The Italian Government is about to introduce rules envisaging a guarantee mechanism to be used to facilitate the removal of bad loans from the books of commercial banks. The European Commission agrees that the mechanism does not envisage any State aid.
The scheme provides for the granting of State guarantees as part of securitization transactions whose underlying assets are bad loans.
The State shall guarantee only the senior tranches of securitization transactions, i.e. the least risky ones, the last ones to be affected by any losses resulting from lower-than-expected credit recovery. The riskiest tranches (i.e. junior and mezzanine) shall not be repaid until the senior tranches guaranteed by the State have been fully repaid.
Guarantees may be requested by banks that securitize and sell their bad loans, against regular payment of a fee to the Treasury, calculated as a yearly percentage of the amount guaranteed. The price of the guarantee is a market price, as recognised by the European Commission which agrees that the scheme does not envisage any State aid. The price shall be calculated on the basis of single name CDS related to Italian issuers with a risk level equal to that of the guaranteed securities. The price will increase in time, both to cover for the higher risk associated with longer duration of the bonds and to incorporate into the scheme a strong incentive to an early recovery of the credit. The price for the first three years is calculated as an average of the mid-price of three-year benchmark CDSs for issuers with a rating equal to that of the guaranteed tranches. In the fourth and fifth year the price will increase after the first step up (5-year CDS) and an incentivizing premium will be paid to offset the lower rate paid for the first three years. From the sixth year onwards the guarantee will be fully priced (7-year CDS). In the sixth and seventh year an additional incentivizing premium will be paid to offset the lower rate paid for the first 5 years.
The State shall issue the guarantee only after the securities have received a rating equal to or higher than Investment Grade from an independent rating agency included in the list of credit rating agencies accepted by the Eurosystem. The rating will be issued on the basis of the strict standards which the agencies are required to abide by, including: an analytical estimate of cash flows associated with the guaranteed security, a check on the credit quality of all underlying loans, the percentage invested in the tranches that will absorb the first losses, the operating capacity of the servicer which will be entrusted with recovery of the credit. Banks shall be required to entrust credit recovery to an external independent servicer. The latter shall prevent any conflict of interest from hampering debt recovery.
The existence of a State guarantee will facilitate funding of transfers of bad loans. This is an additional step in the series of measures taken in the last few months to help strengthening the banking sector (with the most important cooperative banks turned into joint stock companies, the reform of banking foundations, simplification of procedures for the credit recovery and shortening the duration of bankruptcy procedures, compliance with European standards on the tax treatment of loan write-downs, the forthcoming reform of cooperative banks).
With this additional step, this whole set of measures will ensure effective and gradual elimination of the residual weakness still present in Italy's banking sector, i.e. the high levels of bad loans.
The measure is budget neutral; in fact, the fees to be received are expected to be higher than costs and will therefore generate net revenues.