Italy, Europe and Financial Regulation.

Giovanni Carosio

It is customary for analyses of the relationship between Italy and Europe to be based on some measurement of convergence between a supposedly “peripheral” country and some concept of “core” Europe.

Although this approach is, of course, highly conventional, it is widely accepted, first of all by Italians themselves. In fact, in Italy convergence with Europe is more than a concept, it is a national aspiration. When the Prodi government imposed very tough fiscal measures in order to comply with the Maastricht requirements and join the monetary union, it presented them as “sacrifices needed to take us into Europe”; those who were critical were worried about the costs, but they did not dispute the trade-off as it was proposed.

Based on such “revealed preferences” I think this convergence criterion is an important one and I will use it in my description of developments in the financial area. In fact I am convinced that the rate of change in Italian banking and financial markets over the last decade has been much higher than in other developed countries, that this change can to a large extent be described as “convergence”, and that it will probably be instrumental in fostering “convergence” in other parts of Italy’s economy and Italian society.

1. Financial regulatory reform

Let me start with the legislation governing the financial sector. In the late 1980s and early 1990s a number of important reforms were enacted, which in some cases can be seen as “regime” changes.

The need for reform was strongly advocated by the Bank of Italy and, at least from the beginning of the 1980s, the Bank used all the margins of freedom available in the legislation to change secondary regulation and the criteria of supervisory action in order to promote a more market-oriented system. In particular, the model of “structural” supervision, which aimed at maintaining stability at the cost of market segmentation and barriers to entry, was replaced by a model of “prudential” or risk-based supervision.

Two European directives on the coordination of banking regulations and, more generally, the drive towards a single European market helped set in motion the reform process, but the changes introduced went far beyond what was technically required by Community rules. In fact, it is a peculiar feature of the European legislative process that it acts on two widely-separated levels: very broad principles, such as the elimination of all the barriers to the free movement of goods and services, on the one hand, and technical standards, sometimes of a very detailed character, on the other. In between, there is a wide space to be filled by national legislation.

1.1 The abolition of exchange controls

The first reform that I would like to mention is the abolition of exchange controls. A substantial liberalization measure was enacted in 1984. In 1988 a new law finally abolished the State monopoly on gold and foreign currency introduced in 1917 and replaced a system of “eligible transactions” with a general principle of freedom of capital movements.

The trend towards liberalization of the post-war years had been abruptly reversed in the 1970s, when, in the face of recurring balance-of-payments problems, recourse was made to intensified exchange controls and to penal sanctions to stem capital flights. Further balance-of-payments problems arose in the late 1980s and early 1990s (in 1992 we had the worst devaluation of the lira since 1947) but they were tackled with different policies, a mix of fiscal and monetary restraint.

The tendency to view economic policy problems, such as a sudden surge in wage demands or in oil prices, as “market failures” and to use the tools of a command economy to deal with them was typical of the period between the mid-1960s and the mid-1980s. And this cultural attitude may help to explain why it took so long to bring about other pieces of reform in the financial sector.

1.2 The privatization of banks

The banking system remained largely unchanged from the 1930s to the end of the 1980s. Giuliano Amato, the Minister of the Treasury who in 1990 introduced the law which eventually led to privatization, called it a “stone forest”.

The savings banks, non-commercial organizations originally created to protect small depositors and make credit available to small entrepreneurs, accounted for one-third of the deposit market. Five of the six public-law banks were the dominant short-term lending institutions in respectively Piedmont, Tuscany, Southern Italy, Sicily and Sardinia. The three banks most active in financing industrial firms had been nationalized in the 1930s, together with the firms they had come to control. Long-term lending was reserved to institutions specialized by sector or by region, again mostly public or owned by public banks. In all, more than two thirds of the banking system was in the public sector.

Boards of directors of public banks were, directly or indirectly, appointed by the State or local governments. This was part of a more extensive mixed-economy model, extending to a significant part of the industrial sector, which created a large, uncoordinated, parallel form of government, whose policy aims and accountability were rather obscure. But it should be said that the public banks were mostly profitable, contrary to many public industrial firms, that there were no significant distortions in the allocation of credit and that this banking system succeeded in fuelling a process of economic development that in just two decades after the war changed the country from largely agrarian and relatively poor to industrialized and affluent. Still, public banks had no strong incentives to pursue efficiency or to compete, were alien to the logic of mergers and, when government deficits became serious, found it almost impossible to raise capital.

The Amato law in itself simply made it possible to change the legal status of the public banks from public entities to companies limited by shares; this was achieved in most cases by splitting the original entity into a “foundation” and a commercial company, the latter being 100 per cent owned by the former; but it took four more years to repeal a mechanism which required the Council of Ministers to give its approval to the loss of control of each individual bank by its public owner and another four years before a law was enacted in 1998 which made privatization compulsory and imposed a time limit.

It is quite remarkable that the anomaly of a predominantly public banking system in what was essentially a market economy remained largely unchallenged for so many years and that full privatization met with so much resistance. All the more so as Italian economic development was, and is, highly dependent on the banking system.

The quiet acceptance of this legacy of the 1930s – itself due more to the “accident” of the Great depression than to a deliberate political programme – contrasts with the discussions on what made an industrial sector, or firm, so “strategic” as to justify State control. The debate had so exposed the weakness of the model that when the flow of public money to cover losses dried up, the system of “State participations” was to a large extent dismantled without any significant opposition.

Two reasons probably explain the different attitude to the privatization of the banks. The first, as I mentioned earlier, is that overall public banks were viable, if not very efficient, and there was therefore no pressure for change. The second reason was the deeply engrained idea of financial intermediation as a “public utility”, the idea that it could be used to direct economic development or, at least, in a weaker form, that it should be preserved from private interests that might distort the allocation of resources.

The policy of full privatization, advocated among others by the Bank of Italy and the Treasury, finally prevailed, in a period in which the credibility of a system of politically directed enterprises was very low.

Interestingly, the privatization of the banks was not aimed at raising funds to abate government debt. Except for the three nationalized banks and a few other cases where the government owned shares, ownership of the public banks was attributed to newly created “foundations”, whose nature is still the subject of debate and of legal controversy. The foundations are self-governed non-profit entities, entrusted with a capital whose proceeds can be used to fund projects of their own choice, within a range of public-interest activities, such as research, hospitals, public works, etc., stated in the law. They are required to relinquish control of the banks by 2006 and have been diversifying their investments. With a total net worth of about 35 billion euros they are potentially a very significant institutional investor. For the sake of comparison, the total capitalization of non-bank companies quoted on the exchange is about 450 billion. And assuming an average yield of 5 per cent on their investments, they would have a spending capacity of nearly 2 billion, or about one tenth of the government deficit.

It is not surprising that there is controversy over who should appoint the administrators of such a huge non-profit sector, in particular over the role of local government. What is important from our point of view is that the destinies of the foundations and of the banks should henceforth be separated.

1.3 The new banking law and the law on financial markets

Between 1990 and 1992 a number of acts of Parliament complemented the Amato law, resulting in a complete change of the legal framework for banking. In 1993 a new Consolidated Banking Law replaced the 1936 Banking Law and brought together all the earlier legislation in the field.

Under the new rules the long-standing separation between deposit banks and long-term specialized credit institutions was abolished, in favour of a universal banking model.

Banking groups were legally recognized and consolidated supervision was instituted. Non-bank financial intermediaries were regulated..

The objectives of supervision – sound and prudent management of intermediaries and the overall stability, efficiency and competitiveness of the financial system – were established explicitly, the Bank of Italy was required to give prior public notice of the principles and criteria of its supervisory activity, and its regulatory powers were redefined with reference to banking risks.

The Consolidated Law on Financial Intermediation is the second pillar of the new regulatory system and its genesis was also linked to the need to rationalize a very complex corpus of rules arising from the stratification of various legislative interventions; its enactment in 1998 made it possible to substitute more than 30 laws with a single consolidated text. The new law filled the gaps in the Italian regulation of financial intermediation and introduced modern, flexible and to some extent innovative rules concerning financial markets, securities dealing and investment services, insider trading and price manipulation, corporate governance and the rights of minority shareholders, take-over bids and disclosure.

The two laws share the same general goal of achieving a sufficient level of stability and integrity in the operation of financial markets, while leaving competitive forces free to shape the industry.

They also share the same regulatory approach of stating only general principles and minimum standards, while leaving it up to the supervisory authorities to specify the detailed rules in secondary legislation.

2. The transformation of the banking system

While the new banking law made it possible to reorganize financial intermediaries according to the universal banking model or to any form of specialization of their choice, the real engine of change was privatization. The banking system was completely transformed, and in a very short time.

In 5 years the share of total assets attributable to banks controlled by public entities fell from…..to 25 per cent; today, it stands at 10 per cent, one of the lowest levels in Europe. The number of listed banks has increased and they now account for 80 per cent of the system’s total consolidated assets.

As a result, incentives for profit maximization have become much stronger than before, which in turn has led to keener competition, tighter control over costs and a wave of mergers and acquisitions. Since 1990, there have been 566 mergers and acquisitions involving banks accounting for almost 50 per cent of total assets. In the same period the number of banks declined by about one quarter, from 1,100 to little more than 800, notwithstanding the entry in the market of more than 200 new intermediaries. This was accompanied by an increase in the market share of the five largest groups from 34 to 54 per cent, in line with the figure for France and higher than that for Germany.

It is important to note that this higher concentration of the banking market does not mean less competition. On the contrary, whereas in all but the largest cities small local banks had been near-monopolists, today the branch networks of the major banks overlap considerably. At the end of 2001, there were on average 32 banks in each province, compared with 24 in 1985.

Such a dramatic structural change, compressed in a period of only 10 years, was not without its casualties. Specialized long-term credit institutions, no longer shielded by a legal reserve, succumbed to the competition of deposit banks, who could count on lower funding costs and greater economies of scale and scope; with the encouragement and monitoring of the Bank of Italy most of the institutions were absorbed within banking groups; two institutions specialized in mortgage lending, did not survive the fall in property prices; only four remain as independent firms, of which two are investment banks.

The other point of systemic fragility was in the South. There, the three largest banks were hit, in the early 1990s, by low efficiency and the poor quality of their loan portfolios, on the one hand, and increased competition and a general recession, on the other. The latter had particularly severe repercussions in the South because of the concomitant drying up of the public resources that had been used to support personal incomes and ailing firms. This was the only case of public money being spent to rescue banks. The amount involved, about 0.6 of one year’s GDP, was quite small in comparison with what other countries spent and with the costs incurred in Italy in our own pre-1936 history.

It is remarkable how quickly the behaviour of banks changed in the new environment. Labour relations are one area in which this was very visible.

High labour costs and low productivity had long been a weak point of Italian banking, separate wage negotiations for public and private-sector banks being part of the explanation. The problem was repeatedly signalled by the Bank of Italy; the response of the newly-privatized banks was quite different from the past. The number of employees fell by about 6 per cent in the second half of the 1990s and the ratio of staff costs to gross income decreased from 45 per cent in the mid-1990s to 36 per cent in 2000.

The other area in which there has been a striking change in bankers’ behaviour is business diversification. Until......Italian savers were offered a very poor diet of just deposits and Treasury bonds. To-day the country is home to the fourth largest asset management industry in the world, after the United States, Japan and France.

Lending to households is still quite low by international standards, but growing fast. But what is more interesting is that large banks are bent on offering more sophisticated forms of financial assistance and advice to the traditionally underdeveloped sector made up of medium-sized firms.

3. The North-South divide

In Southern Italy the question of the link between the quality of banking services and the economy’s growth potential has become a political issue.

In my view, two reasons explain this particular sensitivity. One is the frustration with the apparent lack of any progress in closing the economic gap between the North and the South. The other is the fact that, after various rescue operations, the banking system in the South is dominated by banks from the Centre and North, supposedly less attentive to the needs of southern firms.

Per capita GDP in the South is 30 per cent lower than the national average. The gap narrowed substantially in the post-war period but has remained more or less stable in the last 20 years.

The official unemployment rate is about 18 per cent, as against 6 per cent in the Centre and 3.8 per cent in the North; on the other hand, the “underground economy” is much larger in the South. This may have something to do with the fact that since 1971 national wage contracts have been identical throughout the country.

The South’s endowment of infrastructure in transportation, energy, communications and water supply is estimated to be on average no more than half that of the rest of the country.

The quality of public services is lower; legal proceedings take longer.

For a long time the riskiness of bank lending, as measured by the incidence of losses, was much higher in the South than in the North. This was a consequence not only of the greater fragility of firms but also of lower lending standards. It is a moot question whether applying lower lending standards helps or damages the local economy. My opinion is that an insufficiently strict selection of credit-worthy projects, together with much State aid, has actually made it more difficult for the stronger firms to grow.

Today independent Southern banks represent only…..per cent of the local credit market. The banks that were acquired by Northern institutions initially curtailed their lending, as new and stricter criteria were adopted. But in the last four years their lending has grown faster and its quality seems to have improved markedly. There is no reason to believe that the major banks will miss the opportunities for profitable business that a relatively less developed market offers.

4. The regulatory authorities

Let me now turn to a subject which is the source of considerable debate at present, in Italy as elsewhere: the optimal structure of regulatory authorities.

Banking supervision and regulation in Italy has always been entrusted to the central bank. The 1936 banking law actually created a separate banking Inspectorate, but this was headed by the Governor of the Bank of Italy and staffed by Bank personnel. In 1947 what amounted to little more than a legal fiction was abolished and the supervisory function reverted to the Bank.

After the Italian securities and exchange commission – Consob – was created in 1974, the division of labour with the Bank of Italy was defined by purpose of regulation, rather than by type of intermediary. The Bank is in charge of the stability-orientated prudential supervision of banks, financial companies and investment firms; Consob is in charge of transparency and investor protection and in this capacity has regulatory powers over companies as issuers of securities and over banks and investment firms as providers of investment services to the public.

There are separate supervisors for insurance companies and for pension funds. They are in charge both of prudential supervision and of consumer protection.

The system can be described as a mixed one, in that it is partly based on type of intermediary (for insurers and pension funds) and partly on supervisory objectives (stability and consumer protection, for banks and investment firms). Importantly, it keeps the traditional link between central banking and banking supervision.

Different countries have, of course, adopted different solutions and this is an area of public policy where a lot of change has occurred recently, without any clear trend towards a single model.

A “pure” functional system is the one adopted by Australia, where the central bank is in charge of monetary policy and macroeconomic stability, an integrated supervisor is in charge of the microeconomic stability of all financial intermediaries and a securities and exchange commission is in charge of transparency and investor protection.

The UK system has a central bank and a supervisor who combines the micro-stability and consumer protection functions.

A country where the set-up has been revised very recently is the Netherlands. The central bank remains responsible for macro-stability and for prudential supervision of banks; it also acquires prudential supervision of investment firms; prudential supervision of insurance and pension funds is entrusted to a new authority, which is closely linked with the central bank, in what has been described as a “partial merger”; conduct of business (i.e. investor protection) supervision for all types of intermediary is the responsibility of a separate Authority for Financial Markets.

The fact that there are so many solutions around and that no convergence is discernible shows that there is no consensus with regard to the relative importance of the different policy objectives that are at stake; it also tells me that I would be very foolish if I tried to convince you that one particular set-up is to be preferred. I will therefore only try to suggest what seem to me to be the most important factors in the choice and tell you what is the state of the debate in Italy.

In my opinion there are two sets of issues that are involved at the same time and failing to keep them separate is often a source of confusion. One is the question of whether to have one integrated supervisor or several specialized supervisors for the three sectors of financial intermediation (banking, securities dealing, insurance; the sectors are four if you include pension funds). The second question is whether it is preferable to have the three main policy objectives of macro-stability, micro-stability and consumer protection entrusted to the same or different organizations.

The latter question is the really important one; it has to do essentially with the incentives for the behaviour of the institution. Putting two or three policy objectives in the same house makes coordination of policies easier, but accountability less clear, as trade-offs become internal and less visible. And the relative advantage of the multi-task versus the single-task solution may differ depending on which pair of objectives one is considering.

My opinion is that it is preferable for the prudential supervisor not to be given the additional task of protecting individual investors and vice-versa. This is because there is an unavoidable conflict, especially in day-to-day decisions, between promoting banks’ stability and protecting the interests of banks’ customers. This in turn has two consequences: first, it may be difficult for a supervisor-cum-investor protector to convince everybody that it is carrying out both duties equitably; second, there is a risk that it would be under pressure, when consumers’ interests are threatened, which can easily become an emotional and political issue, to concentrate on the task where it is more immediately exposed to criticism, rather than on the longer term and less visible objective of systemic stability.

On the other hand, in my opinion there is less of a conflict – and a greater need for coordination – when the two objectives of macro-stability (the job of a central bank) and micro-stability (the job of a prudential supervisor) are considered.

Here, the linch-pin is the function of lender-of-last-resort. This has always been – and still is – a function of the central bank, not so much because it affects monetary policy (as the interactions can be sterilized), but because preventing the failure of an illiquid bank is really just one aspect of stabilizing financial markets, especially if the bank involved is large. Lending to illiquid (but solvent) banks on the one hand requires detailed information on the conditions of each individual institution (which is what bank supervisors have), on the other it contributes to ensuring the stability of the banking system (which is what bank supervisors do). In practice, where the central bank and the banking supervisor are different organizations, a lot of duplication and coordination is inevitably required.

But this problem is not confined to lending of last resort. Let me give another example. We have recently asked all major (systemically relevant) banks to hold capital in excess of the minimum regulatory requirement, by an amount which we intend to vary, if necessary, taking into account the cyclical situation. The intention is to make sure that capital requirements do not lead to a credit crunch when the economy is in recession. This amounts to using a typical supervisory tool in a way which is supposed to stabilize the economy at the same time as it aims at reducing the insolvency risk of (large) individual banks.

To put it in a nutshell, since the job of a supervisor is not to prevent the failure of each bank, but to avoid the risk that such failures may destabilize the whole system, its purpose is almost undistinguishable from a central bank’s objective of systemic stability.

All this is to give you an idea of the arguments being used in the debate about the architecture of regulatory authorities. There seems to be an ample majority in Italy in favour of keeping banking supervision at the central bank and of keeping prudential supervision and investor protection separate.

The question of whether a single integrated prudential supervisor would be better than separate sectoral supervisors appears to raise issues that are more of a practical nature than of principle. The main argument in favour of integration, the existence of mixed conglomerates doing banking and insurance business at the same time, is not very relevant at the moment, as we only have large banks controlling small insurers and vice-versa. But there seems to be some dissatisfaction about what has been called a “proliferation” of regulatory authorities. This refers not only to prudential supervisors, but also to other regulators, such as the authorities for competition, for advertising, for the media, for electricity and gas, for privacy protection. The government has appointed a special commission which is due to report shortly and to propose some streamlining.

5. International regulatory convergence and differences in national economic structures

Even though there are significant differences between European countries in the structure of regulatory authorities and in the tools of day-to-day supervisory action they use, it is true to say, at least in banking and securities intermediation, that the degree of safety and soundness achieved is broadly similar everywhere. This equivalence of supervisory practices, together with the fact that all the main prudential regulations are identical throughout the European Union, has made it possible to allow banks from any EU country to offer services in the others, either cross-border or through the establishment of branches, under the control of the home supervisor alone.

Further convergence either of supervisory practices or of regulations is, of course, possible and in some cases even desirable. But just as there may be very good practical reasons why the institutional set-up of supervision is different across countries, it is clear that there is a limit to the usefulness of convergence in rules.

The new rules now being drafted on capital adequacy for banks are a case in point.

The aim is to assess how much capital a bank should hold, based on a more accurate and comprehensive evaluation of the risk of incurring losses. The number of factors affecting risk that might be relevant is, of course, potentially quite large, but there are obvious limits to how complex a regulation can be and a selection must be made. The problem is that the importance of each factor may vary considerably from one country to another.

In the Basel Committee on Banking Supervision, where the new regulation is being drafted, long discussions have taken place on whether the size of borrowing firms should be a factor in determining credit risk. Statistical evidence seems to bear out that while small firms fail more often than larger ones, their failures are predominantly explained by firm-specific factors rather than the general conditions of the economy and are therefore less correlated in time; the opposite is true for large firms. As a result, for any given level of riskiness of individual firms, a portfolio of loans to small firms is less risky than one of loans to large firms. The problem was whether the improvement in accuracy obtained by including firm size among the determinants of risk would justify the increased complexity.

In Italy 95 per cent of firms have fewer than 10 employees. Firms in that category account for 47 per cent of total employment, compared with 21 per cent in Germany, 22 per cent in France and 27 per cent in the United Kingdom. In manufacturing, firms with over 500 employees account for about one fifth of employment in Italy, as against two thirds in the United States. Such is the diversity in underlying economic structures that we are attempting to cover with a single rule.

In the end firm size has become part of the regulation, because it was too important to some countries to be neglected and too significant in its overall impact to be dealt with through a discretionary adjustment to capital requirements by national supervisors.

But this was probably the frontier of achievable convergence. In other areas of risk the new regulation rightly leaves considerable freedom to national supervisors to assess and decide, the idea being that equivalence in substance of supervisory approaches can be more usefully pursued through the exchange of experiences.

The moral of the story is:

- that the economic structures of our countries are still quite different;

- that convergence in financial regulation is not meant to eliminate or reduce these differences;

- that there is still a need for national authorities to play an important independent role in regulation and supervision in Europe;

- that, as in other parts of the European construction, it is more important to establish a process of institutional adaptation than a perfect and definitive architecture.