OREANDA-NEWS. The change of outlook for Italy's banks to stable from negative is underpinned by expectations of a modest domestic economic recovery, accompanied by lending growth, moderate profitability and improved internal capital generation capacity, says Fitch Ratings. Italy exited a deep, protracted recession in 2015 and we expect a weak recovery, with GDP to grow by 1.1% in 2016. Italy's current GDP is at its 2000 level.

Lending to the private sector stopped contracting by mid-2015 and we expect a modest net lending recovery in 2016, with residential mortgage lending and consumer financing leading the way. Prospects are more muted for SME and corporate lending, where loan demand for financing long-term investments is still weak. Loan books are weighed down by a large stock of impaired loans, representing 16% of sector gross loans at end-June 2015. This represents a key vulnerability for Italian banks, and repairing balance sheets will take a long time.

Positively, additions to the stockpile of watch-list loans are growing more slowly and impaired loan ratios at some large banks are no longer rising, helped by improving recoveries, disposals and, in some cases, modest growth in the loan book. Banks are adopting a focused, standardised approach to the management of impaired exposures and certain bankruptcy and foreclosure reforms may speed up recoveries and workouts.

Fitch's 2016 base case is that net interest income should benefit from slightly higher lending volumes, a shift towards more profitable lending, development of fee-earning activities and low funding costs. In the medium term, implementation of the EU's Bank Recovery and Resolution Directive in Italy may contribute to an increase in funding costs because Italy plans to make all deposits preferred to senior debt and counterparty liabilities in resolution, but this will come into effect only in 2019.

The liquidity profile of Italian banks is much improved, held up by a larger proportion of liquid assets, primarily government securities, on the balance sheet. We expect this to continue because it will take time to build up loan books. Italian banks' 2016 funding plans should remain in line with those completed in 2015, with a preference for cheaper, secured, primarily covered bonds, issuances. Regulatory requirements on loss absorption capacity might force some changes in funding structures, with additional issuance of subordinated and additional Tier 1 instruments. To date, only UniCredit and Intesa Sanpaolo have issued this type of debt.