LONDON, Dec 31 (IFR) - The Italian banking sector is entering 2014 on shaky ground with concerns growing that it will no longer be able to hide from weak profitability and rising bad loans - the same flaws that brought Spanish banks to their knees in the financial crisis.
The increased anxiety comes ahead of the European Central Bank's asset-quality review (AQR), which some analysts fear will reveal a large capital hole at some of country's second tier banks even though the Bank of Italy has been pushing them to clean up their act in recent months.
Although an unprecedented number are under special administration, the fear is that the after-effect of a painful recession, most acutely felt in the SME sector, is still being vastly underestimated.
The percentage of non-performing loans has been mounting - up nearly 8% since 2007 and rising according to a September IMF report - and could be even higher.
"Italian banks are suspected of "evergreening", whereby they keep rolling loans over so that they don't have to recognise a loss and can effectively hide them," said Maxime Alimi, economist euro area at AXA IM.
"The Bank of Italy says it has been very defensive and conservative but the market has yet to be convinced."
While the ECB health checks will only look at 15 of Italy's biggest banks, the concern is that this will only be scratching the surface of a much bigger problem given the country's 706 banks which are generally unlisted and owned by foundations which are not focused on profitability.
Spanish banks were also widely suspected of using refinancing and roll-overs to cover up non-performing loans, particularly loans to small companies.
Italian banks were shunned by investors during the crisis because of the government's poor financial management and dysfunctional political system during the crisis.
However, poor corporate governance, a lack of internal accountability, transparency and trust are now being added to the list of ailments and the problem is shifting from being a sovereign one to a banking one.
"By definition, we don't know what's going on at a lot of these institutions so while there is more to come out, how much is impossible to say," said John Raymond, FIG analyst at CreditSights.
Carlo Mareels, analyst at RBC, said that while banks had set aside some provisioning for bad loans and had extra collateral on these loans, the AQR and stress tests could put an even lower valuation on the liabilities, thereby requiring banks to make more provisionings.
"This is a preoccupation," he said. "This is where you could draw a parallel with what happened in Spain and while we think the bigger banks have enough capital, it is hard to anticipate what the AQR might bring up."
The big worry is that many smaller Italian banks, which are already struggling to shore up capital, will be unable to fix their balance sheets.
Banca Etruria, for example, is seeking to merge with another lender, while Banca Marche and Banca Carige are among the banks looking for capital but are being shunned. .
Meanwhile, Moody's took Mediocredito Trentino-Alto Adige and Banca Sella deeper into sub-investment grade territory in the middle of December to Ba3 and Ba2 respectively from their standalone Ba1 ratings, citing deteriorating asset quality and profitability.
This has eerie echoes with Spain where trouble was brewing for years in what were perceived to be conservative institutions, only to see the relatively unknown Caja Castilla La Mancha being bailed out in 2009.
"We saw in the case of Spain that the failure of one small bank can become a systemic issue if others follow. This could potentially be the case for Italy," said Alimi.
Roberto Henriques, financials analyst at JP Morgan, agreed.
"Even in a scenario where a small institution is resolved or has to undertake burden-sharing, the resulting negative sentiment may become a negative overhang and make it more challenging for other mid-tier banks to raise capital."
The chance of a domestic white knight coming to the rescue of a failing bank also looks slim. That's partly because banks are still deleveraging, but also because no-one wants to run the risk of bringing assets of dubious quality onto the balance sheet, he said.
Without a willing acquirer and no other solutions, bondholders' burden sharing could be on the cards in Italy.
When Spanish banks were taken over by the FROB, they had the flexibility to conduct liability management exercises to create capital in the absence of a formal resolution framework.
But in an effort to limit the burden on taxpayers, this has all changed and Italian banks are unlikely to have as much leeway.
"The fact that there will be a European-wide resolution framework from January 2015 could be an issue for bondholders," said Henriques.
Having said that, some analysts argue that Italy, unlike Spain, can rely more heavily on liquidity available from the ECB.
Italian banks' recourse to the Eurosystem has fallen since May, but it is still very high at EUR232bn, according to the Bank of Italy Financial stability report published in November.
And with the ECB focused on the 15 bigger banks, this might buy enough time for the smaller banks to turn things around just as the economic cycle finally appears to be picking up.
"What happens in the next few months is crucial. The banks' fate rest on the economy and if we see an improvement in the backdrop, banks might be able to stabilise," said Henry MacNevin, associate managing director at Moody's for banking. He added however that Moody's viewed the Italian banking system as among the weakest banking systems in Europe. (Reporting by Helene Durand, IFR Markets; Editing by Natalie Harrison and Luzette Strauss)