OREANDA-NEWS. The Italian government's exploration of initiatives to strengthen banks' capitalisation using public funds highlights the pressure on the banking sector from weak asset quality, says Fitch Ratings. Measures that would strengthen asset quality or capital without triggering bail-in could be positive for Italian banks' Issuer Default Ratings. But the impediments under EU legislation to using public funds will make a solution difficult to achieve.

Market volatility following the UK's EU referendum result hit the Italian bank sector particularly hard because it is one of Europe's weakest. Profitability and internal capital generation is weak. Asset quality pressure is a main driver for the Negative Outlooks on several large and medium-sized Italian banks.

The European Commission recently approved a precautionary EUR150bn government-guaranteed debt liquidity package for banks. Such temporary "extraordinary public financial support" is permitted under the EU Bank Recovery and Resolution Directive (BRRD) for solvent institutions.

The Italian authorities are exploring options to strengthen the banks and appear willing to commit public sector funds, according to the media. There has been no public announcement of the additional measures under consideration, but they appear to include direct capital injections or issuance of hybrid capital instruments to be acquired by the state. An increase in the size of Atlante, a vehicle to participate in bank capital increases and invest in impaired loans, is also possible. The effectiveness of any intervention would depend on the size of the support (EUR40bn has been reported by the media).

Impaired loans are a large tail risk as banks rely on the value of collateral during the lengthy recovery process. Reducing impaired loans would directly improve banks' credit profiles and remove potential contingent liabilities for the stronger ones, whose contributions to resolving weaker institutions and to Atlante have affected their financial profile.

We believe it will be difficult to reach the political consensus necessary to inject public funds as equity under Article 108 of the Treaty on the Functioning of the European Union, which would be exempt from EU state aid rules, at least in the short term. Otherwise, any injection of public funds, permitted under the BRRD provided it is precautionary following a stress test, would be subject to the state aid rules.

State aid rules require private sector burden-sharing in most cases, which would increase the risk of a bail-in of junior debt in the event of precautionary recapitalisation. We believe the Italian government would want to avoid a bail-in following the political repercussions when it had to impose losses on retail investors in late 2015. Retail investors hold roughly a third of total outstanding Italian bank debt, and their bail-in would disrupt financial stability and undermine depositors' confidence.

As only five Italian banks are subject to the European Banking Authority stress tests - results due to be published on 29 July - smaller ones would presumably need to undergo a Bank of Italy stress test to be eligible for a BRRD precautionary recapitalisation.

There has been an unprecedented number of legislative initiatives in 2016 aimed at helping banks to repair their balance sheets, including changes to improve the work-out of impaired loans. This shows the authorities are committed to tackling the problems. But these initiatives came late and could prove less effective than the government envisages.