banking regulations.

Governance can be enhanced by tightening banking regulations in a few areas, such as fit-and-proper rules for bank directors and strengthening supervisory scrutiny when assessing, before a major acquisition, the financial soundness of the major bank shareholders and their ability to provide additional support. In the recent past, some foundations borrowed funds to participate in the bank’s capital increases and became over-leveraged. The new related-party transaction provisions should be strengthened by tightening the definition of related parties when there is a link through economic influence. Transactions should not feature more favourable terms relative to the transactions with unrelated parties.

(ii) The current legal framework for foundations.

The legal framework needs to be revised to ensure:

  • Minimum standards of transparency.

Foundations should follow a harmonised set of accounting principles to enhance transparency and public accountability. Audited financial accounts should be required, at least for the largest foundations.

  • Investment policy aimed at diversification and caps on leverage.

Foundations should move towards a more balanced portfolio and follow prudent asset allocation policies (diversification, minimum reserves invested in safe assets, etc.). A leverage cap would also be advisable in order to minimise spillovers to banks. Over time, foundations should give up control over banks, even when this control is not de jure but de facto through special arrangements and networks.

  • Stronger corporate governance arrangements,

such as term limits for foundation Board members and a cooling-off period between a political office and the appointment to a foundation (or vice-versa) – a provision currently left to the ‘Code of Ethics’.

  • Robust oversight.

The Ministry of Finance (or another entity such as the Bank of Italy) should be empowered to play an oversight role as originally envisaged, with adequate sanctioning powers.

(iii) Cooperative banks.

The largest cooperative banks, included those listed, should be encouraged to convert to joint stock companies. Such reforms would improve governance and create incentives for new shareholders to inject fresh capital, rationalise costs, and provide opportunities for mergers.

Disclaimer: The views expressed herein are those of the author and should not be attributed to the IMF, its Executive Board, or its management. Based on Jassaud (2014) and IMF (2013a, 2013b, 2013c, 2014a, 2014b).

References

IMF (2013a), “Italy: 2013 Article IV Consultation”, IMF Country Report 13/298, September.

IMF (2013b), “Italy: Financial System Stability Assessment”, IMF Country Report 13/300, September.

IMF (2013c), “Italy: Selected Issues”, IMF Country Report 13/299, September.

IMF (2014a), “Italy: 2014 Article IV Consultation”, IMF Country Report 14/283, September.

IMF (2014b), “Italy: Selected Issues Paper”, IMF Country Report 14/284, September.

Jassaud, N (2014), “Reforming the Corporate Governance of Italian Banks”, IMF Working Paper 14/181, September.

Footnote

1. Foundations are not unique to Italy, and are common in Austria and Spain, for example.

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Topics:  Europe's nations and regions Financial markets

Tags:  Italy, banking, corporate governance, bank governance, stress tests, cooperative banks

Economist in the Monetary and Capital Markets Department, International Monetary Fund

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