OREANDA-NEWS. If the ECB's guidance to banks on non-performing loans (NPLs), published last week, is implemented, the Italian banking sector's asset quality is likely to come under increased scrutiny and rise further up the agendas of national regulators, governments and eurozone authorities, says Fitch Ratings. This is because the ECB says that banks with high levels of NPLs will be expected to have "ambitious" and "realistic" targets to reduce these and that a "wait-and-see" approach has not resolved the issue.

Failure to deal with weak asset quality is one of the barriers holding back confidence in Italy's banking sector and is stalling the flow of capital to support economic growth. We forecast GDP growth for Italy of 0.8% in 2016 and 1% in 2017, below the eurozone average.

We took negative rating actions on several Italian banks in 2016, generally based on continued weak asset quality. Negative Outlooks reflect likely downgrades unless banks take steps to materially reduce high stocks of NPLs. In our opinion, several government-led initiatives to speed up the recovery of NPLs should result in a gradual reduction, but this is unlikely to bring significant improvement in asset quality in the short term. The effectiveness of the initiatives is untested and the size of the problem is large.

The sector's combined "sofferenze" and "unlikely to pay" exposures reached EUR340bn at end-June 2016, equivalent to about 20% of Italy's GDP. Net of reserves, the figure halves to about 10% of GDP.

If the restructuring plan devised for Banca Monte dei Paschi di Siena (MPS) is successful, this could act as a model for other Italian banks looking to clean up their balance sheets. However, the MPS transaction is complex and execution risks are high. If it ran into trouble, a new solution will need to be found quickly to prevent the bank from failing. Options without creditor bail-in are limited.

In recent months, the government backed a securitisation scheme to help shift NPLs off banks' balance sheets, encouraged the establishment of specialist funds to invest in bank capital-raising exercises and pushed through the modernisation of insolvency laws in an effort to speed up the country's lengthy recovery procedures.

An in-depth update of Italian banks' asset quality, published today, is available by clicking on the link above.