OREANDA-NEWS. The success of the scheme to help Italian banks reduce the stockpile of non-performing loans (NPLs), outlined by the Italian government yesterday, will depend largely on how NPLs are valued, says Fitch Ratings. Full details are lacking, but the government clarified that participation in the scheme will be voluntary. This may limit take-up, and we also doubt whether the scheme will be sufficiently attractive to entice banks to make significant use of it. Our initial impression is that the mechanism's ability to materially improve asset quality in the Italian banking sector is limited.

Public details on the workings of the scheme are patchy but banks will transfer NPLs into securitisation vehicles that will issue structured notes, backed by the NPLs. Only senior tranches, which must be rated at a minimum of 'BBB-', will be guaranteed by the Italian government.

Valuation of the NPLs could prove tricky. Accounting and market values are likely to differ considerably. If negative adjustments are crystallised when NPLs are transferred to the securitisation vehicles, banks would need to make additional provisions, which could drive them to report losses and reduce their solvency ratios. On the other hand, if NPLs were transferred at book value, appetite for the structured notes could be weakened if investors viewed the underlying assets as overvalued.

We think the cost of structuring the notes might be high, discouraging the less profitable banks, typically those who could benefit the most, from taking advantage of the scheme. Government guarantees will attract fees linked to ratings assigned to the notes. Pricing will be based on credit default spread (CDS) prices for a basket of Italian financial and non-financial issuers. This could prove costly.

The track record of Italian NPL securitisations is mixed. Cumulative recoveries have been 35%-40% lower than originally envisaged by the servicers as cash has sat in Italian courts awaiting distribution to creditors. Based on the performance of two outstanding Fitch-rated NPL transactions, we estimate that only 30%-50% of defaults at closing have been fully resolved within five to seven years.

The steady increase in Italian NPLs, which reached EUR201bn (over 12% of GDP) at end-November 2015, growing 11% year-on-year, adds more pressure on the already lengthy and uncertain recovery process. The government announced for next week further changes in insolvency laws, in addition to the ones approved in June last year, to accelerate the property enforcement process. These changes may help but it is too early to say how effective the revised laws will be.

At this stage, the scheme is likely to be neutral for Italian bank ratings because any improvements in asset quality could be offset by a negative impact on profitability and capital ratios.

Additional information on Italian NPLs is contained in a recent Asset Quality Monitor report and our EMEA Banks Chart of the Month, available by clicking on the links below.