1. • The positive political backdrop driven by Renzi’s reforms should
support the Northern Italian real estate market;
• Certain parts of the market are still distressed even after investors
have been rewarded in Spain, Ireland and Portugal;
• Banks are motivated to sell their non-performing loans (NPLs) as
they have little capacity to process/service the inventory.
Gregory Perdon & Thais Batista
Daniel Williams & Jing Hu
+44 (0)20 7012 2522 | investment@arbuthnot.co.uk
For business. For family. For life.
Italian Thematic
April 2015

2. Italian Thematic – March 2015
2
Introduction
As we enter the sixth year since the turning point in the credit crisis, unprecedented measures have been undertaken
by central banks and governments alike to foster growth. Europe faced significant challenges during its sovereign
debt crisis, with certain states forced to go cap in hand to supranational lenders such as the IMF for bailouts. Over
the last three years, the macroeconomic situations in Portugal, Ireland, Greece and Spain have been improving
slowly and have delivered attractive returns for investors whilst Italy has remained largely absent from the return set.
We now draw our attention to the region and the opportunity which we believe to be worthy of analysis.
This thematic research report seeks to review the state of the Italian economy, address the oversized Italian banking
system, outline the main challenges facing the sector, and make the case that an attractive risk-reward opportunity
exists within certain areas of the Italian non-performing loan (NPL) market.
Italy and the Credit Crisis
Italy is the eighth largest economy in the world, generating an annual GDP of approximately €1.6 trillion (World
Bank, 2013). However, the financial crisis has hit Italy hard, with the country going through “the worst crisis in
history, even more devastating than the period between 1929 and 1934”, according to Gianni Toniolo, Professor
of Economics (at Rome University). Italian real-GDP peaked in 2007-08 (Figure A) and now, seven years later, is
10% lower. Furthermore the Bank of Italy is expecting a contraction of close to 2% for 2014. Unemployment keeps
pushing higher (13.4% as at Nov 2014) whilst youth unemployment (age 15 – 24) has reached a record high of 44%.1
Low inflation and slack in the economy both persist whilst Italian companies struggle with weak balance sheets
and tight credit conditions. Italy benefits from exports (similar to Germany), selling both light and sophisticated
machinery (including automobiles) to the rest of Europe and abroad; unfortunately, the automobile sector has been
the most affected with a 40% drop in capacity, reaching levels not seen since the 1960s. At the same time, Italy’s
government debt-to-GDP ratio has reached 132%, the highest since the Mussolini era. It is therefore no surprise
that the FTSE MIB Equity Index (Milano Italia Borsa, a leading Italian index) has significantly underperformed the
broader Eurostoxx 50 Index (Figure B).
Figure A: Low GDP & Deflation
-­‐2%
-­‐1%
0%
1%
2%
3%
4%
5%
-­‐8%
-­‐6%
-­‐4%
-­‐2%
0%
2%
4%
6%
Dec-­‐03
Dec-­‐04
Dec-­‐05
Dec-­‐06
Dec-­‐07
Dec-­‐08
Dec-­‐09
Dec-­‐10
Dec-­‐11
Dec-­‐12
Dec-­‐13
Dec-­‐14
Italy
-­‐
GDP
%
y/y
Italy
-­‐
CPI
%y/y
(RHS)
Source: Bloomberg
Figure B: Lacklustre Equity Market Performance
0
20
40
60
80
100
120
140
160
180
Jan-­‐04
Jan-­‐05
Jan-­‐06
Jan-­‐07
Jan-­‐08
Jan-­‐09
Jan-­‐10
Jan-­‐11
Jan-­‐12
Jan-­‐13
Jan-­‐14
Jan-­‐15
FTSE
MIB
Eurostoxx
50
Jan
2004
=
100
Source: Bloomberg
1 Italian National Institute of Statistics (Istat)

3. Italian Thematic – March 2015
3
Renzi’s Reforms
The individual tasked with tackling the aforementioned economic challenges is Italy’s Premier Matteo Renzi. Elected
in February 2014, he has been very vocal about his objectives to rewrite labour laws, improve the judicial system,
address bureaucracy and attract foreign investment, all whilst remaining within the EU mandated limit of a 3% deficit
to GDP. Change is of course ‘easier said than done’ as reforms are incredibly difficult to push through due to chronic
political scandal, entrenched bureaucracy and economic malaise. Many plans for investment by foreign companies
have been withdrawn because of inefficiency and uncertainty of the Italian court system.
Our view is that Renzi is the right pair of hands for the job, but these structural reforms will take time. Changes to the
labour market will, in theory, encourage hiring, modernisation in the justice system will make ‘doing business in Italy’
easier (Figure C) and cleaning up the banking system will make Italy a more attractive destination for investment.
With these measures, Italy should have a fighting chance to stabilise, re-establish channels of credit and move back
towards economic growth.
Figure C: Doing Business Survey 2015
1,185
0
200
400
600
800
1000
1200
1400
1600
1800
Singapore
New
Zealand
Russia
Norway
Sweden
Hong
Kong
Japan
Switzerland
Germany
France
Australia
Austria
Denmark
US
UK
China
Spain
Netherlands
Portugal
Canada
Ireland
Poland
Brazil
Israel
Pakistan
Egypt
Italy
India
Greece
Time
(in
days)
to
resolve
a
dispute
in
court
(including
waiSng
period
aTer
filing
the
lawsuit)
Source: World Bank
Figure D: Banking System: Italy vs Euro Area
Italy Euro Area
684 Number of banks 5,605
2.6x Banks assets/GDP 3.2x
64 Number of branches per 100,000 adults 37
40% Market share of top 5 banks 63%
€333bn Non-performing loans (NPLs) €1,200bn
20% NPL/GDP 9.2%
Italy has more bank branches per person than hotels – second highest in the OECD.
Source: RBC, ECB, Bank of Italy, PwC
Italian Banks, SMEs and Access to Capital
European banks’ assets stand at approximately three times GDP while the ratio in the U.S. is below one. Companies
in the EU tend to borrow from banks rather than accessing capital markets directly, as they do in the U.S. In Europe,
the Italian banking system is one of the largest with nearly 700 banks (Figure D), but its ability to increase lending
to help stimulate the economy has been thwarted. Despite a drive to consolidate the sector, the Italian banking
system still has a large number of small cooperatives and regional banks working locally to support small and
medium enterprises (SMEs).
SMEs are a key component of the Italian economy2
, accounting for more than two-thirds of value addition to the
economy (IMF) and providing nearly 3.5 million jobs (Eurostat). SMEs tend to obtain financing via loans granted
by smaller local banks that are in turn funded by retail deposits. Over time as the relationship deepens, the bank
acquires ‘soft’ information about the SME and will more easily renew/increase lines of credit. As a result, small
banks and SMEs are less exposed to an international credit/banking crisis because they tend not to borrow in the
overnight markets, but quickly get into trouble during periods when the domestic economy starts to slow.
2 More than 99% of non-financial businesses in Europe are Small and Medium enterprises (SMEs), i.e. businesses with fewer than 250
employees. Italy is home to 17.2% of European SMEs. In comparison, France has 12.0% and Germany has 10.2%. (Source: European
Commission)

4. Italian Thematic – March 2015
4
Figure E: High Corporate Tax and Borrowing Rate
0
1
2
3
4
5
6
0
5
10
15
20
25
30
35
40
Cyprus
Ireland
Lithuania
Slovenia
Finland
Estonia
EU
average
UK
Slovakia
Portugal
Austria
Netherlands
Greece
Germany
Spain
Italy
France
Belgium
Malta
Corporate
tax
rate
2014
(%)
SME
loan
rate
(%,
RHS)
Source: Arbuthnot, Bloomberg
Figure F: Leverage of Firms (%Net Debt/EBITDA3
)
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Ireland
Germany
France
Italy
Spain
Portugal
Greece
United
Kingdom
0-­‐1x
1-­‐2x
2-­‐3x
3-­‐4x
4-­‐5x
5-­‐6x
6x+
Source: Arbuthnot, Bloomberg
The relationship between SMEs and the capital markets is challenging. Small entrepreneurs are culturally (Caselli,
et al., 2013) reluctant to engage with equity investors4
and until recently, the easy availability of bank credit made
obtaining debt the most logical source of funding. In addition, corporate taxes in Italy are high (Figure E) and
interest paid on debts is naturally tax deductible. On top of that, the less favourable tax treatment for equity vs
debt financing5
further discourages equity issuance. This has resulted in a heavy reliance on debt (more than 80%
of Italian firms are leveraged, Figure F) which exposes firms to higher interest rates. About 50% of outstanding
corporate debt is extended to highly levered corporations, which also suffer from low profitability as half of their
operating cost goes to service interest payments (IMF, 2013). Sustained weakness in corporate profitability against
the backdrop of lacklustre economic growth is a recipe for deterioration in loan quality, which itself works against
the strength of the banks’ balance sheets.
Monetary support
Regarding Europe as a whole, the European Central Bank (ECB) faces a major challenge trying to foment stagnant
economies by balancing stricter rules for banks with credit stimulus, while governments bear the responsibility of
passing reforms that should pave the way for long-term change.
As a direct result of ECB President, Mario Draghi’s “whatever it takes” commitment to save the euro and assist
member states with funding costs, government yields have retreated spectacularly. Italy is no different and has
been a clear beneficiary; it now costs the Italian government only 2% pa to borrow capital for 10 years, down from
a level of 6% pa back in July 2012. But despite this, the effective medium to long-term borrowing rates for Italian
corporates remain high. Low sovereign spreads (mentioned above) improve financial stability but it is believed that
tighter borrowing conditions are holding back investment and economic growth in Italy.
The recent Asset Quality Review (AQR), conducted by the ECB aimed to review each6
banks’ assets through a
standardised measurement, found that banks in Italy, Greece and Germany were most challenged7
. ECB auditors
also conducted an assessment of the accuracy of reported values as at 31st December 2013 and found that
European banks were under-estimating their non-performing loan (NPL) inventory by €136 billion.
In anticipation of the results of the AQR, the large Italian banks started to recognise more losses on their balance
sheets and announced plans to raise capital and dispose of NPLs. Italian banks had raised €11 billion in capital
before the AQR results were published in October 2014. Banca Monte dei Paschi di Siena (MPS) sold its founder’s
shares and raised an additional €5 billion of capital in June 2014 to repay the bulk of its state aid.
Looking at these forces, we tried to find where these measures would be more fruitful and what would be the best
way of expressing it – in our view, Italian NPLs are the answer.
3 EBITDA = Earnings before interest, taxes, depreciation and amortisation. It is an indicator of financial health of a company as it eliminates
the impact of financial and accounting decisions.
4 Equity market capitalisation in Italy stands at 50% of GDP which is in the lower quartile of OECD.
5 Distributed corporate earnings are taxed at the peak rate (43%) and tax on interest income is taxed at (26%), reducing the net return on
equity investment.
6 130 banks across the EU participated in this exercise. It is expected that the ECB will directly supervise these 130 credit institutions,
representing almost 85% of total banking assets in the euro area.
7 According to the results of the AQR, the total downward adjustment required in carrying value of banks’ assets was €47.5bn, largely
coming from Italy (€12bn), Greece (€7.6bn), Germany (€6.7bn) and France (€5.6bn).

5. Italian Thematic – March 2015
5
Box 1: What is an NPL?
NPLs are loans on which borrowers have not made payment (interest/principal or both) for approximately 3
months. Most banks allow customers a grace period to reinstate their payments, and beyond that they are
marked as non-performing. Internationally, for a loan to be classified as non-performing (Barisitz, 2013), it
should meet one of the following three criteria:
• Principal or interest is more than 90 days overdue;
• Presence of underlying “well-defined weaknesses” of either the loan or the borrower;
• Loan belongs to the weakest three credit qualities out of the total five credit qualities:
standard > watch/special mention > substandard > doubtful > loss/write-off.
Italy however, has a stricter approach; the Bank of Italy classifies NPLs under the last four of the following
categories:
• Performing/Standard loans: Loans that make regular payments;
• Substandard loans: Loans experiencing temporary difficulties, which
may be overcome within a reasonable period of time;
• Past-due loans: Loans overdue for more than 90 days on a continuous basis;
• Bad debt: Loans to insolvent borrowers, even if the insolvency
has not been ascertained in a court of law;
• Restructured loans: Loans with a rescheduled agreement (including the
reduction of interest/principal or conversion of debt into equity etc.).
Generally speaking, the initial loans made are of two types: secured or unsecured. When banks attempt to
recover secured NPLs, they tend to foreclose on the collateral and auction it. But depending on local laws,
foreclosure can be difficult, costly and time consuming. When recovering unsecured loans (such as credit
card debt) banks will attempt to ‘work something out’ with the borrowers, as unpaid debts in Italy remain a
liability for life.
History of NPL Transactions
In the U.S., sale of NPLs first took place after the “Savings and Loan Crisis” in the 1980s and continued
in Japan and Asia with sales of NPLs helping to get South Korea back on track after the Asian crisis of
1997. Italy was one of the first European countries to recognise the NPL problem in 1999 and it created a
securitisation law to facilitate the sale of NPLs. During the most recent global financial crisis, NPLs in the
U.S. went onto the market very quickly but European nations only followed when the crisis hit the continent
in 2011. Since then, the principal banks in the UK, Denmark, Ireland, Spain and Portugal have engaged
in NPL sales or created bad banks such as the National Asset Management Agency. The Irish bad bank
NAMA acquired €74 billion of loans up to 2011 and has disposed of €12.5 billion by 2014. Spanish bad
bank SAREB is in the process of buying €90 billion of bad debt and plans to sell it over a long period. Whilst
Denmark’s bad bank, Finansiel Stabilitet, created in 2008 when the housing crisis impacted the household
consumption led economy, took over assets of 12 distressed banks.
Legally, the purchase of receivables (buying NPLs or bad debt) in Italy is considered to be a form of lending
and reserved for licensed banks and financial intermediaries. If foreign investors are interested in acquiring
the debt they have to do so through securitisation techniques. Securitisation allows a special purpose
vehicle (SPV) to pool money from various investors and purchase Italian NPLs. Investors receive asset-
backed securities from the SPV which are then repaid by the collections and recoveries made on the
securitised NPL. The securitisation law (Law No. 130/1999) passed by the Italian Government in 1999 was
aimed to promote the entry of international investors.

6. Italian Thematic – March 2015
6
Banks and NPLs
The greater the amount of non-performing assets, the weaker the bank’s balance sheet. As a bank stops earning
income on assets, its Net Interest Income8
reduces. On average, Net Interest Income forms circa 60% of European
banks’ operating income and any reduction in Net Interest Income will reduce profitability and prospects for dividend
growth. In the short run, many banks may be able to ride out minor setbacks in their loan books through provisions
and reserves, but if problems persist, capital adequacy erodes, and this reduces shareholders’ confidence, bank
stability, and increases funding costs.
As per Basel III9
regulations, banks are required to maintain adequate capital in proportion to the riskiness of their
assets. When the ratio of NPLs becomes too high, the bank must shore up its capital base either through the
issuance of equity (which dilutes existing shareholders), issuance of debt (which increases the bank’s interests
costs and leverage) or by selling assets (like NPLs or bank branches) to raise cash.
It is not always feasible for banks to raise additional capital and maintain adequacy in the face of increasing
NPLs. One solution is to set aside cash on their income statement to cover potential losses on loans (loan loss
provisions) and reduce assets by writing down bad debt on their balance sheet. If banks have accumulated too
many NPLs, they can also sell them to third party investors, who attempt to recover some of the capital owed. The
sale of NPLs to a third party has two positive side effects on financial institutions: firstly it enables the bank to
increase its percentage of performing loans, therefore reducing the amount of regulatory capital which it is required
to upkeep, and secondly, it frees up space on the balance sheet enabling the bank to initiate new loans which may
generate additional Net Interest Income. This Net Interest Income can either be retained or distributed in the form
of dividends at a later date.
8 Net Interest Income is the difference between interest earned on assets (loans) and interest paid out on liabilities (deposits).
9 Basel III is a comprehensive set of reform measures, developed by the Basel Committee on Banking Supervision, to strengthen the
regulation, supervision and risk management of the banking sector. (Source: BIS)

7. Italian Thematic – March 2015
7
Box 2: Accounting Treatment of NPLs
Consider Banca Pizza’s stylised Balance Sheet and Income Statement for the years 2013-2014. Banca
Pizza has recognised 20% of its total loans as non-performing loans. If the bank predicts no losses on the
NPL then it can choose to make no loan loss provisions (See Income Statement 2013 Case 1), expecting the
NPLs to be recovered at their face value, or it can choose to allow for loan loss provisions, thus expecting,
in this example, only 50% of the NPLs face value to be returned to the bank (See Income Statement 2013
Case 2).
Allowing for loan loss provisions reduces a bank’s profits as can be seen in Case 2 where profits are lower.
Over the course of the past few years, high loan loss provisions have significantly reduced profitability for
many Italian banks.
Banca Pizza Balance Sheet 2013
Balance sheet of bank on 31-Dec-2013
Asset Liabilities
Loans 1000 Deposits 400
of which NPL 200 Short-term debt 300
Cash 200 Long-term debt 100
Shareholder’s equity 400
S.E.
Total assets 1200 Total liabilities + S.E. 1200
Source: Arbuthnot
Banca Pizza Income Statement 2013
Income statement for year 2013
Case 1 Case 2
Interest income 400 400
Other income 100 100
Total revenues 500 500
Interest expense 100 100
Other expense 50 50
Loan Loss Provisions (LLP) - 100
Total expense 150 250
Income before tax 350 250
Income tax (@ 30%) 105 75
Net income (Profit/Loss) 245 175
In the following year, assuming the bank can sell its NPLs to a third party buyer at a price of 25% of face
value, it will be able to generate cash of €50 and will recognise losses against the loan value of the asset. In
Case 1 the bank recognises a loss of - €150 (= 50 - 200) but in Case 2 as it had previously made provisions
for loan losses of €100, so its loss in this year is reduced to - €50 (= 50 - (200 - 100)). In effect, after
making the NPL sale the bank’s profitability is higher if it had already accounted for the loan loss in the
previous period (Case 2). Due to this write-off the bank’s loan book has also reduced from €1000 in 2013
to €800 in 2014.
Banca Pizza Balance Sheet 2014
Balance sheet of bank on 31-Dec-2014
Asset Liabilities
Loans 800 Deposits 400
of which NPL - Short-term debt 300
Cash 250 Long-term debt 100
Shareholder’s equity 250
S.E.
Total assets 1050 Total liabilities + S.E. 1050
Source: Arbuthnot
Banca Pizza Income Statement 2014
Income statement for year 2014
Case 1 Case 2
Interest income 400 400
Other income 100 100
Income from sale of NPL -150 -50
Total revenues 350 450
Interest expense 100 100
Other expense 50 50
Loan Loss Provisions (LLP) - -
Total expense 150 150
Income before tax 200 300
Income tax (@ 30%) 60 90
Net Income (Profit/Loss) 140 210
Since NPLs carry high risk-weights, by disposing of these loans in the year 2014, the bank is also able to
improve its capital adequacy ratios (everything else held constant).

8. Italian Thematic – March 2015
8
Italy’s NPLs
Since the financial crisis, the amount of Italian bad debt10
has nearly quadrupled to €179 billion (Figure G). The
inventory of NPLs has also grown quickly in the last two to three years, but the corresponding transfer of NPLs from
banks’ balance sheets to third party investors has been insignificant.
One of the reasons for deep discounts and the low volume of transactions to date is the poor granular level of
customer data supporting these loans. Investors are sceptical of the level of quality controls applied to NPL books
and are only willing to bid at stiffer discounts to account for these unknowns. This creates a conundrum for banks.
The situation is not too dissimilar to the information asymmetry problem which faces the second hand car market.
The buyer cannot make a complete assessment of the second hand car due to the lack of information and therefore
is only willing to make a low bid. The buyer knows that the seller has more information about the condition of the
car so the buyer will apply a discount. The seller knows the exact condition of the car and is in a better position to
take advantage of the buyer.
The ratio of non-performing loans to total loans (incl. households, corporates and other loans) stands at 16% (2013)
and has tripled from its 2007 level (Banca D’Italia, 2014 - May). The NPL ratio for corporate loans only (i.e. non-
performing corporate loans to total corporate loans) is in a much worse condition at 29% (IMF Staff, 2014). The
sale/transfer of ageing NPLs is becoming increasingly urgent as their size relative to the overall domestic lending
market has become ‘unmanageable’. This has significantly impacted banks’ profitability as increased loan loss
provisions have absorbed more than the entire operating profits in 2013 (Figure I).
Extrapolating from the previous NPL sales cycles (2000-2003 & 2005-2007), and presuming lenders will increase
their efforts to address the issue of under-performing assets, we could conservatively expect approximately 40%11
of total Italian bad debts (circa €68 billion) to be sold over the coming 3-4 years. Since 2011, less than €15 billion
of NPLs (face value12
) have been sold but the trend is encouraging, with less than €1 billion NPLs sold in 2011,
€4 billion in 2012, €5 billion in 2013, and €6 billion in the first 9 months of 2014. It is further expected that an
additional €6 billion worth of NPLs were closed in Q4 2014 (Figure H).
Figure G: Bad Debt – Quadrupled Since the Crisis
0
20
40
60
80
100
120
140
160
180
200
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
16.0%
18.0%
Jun-­‐98
Dec-­‐98
Jun-­‐99
Dec-­‐99
Jun-­‐00
Dec-­‐00
Jun-­‐01
Dec-­‐01
Jun-­‐02
Dec-­‐02
Jun-­‐03
Dec-­‐03
Jun-­‐04
Dec-­‐04
Jun-­‐05
Dec-­‐05
Jun-­‐06
Dec-­‐06
Jun-­‐07
Dec-­‐07
Jun-­‐08
Dec-­‐08
Jun-­‐09
Dec-­‐09
Jun-­‐10
Dec-­‐10
Jun-­‐11
Dec-­‐11
Jun-­‐12
Dec-­‐12
Jun-­‐13
Dec-­‐13
Jun-­‐14
Bad
debts
(EUR
bn)
-­‐
Italy,
RHS
Bad
debt/Loans
(%)
-­‐
Italy
Bad
debt/Loans
(%)
-­‐
Consumer
Households
Bad
debt/Loans
(%)
-­‐
Non
Fin
Corp
Source: Bank of Italy
Figure H: NPL Transactions in Italy
2
0.2
0.7
2
2.5
4.5
2
0.8
6
0
2
4
6
8
10
12
2011
2012
2013
2014
Secured
retail
Unsecured
Retail
SME/Corporate
In
Progress
<€1bn
€4bn
€5bn
€12bn
Unicredit
has
been
one
of
the
most
acGve
sellers
since
2013,
accounGng
for
half
of
transacGons
completed
and
in
progress
in
2014.
Source: PwC
10 Bad debts are a part of NPL. Italian NPL form 15% of total loans and bad debts are 8% of total loans. Other components of NPL are
Substandard, Restructured and Past-Due loans. See section on NPLs.
11 Arbuthnot estimates.
12 Face value of a loan is the original amount that the bank has extended to the borrower. Market value of the loan is the expected recovery
that can be made on the loan.

9. Italian Thematic – March 2015
9
Figure I: Loan Loss Provision Growth
0
20
40
60
80
100
120
140
2008
2009
2010
2011
2012
2013
Italy
Banking
groups:
loan
loss
provisions
as
a
percentage
of
opera>ng
profits
Source: Bank of Italy
Figure J: House Prices in Europe
70
75
80
85
90
95
100
105
110
115
2005Q1
2005Q2
2005Q3
2005Q4
2006Q1
2006Q2
2006Q3
2006Q4
2007Q1
2007Q1
2007Q1
2007Q1
2008Q1
2008Q2
2008Q3
2008Q4
2009Q1
2009Q2
2009Q3
2009Q4
2010Q1
2010Q2
2010Q3
2010Q4
2011Q1
2011Q2
2011Q3
2011Q4
2012Q1
2012Q2
2012Q3
2012Q4
2013Q1
2013Q2
2013Q3
2013Q4
2014Q1
2014Q2
House
price
Index
(2010=100)
Germany
Spain
France
Italy
United
Kingdom
Source: Eurostat
NPL Servicers
Investing in NPLs in Italy is near impossible without the assistance of a ‘servicer’. These companies communicate
with borrowers, collect payments and/or negotiate work-outs or solutions. Servicers can also be involved with the
acquisition or disposal of a portfolio, as they tend to have deep local knowledge of the market in which they operate.
They can be compensated in different forms such as a flat fee and/or a performance fee for an attempted, partial or
successful collection. Often the success of the servicer depends on their ability to negotiate and secure repayment
at a level which is above the valuation placed on the paper by the investor. Servicers often rely on databases to
create statistical models to price NPL portfolios effectively and in turn ‘sell’ their track record of valuation/recovery
to other buyers. Their models continuously evolve with each experience of NPL portfolios serviced as more data
points are added. This creates a barrier for new entrants and gives the experienced players a competitive edge in
estimating the pricing of a portfolio and maximising expected profits from it.
Banks often sell portfolios of NPLs in one of three ways: 1) through a negotiated deal, 2) through an auction, or 3)
they contract a continuous flow agreement with a servicer (or other buyer) within which a certain type or quality of
NPL will be automatically transferred to the latter. When acquiring unsecured loans, firms tend to rely more heavily
on statistical models, and will bid for larger volumes. On the other hand, when buying a portfolio of secured NPLs (for
example, mortgages backed by property), the acquirer will have to review the underlying assets carefully and take
a view on the inherent value as, often, the investment will succeed or fail based not only on the recovery ratio but
also on the general directionality of the underlying asset (whether property values are appreciating or depreciating).
The net return for the buyer of the NPL portfolio will depend on the amount the servicer is able to recover, the time
and cost it incurs during the process, and the change in value of the underlying asset. And it is for these reasons
that pricing the portfolio correctly is key to the process.
Catalysts for NPL sales
As with any investment case, a catalyst is needed – the Italian government and regulators are encouraging banks to
reduce the ratio of NPLs and increase new lending. The heavy risk-weighting that NPLs attract (often 150%13
) make
them onerous to hold on balance sheets and can prevent banks from making new loans or potentially rolling their
existing loans to their customers.
Italian banks’ NPL departments are stretched14
. A typical workload of 400 NPLs per loan officer is considered
manageable, but according to Francesco Guarneri – President of Guber, (one of the most informed servicers in
Northern Italy) – banks have loaded between 1,000 to 1,200 files on each of their loan officers. With employees in
the recovery departments overloaded and weak IT infrastructure, banks might be tempted to reduce NPLs due to
their inability to process them.
13 Risk weights for overdue loans (>90 days), other than residential mortgage loans: 150% for provisions that are less than 20% of the
outstanding amount; 100% for provisions that are between 20% - 49% of the outstanding amount; 100% for provisions that are no less
than 50% of the outstanding amount, but with supervisory discretion are reduced to 50% of the outstanding amount. (Source: BIS,
Basel II: Revised international capital framework)
14 Italy has nearly 20% of total SSM (Single Supervisory Mechanism) banks NPL. (Source Bank of Italy AQR 2014 – 2)

10. Italian Thematic – March 2015
10
The NPL books are ageing, and the longer the credit goes unserviced or unrecovered, the lower the probability of a
reasonable rate of return, which in turn reduces the present value. In an attempt to salvage as much value as quickly
as possible, banks might be tempted to begin selling and realising cash.
Italian banks are better prepared, having gone through the process of preparing for the AQR. The fact that some Italian
banks successfully raised equity before the AQR has shown increasing interest from the international community
in the region. Italian banks also applied considerable “hair-cuts” to their NPL books in advance of the ECB review,
valuing those assets at a level closer to what international investors might be willing to pay. PwC quotes UniCredit
as a case in point: the bank created a non-core division with €87 billion in assets, set up an ongoing competitive
auction process for its NPLs, increased provisioning by 10% and sold €1.7 billion of NPLs in only a few months.
Italian banks have already provisioned for losses of nearly 40%15
on their NPL portfolios (i.e. they have already
accounted for a loss of 40% on the total face value). In the scenario where they have to write-off these loans
completely, they will realise a further loss of 60% which would negatively affect their income statement. However,
if by means of an NPL sale they can salvage even 15-20% of the face value, then the total loss could be more
‘manageable’.
The Italian government’s tax treatment of loan loss provisions was historically less favourable than other European
nations. However, the government is softening its stance. The new Stability Law (2014) modified the tax treatment
of banks’ loan losses, where write-downs and write-offs of loan losses are now both tax deductible in equal portions
over five years. In comparison, under the old tax regime, write-downs, where the court does not approve the
insolvency of the assets, could only be deducted up to 0.3% of the corporate’s total loan book before tax in the first
financial year with the remaining deductible over the next 18 years; on the other hand, write-offs, although they can
be fully deducted before tax in the current year, often take the court years to declare insolvency on the underlying
assets. By incentivising banks to recognise loan losses upfront, the tax burden is significantly relieved during
economic downturns. It is interesting to note that the IMF in its Financial Stability Review16
(2013) recommended an
increase in the tax deductibility of loan losses to help tackle the NPL problem.
Foreign banks are withdrawing from the NPL market as they recommit to their core businesses and geographies. For
example, a German bank might sell an Italian NPL book as the Head Office recognises the lack of local expertise
required to service this foreign business. Simultaneously, the foreign institution may wish to free-up space on its
balance sheet in order to focus on its domestic business.
But any sale requires a buyer as well. Previously, investors were relatively uninterested in Italian NPLs. But this is
changing as private equity firms (mainly from the U.S.) are circling the market and starting to make low bids. To date,
the Italian banks have largely declined to trade as they seek higher prices. But as the market develops for some of
the above mentioned reasons, buyers and sellers might begin ‘meeting in the middle’ and activity could increase
quickly.
Where is the Investment Opportunity?
We see investing in secured Italian NPLs as a way of participating in the European work out story. By taking this
exposure we are investing in a distressed asset class, in a periphery country, with the long-term view that the
situation will revert to normal levels. We see the opportunity set comprising of the following:
Different from liquid bonds that exchange hands easily, investors who want to participate in the NPL story need to
be on the ground and have local knowledge to pick and price the NPL books based on the credit risk of the borrower
and on the quality of the collateral. The borrower is typically an individual or a private company, not a listed company
with published financial statements. All of this makes NPLs a difficult asset class to access, increasing the discount
and the potential upside for investors.
We have chosen to focus on secured loans as we see that subset as less crowded than unsecured. So far,
international investors have been flocking into unsecured NPLs claiming that the judicial system in Italy is not
reliable and they want to mitigate that risk. Talking to local investors, we discovered that actually unsecured is what
the Italian banks are willing to sell at the moment, not giving much alternative to investors who are willing to put
large sums of money to work in a short timeframe. This leaves the secured market preserved, with NPLs trading at
attractive prices for experts to pick and choose.
15 Source: ECB Statistical Data Warehouse.
16 Other recommendations included: Increasing Banca D’Italia inspections to enhance provisioning and write-offs, and expedition of judicial
process by adopting best practises and through special insolvency courts.

11. Italian Thematic – March 2015
11
The political landscape in Italy is changing, in contrast to other European countries where the population still resists
the need for austerity and reforms. Italy has benefited from positive momentum as Renzi is tackling labour and
judicial reforms. The labour reform should have a deep impact on the country’s productivity while the judicial reform
can directly impact NPL valuations as debt recovery becomes easier and quicker to foreclose on the borrowers.
Currently the Italian legal system is comparable to underdeveloped countries, taking almost double the time to
pronounce a verdict in comparison to other European countries.
The collateral for secured NPLs is typically properties, and therefore the process of investing in NPLs is very much
linked to the real estate market. If the collateral increases in price, it is easier to negotiate with the borrower and
avoid a legal fight due to the fact that the borrower now has more to lose. Another possibility is to get direct exposure
to properties, participating in auctions resulting from foreclosures. When analysing the NPL books of the banks, the
investor has information on the collaterals and knows which properties may go to auction. If the bank does not sell
the NPL book and decides to repossess the property, the investor can participate in the auction.
After Ireland, Spain and Greece, there is expectation that Italian Real Estate is set to recover. So far the Italian
property market has stalled with the number of residential transactions down 50% since 2006 levels. Home prices
(Figure J) have continued to fall, declining for the seventh year in a row (down 16% since 2008), while the sector
is suffering from low transaction volumes as sellers refuse to deal at current levels. Buying from a seller who was
forced to give the property as a guarantee can be a way to access the real estate market. The first signals of recovery
were spotted in early 2014 when for the first time since Q4 2011 the number of transactions had increased. This
result was mainly impacted by more activity in commercial transactions, concentrated in the biggest cities.
When looking at NPLs, the success ratio will largely depend on whether the investors’ interests are aligned with
the servicer’s interests. The servicer should perform detailed due diligence in order to obtain the best NPLs for the
right price; it should also utilise regional discretion when acquiring the portfolios, given the divergence of judicial
efficiency between northern and southern regions of Italy. The average length of civil proceedings is two years longer
and the backlog of cases is four times larger in the south than in the north, an important consideration as time
dilutes the return on investment. Pricing, geography, ease of recovery, collateral analysis, and age or vintage of the
loans should all be considered as crucial aspects that we need the servicer to correctly access.
With this background in mind, we now see banks being forced to sell their NPLs as they need to readapt their balance
sheets to an era of lower leverage whilst simultaneously transforming their credit books back into a profitable
business. The IMF has suggested a three-pronged approach for the Italian banks: 1) create stronger supervision
with proper guidelines for working out NPL exposure, 2) develop an active NPL market as an alternative to lengthy
bankruptcy procedures, and 3) speed up foreclosures through out-of-court settlements. If the Italian banking sector
heeds the IMF’s recommendations, attractive opportunities for NPL purchases will emerge over the coming months.
Risks
Investors should be wary of the risks17
when investing in Italian NPLs. Firstly, from an economic standpoint, despite
the drastic measures taken by the ECB, lack of support in Italy for Renzi and his social reforms could be a severe
headwind for NPL investors. Secondly, should banks’ loan books continue to deteriorate, NPL portfolios will most
likely experience further depreciation regardless of how cheaply the portfolio was traded. Thirdly, the asset class
is illiquid, and there is no guarantee that a reasonable price can be obtained on the secondary market, or an exit
secured. Finally, distressed investing can often involve lengthy legal disputes, adding to legal costs.
Reliance on the servicer’s expertise, their internal models and their ability to recover, is crucial and an unavoidable
part of this style of investment. The ability to price the NPL correctly, knowledge of the real estate backing the
loan and the legal background serve as challenges, but equally can offer savvy investors an edge when competing
against other buyers for the best portfolios.
Lastly, we recognise that a high level of sophistication is required in order to properly analyse the NPL market, as
the underlying securities can sometimes be complex in nature, along with present legal challenges which would be
faced in a foreign jurisdiction. As a result, much due diligence is required before making allocations to this market.
17 By no means an exhaustive list.

12. Italian Thematic – March 2015
12
Conclusion – It’s Good for Italy
International investors are approaching Italy with the mindset to replicate the success achieved in other countries,
such as Ireland and Spain. Those investors have been rewarded as certain European banks have successfully
improved their balance sheets (Figure M). Now Italian banks are preparing for this process. Business confidence
is showing signs of improvement (Figures K & L) while clear and present catalysts exist to help banks successfully
unload their NPLs. The sheer volume of NPLs is hampering banks’ profitability while their NPL departments are
overextended. The government and regulators are encouraging banks to reduce the ratio of NPLs, and make it
less costly to recognise losses upfront. Foreign banks are withdrawing from the market and do not have the local
knowledge to exit the bad debt themselves. Italian banks’ ability to raise capital successfully (even from foreigners)
ahead of the AQR underscores the foreign interest in this economy to replicate the success of other periphery
countries such as Spain and Ireland.
Figure K: Business Confidence Has Ticked Up
70
75
80
85
90
95
100
105
110
115
120
Nov-­‐06
Feb-­‐07
May-­‐07
Aug-­‐07
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Aug-­‐10
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Feb-­‐11
May-­‐11
Aug-­‐11
Nov-­‐11
Feb-­‐12
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Feb-­‐13
May-­‐13
Aug-­‐13
Nov-­‐13
Feb-­‐14
May-­‐14
Aug-­‐14
Nov-­‐14
Business
confidence
Consumer
confidence
Index
Source: Bloomberg
Figure L: Purchase Managers’ Surveys Recovering
40
42
44
46
48
50
52
54
56
Dec-­‐11
Mar-­‐12
Jun-­‐12
Sep-­‐12
Dec-­‐12
Mar-­‐13
Jun-­‐13
Sep-­‐13
Dec-­‐13
Mar-­‐14
Jun-­‐14
Sep-­‐14
PMI
Composite
PMI
Manufacturing
PMI
Services
Index
Source: Bloomberg
Figure M: Ireland and Spain Have Benefitted from Transparency, Average Price-To-Book Ratio of their Lead Bank
Source: Arbuthnot, Bloomberg
Fewer and fewer new loans are becoming non-performing, which is good news – however, the inventory of existing
NPLs on banks’ balance sheets is too large to be ignored. An active NPL market offers an alternative to lengthy
bankruptcy and provides capital injections, thus reducing dependence on state finance. It rids the banking staff of
onerous management of troubled assets. Overall, to stimulate growth in Europe there is a need to enable banks to
allocate greater financial resources to support SMEs, the key players in the Italian economy. We believe that the
window of opportunity is now open for acquiring Italian NPLs, but will most likely close in the coming twelve months.
The authors of this report wish to acknowledge the contributions of Mr Jayant Yadav.

13. Italian Thematic – March 2015
13
Selected Bibliography
Alessi, M., Colli, S. D. & Lopez, S. J., 2014. Loan Loss Provisioning and Relationship Banking in Italy: Practises and
Empirical Evidence. Journal of Entrepreneurial and Organizational Diversity, 3(1), pp. 111–130.
Banca D’Italia, 2014 - July. The recent Asset quality review on non-performing loans conducted by the Bank of Italy,
Rome - Italy: Banca D’Italia.
Banca D’Italia, 2014 - May. Financial Stability Report - Number 1, Rome - Italy: Banca D’Italia Eurosystem.
Banca D’Italia, 2014 - November. Financial Stability report - Number 2, Rome - Italy: Banca D’Italia Eurosystem.
Barisitz, S., 2013. Nonperforming Loans in Western Europe – A Selective Comparison of Countries and National
Definitions. Focus On European Economic Integration, Q1.
Caselli, S., Chiarella, C., Gatti, S. & Gigante, G., 2013. The Capital Markets for Italian Companies: A Resource to
Relaunch the Country and Renew Growth, Italy: CAREFIN, Università Bocconi .
ECB Staff, 2014 - October. Aggregate report on the comprehensive assessment, Frankfurt, Germany: European
Central Bank - Eurosystem.
Gallo, A., Caselli, F. & Pagani, F., 2014. Situation Room Italia Reforms and Macroeconomic Performance. [Online]
Available at: http://lseitalians.co.uk/2014/11/14/situation-room-italia/
[Accessed December 2014].
IMF Staff, 2013 - September. Italy: Financial System Stability Assessment, Washington, D.C.: International Monetary
Fund.
IMF Staff, 2014 - September. Italy - 2014 Article IV Consultation, Washington, D.C.: International Monetary fund.
IMF Staff, 2014 - September. Italy - Selected issues, Washington D.C.: International Monetary Fund.
IMF Staff, 2014. Italy - 2014 Article IV Consultation, Washington, D.C.: International Monetary Fund.
IMF, 2013. Italy: Financial System Stability Assessment, Washington, D.C.: International Monetary Fund.
Muller, P., Gagliardi, D., Caliandro, C. B. N. U. & Klitou, D., 2014 - July. A Partial and Fragile Recovery: Annual Report
on European SMEs 2013/2014, s.l.: European Commission.
Rachael Sanderson, 2014. Italian finance: Time to modernise. Financial Times, 4th March.
Richard Thompson, 2014. European Portfolio Advisory Group Market update (9 months 2014), London: PwC.
Vincenzo, A. D. & Ricotti, G., 2014. The use of tax law from a macroprudential perspective: the impact of some recent
tax measures on procyclicality and banks’ stability. Banca D’Italia - Notes on Financial Stability and Supervision,
April.

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