OREANDA-NEWS. The resolution plan approved by the European Commission for four failed local banks on 22 November 2015 will be costly for Italy's banking sector, says Fitch Ratings.

All Italian banks have to fund a newly established national resolution fund (the fund), which will initially be used to contribute EUR3.6bn towards safeguarding EUR27.8bn of deposits and senior bonds of Banca Marche, Banca Popolare dell'Etruria e del Lazio, Cassa di Risparmio della Provincia di Chieti and Cassa Di Risparmio di Ferrara. The fund will also guarantee EUR400m of impaired loans. In our view, this is expensive for the banking sector, especially as the four banks represent only 1% of sector assets.

Establishing resolution funds are part of the EU's Bank Recovery and Resolution Directive (BRRD) but Italian banks are being asked to make extraordinary contributions in 4Q15. This will add pressure to the sector's weak efficiency metrics and compress already modest profitability ratios.

Intesa Sanpaolo, UniCredit and UBI Banca announced extraordinary contributions to the fund, respectively of EUR380m, EUR210m and EUR70m, to cover their share of resolution costs for the four banks. These banks had already made ordinary contributions of EUR95m, EUR90m and EUR20m earlier in the year, so that total fund contributions are equivalent to 10% of nine month pre-tax profits to end-September 2015 at Intesa and UniCredit and 25% for UBI Banca. The sector reported a 5.2% return on equity for 1H15 and most of the country's large banks operate with cost-to-income ratios of around 65%, high compared with EU peers.

It is not clear whether this resolution approach might be rolled out for other Italian banks. If this were the case, the banking sector might face additional extraordinary contributions to the fund and for larger banks, the approach would likely prove too costly. Excluding the four banks in resolution, 10 Italian banks are in special administration. Special administration is a pre-resolution procedure and a well-established part of the Bank of Italy's crisis-management toolkit. Seven of these are cooperatives and the authorities may be inclined to liquidate these given their small size.

The four banks entered administration between May 2013 and February 2015 and recent financial information is unavailable. Disclosure about the resolutions is limited but we assume the banks are insolvent and asset quality is poor, judging by the need to cover EUR1.7bn of losses and the low 18% recovery rate from the banks' combined impaired loans. Following recapitalisation, four 'good' banks emerged and all doubtful loans were transferred into one 'bad' bank. Buyers will be sought for the 'good' banks.

Equity and subordinated debt issued by the four banks were written off, in line with BRRD and EU state aid rules. However, depositors and senior bondholders were spared. The BRRD allows resolution authorities, under exceptional circumstances, to exclude certain liabilities from write-down to avoid spreading contagion. But the situation is complicated by the fact that the new resolution arrangements have not fully come into effect and Italy chose to delay implementation of the bail-in tool until Jan 2016. The Bank of Italy has stated that their approach avoids using public funds; this helps avoid the need for senior creditors to bear losses equivalent to at least 8% of liabilities and own funds, as would normally be required under the BRRD either before public equity can be injected in a bank resolution, or before resolution financing can be provided to exclude a liability class from bail-in.

Italy's implementation of BRRD introduces full depositor preference from January 2019. Until then, deposits in excess of EUR100,000 not held by individuals and SMEs and senior unsecured debt rank equally in liquidation and resolution. Retail investors subscribe to considerable amounts of senior unsecured bank debt in Italy, reflecting previous retail tax advantages for holding debt as opposed to deposits. By assuring senior bondholders that they will, at least until 2019, rank pari passu with large depositors in resolution or liquidation, we believe the authorities are seeking to retain retail investor confidence in senior bank debt. The four banks in resolution issued subordinated debt to retail holders but these will be bailed-in.