OREANDA-NEWS. August 03, 2015. Asset quality is the largest risk for most Italian medium-sized banks, Fitch Ratings says. We think this is another reason that consolidation would be positive for the sector, as it would help the banks achieve the critical mass needed to dispose of impaired exposures.

High impaired loans ratios (generally in double digits, with Credito Emiliano a notable exception) are due to borrower deterioration in a long recession, and a fall in gross lending volumes. Regulatory initiatives like the European Central Bank Asset Quality Review (AQR) have also encouraged banks to recognise problematic exposures.

New impaired loan formation has slowed since early 2014, and coverage has increased in recent years on more stringent provisioning and regulation (including the AQR) and different tax treatment of loan loss charges. But unreserved impaired loans are still high relative to Italian medium-sized banks' Fitch Core Capital (FCC). It is above the FCC of half the Fitch-rated banks, meaning capital at risk is high.

This is an important ratings consideration, and contributes to the sub-investment-grade ratings of five of the banks, while three banks are rated in the 'BBB' category.

Italy's medium-sized banks are using more focused approaches and standardised processes to manage their impaired exposures. Government and industry-wide attempts to get impaired loans off banks' balance sheets are also taking shape. These include the recent Decree to simplify and speed up some bankruptcy and foreclosure procedures.

Any meaningful asset-quality improvement requires the banks to reduce the stock of impaired exposures, either through faster workout or disposals. We think the banks would stand to gain if a 'bad bank' solution emerged that helped overcome hurdles encountered by individual banks in selling portfolios of impaired loans. These include price disagreements, the small size of the portfolios and the difficulty in bundling portfolios of loans with different characteristics.

The need to achieve critical mass when disposing of impaired exposures adds to the potential benefits of domestic consolidation among the medium-sized banks. Consolidation would also give them the scale to better absorb higher European regulatory costs and boost their still-mediocre profitability. A law approved in March requiring the medium-sized cooperative banks to become public limited companies may simplify consolidation. Consolidation could reshape the sector significantly.

The Stable Outlooks on most of the Italian medium-sized banks' Long-Term Issuer Default Ratings reflect prospects for their standalone viability, and the improving operating environments as Italy exits recession.

For a full discussion of the sector, see 'Peer Review: Italian Medium-Sized Banks' published today and available at www.fitchratings.com.