Banks emerge as Italy's elephant in the room From the top floor of UniCredit's gleaming new skyscraper in Milan, where Italy's largest bank by assets moved last week, the view stretches uninterrupted across the poplars of the Lombardy plain to the snow-capped Alps. For the Italian banking sector the outlook isn't so clear. Two years of crippling recession, the European sovereign debt and a decade of economic stagnation have taken their toll on the balance sheets of the country's banks. The average non-performing loan ratio has nearly tripled to 14 per cent since 2007. The worst hit, Monte dei Paschi di Siena, Italy's third-largest bank by assets, faces the threat of nationalisation. And while senior Italian bankers have ruled out the need for a so-called "bad bank" for the country, the annual International Monetary Fund report on Italy published in September highlighted the banking sector as a significant point of weakness for the Italian economy. Having gone through the first hit of the financial crisis relatively unscathed because of the low use of structured products, the picture has darkened. "High NPLs represent a growing risk to bank profitability and soundness," the IMF said. The situation is most extreme at Monte dei Paschi where the board on Tuesday finally caved in to demands from Brussels and agreed a €2.5bn capital raising, 8,000 job losses and cuts to the salaries of top managers in order to be allowed to take €4.1bn in state bail out bonds to keep it viable. Its NPL ratio was 12.5 per cent in the second quarter, the highest among Italy's largest banks. At UniCredit, and Intesa Sanpaolo, Italy's second-largest bank by assets, NPLs rose less quickly in the second quarter and overall accounted for about 8 per cent of total loans, presenting a more equable outlook. Both banks also have core capital at about 9 per cent. Federico Ghizzoni, chief executive of UniCredit, said last week that there were already signs that Italy's banking system has ridden out the worst of the crisis. With recession predicted to end in the last quarter of this year, he expects their percentage of NPLs to start falling at least by the middle of next year. The prospect of rising rates could also give a boost to the sector, which has outperformed the Eurofirst 300 Banks Index by 15 per cent. Still, the sudden exit of Enrico Cucchiani, chief executive for 21 months of Intesa Sanpaolo, last month after a clash with Italian shareholders over his hands-off management, has unsettled some foreign investors. Meanwhile, Mr Ghizzoni's persistent evasiveness regarding a precise timeframe on his much-trumpeted target to achieve a 10 per cent return on equity has riled others. Italian banks have a poor record of hitting cost and profit targets. Not one Italian bank has ever made its business plan over the past 10 years," says one large London-based investor. Some analysts say these tensions will be merely an appetiser ahead of the expiry of Europe's longer-term refinancing operation (LTRO) and next year's EU-wide stress test, to be preceded by an asset quality review (AQR) at the eurozone's top 130 banks. Italian banks, which were the biggest takers of Eurosystem borrowing, having taken €255bn as at the end of June, have repaid only €3.5bn, the least in Europe. The IMF estimates Italian banks face a funding gap of about 12 per cent of their total liabilities with the expiry of the LTRO next year and the phasing out in March 2015 of government-guaranteed bonds as European Central Bank eligible collateral. The AQR may reveal more funding gaps. Goldman Sachs analysts estimate there is still an aggregate capital shortfall of €16bn for the six largest banks - UniCredit, Intesa Sanpaolo, Monte dei Paschi, Banca Popolare di Milano, Banco Popolare and UBI Banca - with the weight of this gap on the last four. Senior Italian bankers expect the pressure from the likely expiry of the LTRO, coupled with the AQR, to finally trigger a long-anticipated consolidation among Italy's smaller banks. The IMF singled out the fragmentation of Italy's banking sector - there are 740 individual banks, according to the European Banking Federation - as a point of weakness. "I expect to see some consolidation among midsized banks happening in the first half of next year," says the chief executive of one of Italy's largest banks. What is still unclear is how the larger banks - which took out the bulk of the LTRO funding - plan to face its expiry given the strain they are already under from deteriorating asset quality. Some analysts predict that it may be the trigger that pushes ECB president and fellow Italian Mario Draghi to extend the LTRO programme in some form. Another challenge is the high ownership of Italian government bonds. During the sovereign crisis, Italian banks, like those in Spain, snapped up sovereign debt to reduce the selling pressure on their home debt and therefore stabilise widening spreads. While the split between domestic and non-resident ownership of Italian sovereign debt in 2010 was still roughly 55/45, it has since widened to nearly 70/30. Nicholas Spiro, a sovereign analyst, says that while the shift in ownership has helped shield Italy over the past year or so, it is also "strengthening the negative feedback loop between the sovereign and its banks and making Italy even more vulnerable to a deterioration in market sentiment." For the Italian economy, Mr Spiro says "Italy's ailing banks are the elephant in the room."