Italian banking-foundations-2014-02-05-1


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Poche settimane fa, quando Alessandro Profumo ebbe a dire che l’opposizione della fondazione capeggiata dalla Mansi all’aumento immediato di capitale del Monte dei Paschi di Siena poteva avere conseguenze sulla stabilità di Mps e di riflesso su quella del sistema bancario italiano, andò incontro alla censura di Giuseppe Guzzetti, presidente del cartello delle fondazioni italiane. Definì l’affermazione di Profumo “avventata e destituita di ogni fondamento” . Ma da che pulpito veniva la predica? Guzzetti ha sempre sostenuto di essere un esperto di fondazioni e non di banche. Che cosa ci capisce allora di stabilità finanziaria e di corsa agli sportelli? O forse pensava che bastasse la sua parola per infondere fiducia nei correntisti del Monte dei Paschi? Non gli ha sfiorato la mente il pensiero che, proprio perché non è un esperto, potesse invece finire per spaventare i suoi interlocutori con rassicurazioni di facciata, per intenderci alla Schettino sulla plancia della Concordia?

Il caso Monte dei Paschi chiama in causa, ancora una volta, il ruolo delle fondazioni, istituzioni non profit grandi azioniste degli istituti di credito. Farebbero meglio il loro mestiere se non si occupassero di banche. Qui sono raccolti i nostri recenti interventi sul tema.

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Italian banking-foundations-2014-02-05-1

  1. 1. Italian Banking Foundations 05 February 2014 Italian Reforms Stakes for CoCos: killing 3 birds with 1 stone Andrea Filtri Equity Analyst +44 203 0369 571 2010-12 confirming the un-sustainability of the current model In Re-Foundation, 28 May 2012, we concluded that the crisis broke the symbiotic relationship between Foundations and banks, making it financially unsustainable. The latter required capital injections and reduced dividends, forcing the former to cut grants and distribute reserves. Updating our study for 2011-12 we reconfirm our diagnosis as events evolved more negatively than we had predicted. Asset value and grants are down 16% and 30% vs 2010, respectively, and cash flow has been negative for 4 consecutive years. Taking banks‟ consensus DPS and keeping other income sources stable, we calculate grants should fall by 39% to preserve capital levels. Antonio Guglielmi Equity Analyst +44 203 0369 570 1998 Parliament’s debate identified the risks but the law left some issues unresolved Digging in Parliament‟s archives, we retrace the debate which led to the Ciampi law which provided the Foundations‟ legal framework. The crux of the fight was on the powers of the regulatory authority (yet to be implemented), on forcing portfolio diversification, the disposal of bank stakes and outsourcing investment management. This confirms to us: a) MPs had already identified the crucial factors/risks of the new framework and; b) that the matters discussed are still very relevant today, suggesting the current law did not address all issues. Andrea Carzana Equity Analyst +44 203 0369 576 IMF, ECB and Italian Treasury all pointing to a reform of Banking Foundations MPS, Carige, Banca Marche, CariFerrara, Tercas, BP Spoleto, Veneto Banca, Banca Cividale. These are only some of the many banks under special supervision as the surge in bad debts is jeopardising capital adequacy. They jointly hold over €300bn of assets or c.7% of industry‟s total stock; a potential systemic issue. Their peculiar governance is representing an obstacle for their recapitalisation. The issue is known abroad: Mario Draghi (ECB chairman), the IMF, Bank of Italy and the Finance Minister called for a reform of Foundations. The latter is reported to support a reform of the Foundations‟ law mandating portfolio diversification, prohibiting leverage and control of a bank and investing in hedge funds and derivatives. Converting equity stakes into CoCos: the transition towards full diversification Foundations‟ investments need to generate stable and growing cash flows to fund grants. In ReFoundation we showed that bank stakes provided sub-optimal risk-adjusted returns vs a variety of alternatives, suggesting change is due. We acknowledge the difficulty for Foundations to abandon banks while these are still troubled and have depressed valuations. At the same time, Foundations are under pressure to return to giving more grants. We propose a transitory solution towards portfolio diversification: converting the Foundations‟ stakes into bank CoCos would: a) increase the visibility of investment yield while; b) upgrading the governance of the Foundationbank model; c) leaving banks‟ capital adequacy unchanged. This is feasible as in Dec-13, Parliament allowed tax deductibility of CoCo coupons for banks. Win-Win-Win: EPS +14-30%, RoTE up 2-5 p.p., from buybacks below TE We see the CoCo for equity swap as a positive evolution for all stakeholders. While it is neutral to bailout risk, Foundations gain higher and visible yield (c.8.3%), banks gain on governance and profitability and minority shareholders gain EPS and DPS accretion. We simulate the operation on ISP and UCG, where Foundations own, on aggregate, 28% and 11% of ordinary shares. We calculate this would lead to: a) 14% EPS and 5 p.p. RoTE boost at ISP and 30% EPS and 2 p.p. RoTE hike at UCG, b) 1 p.p. higher div. yield, c) 3% investment yield premium for Foundations. The positive outcomes for all stakeholders derive from the below-BV valuation of shares allowing the accretive impact of the share buyback to more than compensate the earnings dilution from higher interest costs of CoCos. Higher valuations could provide less appealing financials, implying there is a window of opportunity to carry the swap out today, in our view. Had Foundations held CoCos since 2001, they would have made €22bn extra profits after costs and grants; 50% and 140% boost to the current total capital and 2001-12 cumulative grants. The deal would gear up bank balance sheets by 0.6-2 p.p. to 3.3-4.5% TE/TA, in line with EU retail peers and with no implications from bail-in regulation, hence at no compromise to the risk profile. CoCo for equity swap simulation ISP UCG 28% 11% 13,820 6,885 8.33% 8.33% -18% -10% 3,297 3,490 2015e EPS change, % 14% 30% RoTE points change 5% 2% 2015e DPS change (unchanged payout) 23% 19% 1.2% 0.7% Foundations holding Buyback/CoCo, Eur m Coupon, % Impact to 2015e adj. profits Shares cancellation (m) Yield change, % IMPORTANT DISCLOSURE FOR U.S. INVESTORS: This document is prepared by Mediobanca Securities, the equity research department of Mediobanca S.p.A. (parent company of Mediobanca Securities USA LLC (“MBUSA”)) and it is distributed in the United States by MBUSA which accepts responsibility for its content. The research analyst(s) named on this report are not registered / qualified as research analysts with Finra. Any US person receiving this document and wishing to effect transactions in any securities discussed herein should do so with MBUSA, not Mediobanca S.p.A.. Please refer to the last pages of this document for important disclaimers.
  2. 2. Italian Banking Foundations Contents Confirming the diagnosis 3 A very actual, old debate 14 Pressure (to reform) is all around 20 CoCo: transit to portfolio diversification 24 Buyback neutral to capital ratios 27 Appendix 32 IMPORTANT DISCLOSURE FOR U.S. INVESTORS: This document is prepared by Mediobanca Securities, the equity research department of Mediobanca S.p.A. (parent company of Mediobanca Securities USA LLC (“MBUSA”)) and it is distributed in the United States by MBUSA which accepts responsibility for its content. The research analyst(s) named on this report are not registered / qualified as research analysts with Finra. Any US person receiving this document and wishing to effect transactions in any securities discussed herein should do so with MBUSA, not Mediobanca S.p.A.. Please refer to the last pages of this document for important disclaimers.
  3. 3. Italian Banking Foundations Confirming the diagnosis In Re-Foundation, 28 May 2012, we highlighted how Italian Banking Foundations needed to change to earn sustainable investment returns to fund their grants. In essence, we concluded that the Foundations-Banks model - based on stable, concentrated equity shareholdings in banks, in exchange for high dividends to fund grants - was no longer sustainable. We suggested Foundations should diversify investment portfolios by selling the banks’ shares. Our analysis based on data up to 2010. Two years on, little has changed. On aggregate, the main Foundations’ assets (excl. MPS) have fallen a further 16% (50% due to the bank exposure), with grants down 30% 2010-12 and implying 30% real contraction vs 2001. From 2009, underlying cash flows turned negative, denting 4% of Foundations’ assets. 2011-12 reported figures came below our projections made two years ago. Taking BBG consensus on banks’s DPS and holding other income constant, we calculate Foundations should cut grants by 39% to preserve capital. This confirms our thesis of unsustainability of the current model and the need to diversify investment portfolios to recover higher and more stable profitability. Retracing our own footsteps Fair value/mark to market convergence implies fair representation of reality In our previous report Re-Foundation, published on May 28th 2012, we have broadly explained how the absence of uniform FV/MTM principle has allowed Italian Banking Foundations (Foundations) to smoothen results out in the past. We recall that for several years Foundation‟s profits did not reflect the economic change in the value of the portfolio. Rather, they derived from the adoption of different accounting principles for the different types of investments and for the various investment operations. In general, annual profits embed all realised cash flows, regardless of what investment generated them. So, all dividends/coupons received from any investment will enter the annual profit and will contribute to the grant pool. As for the recognition of deltas in mark to market (MTM), these will only translate in the P&L if the Foundation realises this through active buying/selling. By their nature, strategic stakes, composing the majority of Foundations‟ portfolios are hardly traded. This implies that for the purpose of their activity, Foundations consider the bank holding as a perpetuity, mostly focussing on the dividend yield generated rather than looking at the short term fluctuations in share price. To put it simply, a strong appreciation in share price would not translate in any extra revenues (unless shares were sold). The same principle will hold for other investments, with the exception of diversified investments which carry no intangible value as strategic stakes do, and will therefore be more actively traded. This has two main implications for Foundations: a) unrealised capital gains/losses have been used to smoothen annual grant pools. b) de-touching of accounting from reality has led Foundations to over/under spend. As a consequence of the two implications above, capital resources of Foundations have been overstated for a number of years. However, the divergence between reported and real value of capital is now really thin as the two have converged. Chart 1 shows the evolution of the total Foundations‟ capital from 2000 to 2012 compared to the equivalent amount classified according to MTM principles. Over the 20052012 period, Foundations carried latent gains on their investments which progressively realigned to their accounting values as markets retraced in recent years. The discrepancy between the two methods reached a peak €31bn spread in 2006, i.e. 65% above the reported €47bn capital. This positive gap progressively shrunk in the following years to almost 0% in 2011 and 4% in 2012. We can therefore conclude that taking reported values is now a good starting point, as it closely reflects the reality Foundations are facing in 2012. 05 February 2014 ◆ 3
  4. 4. Italian Banking Foundations Chart 1 - Foundations asset: MTM vs accounting value, Eur bn (MTM-reported)/reported, % (rhs) Asset book value (€, bn) Asset mark to market value (€, bn) 90 0.70 80 0.60 70 0.50 60 50 0.40 40 0.30 30 0.20 20 0.10 10 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: ACRI, Mediobanca Securities 2012 grants back to 2001 levels: 30% real contraction; -30% nominal one vs 2010... Chart 2 shows the evolution of the cumulative Foundations‟ grants from 2001 to 2012. As we commented in our report “Re-Foundation” published in May 2012, up until 2007, Foundations have been able to satisfying the growing demands from their communities through the continuous growth of grants. Indeed, grants rose by c.70% 2001-07, from €953 to €1.624. However, in 2008, financial crisis hit banks and their ability to pay dividends, ultimately impacting Foundations‟ cash flows and ability to fuel grants. In the 2007-10 period, grants were down 18%. The contraction endured more than proportionately, with 43% contraction 2007 to 2012 and 30% 2010-12. This implies in 2012 Foundations are back to the grant levels of 12 years before, a 30% real contraction. The contractions have been already amply cushioned by the heavy use of reserves (stabilisation fund) by Foundations, suggesting the underlying drops would have otherwise been much more severe. Chart 2 - Total grants per year (€M) 1700 Grats 1624 Gran ts/ MTM cap ital 1600 3.5% 1624 3.0% 1500 2.5% 1432 1400 1333 1.5% 1232 1200 1170 1.0% 1100 1000 2.0% 1324 1300 1069 1044 953 929 949 900 0.5% 0.0% 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: Mediobanca Securities, ACRI 05 February 2014 ◆ 4
  5. 5. Italian Banking Foundations …as Foundations keep holding tight on ‘their’ banks... The free fall of grants, which has reached the lowest level in twelve years, has once again demonstrated our thesis of unsustainability of the Bank-Foundation model. Despite this, by looking at how the relationship Bank-Foundation has developed in the past two years, little has changed. Indeed, we notice that, after twenty years from the first reform, Foundations still have a firm grip to „their‟ original banks. Chart 3 shows the distribution of the 88 Foundations in 2010 and in 2012:  15% is still over 50% control in 2012, vs. 17% in 2010;  31% is above the 20% stakeholding in 2012, vs. 40% in 2010;  50% is above the 5% stakeholding in 2012, vs. 56% in 2010;  25% has no stake in the saving banks in 2012, vs 20% in 2010. The small decrease in the banks‟ stakes owned by Foundations is not the consequence of the active selling of shares, but is mostly due to the dilution suffered in the banks‟ capital increases of 2011 and 2012 (UCG, ISP, PMI, UBI, Banco Popolare, MPS) imposed by the lack of free resources. Chart 3 - Foundation’s stake into saving bank, 2010 (lhs) and 2012 (rhs) Foundation with > 50% stake of the saving bank Foundation with > 50% stake of the saving bank Foundation with no stake of the saving bank 15 20 18 14 21 Foundation with <5% stake of the saving bank Foundation with stake of the saving bank between 5% and 20% Foundation with no stake of the saving bank 13 14 17 22 22 Foundation with <5% stake of the saving bank Foundation with stake of the saving bank between 5% and 20% Foundation with stake of the saving bank between 20% and 50% Foundation with stake of the saving bank between 20% and 50% Source: ACRI …while on the other side, banks’ dependence on Foundations keeps on falling Chart 4 shows the evolution of the capital of all Italian banks (light blue) and Foundations (dark blue) and the incidence of the latter on the former. For Foundation-originated banks, the idea underlying is that initially the two were one and the same; as time went by and banks emancipated and grew, the two factors diverged. As we are using the total capital of all Italian banks, this includes the one of Popolari, cooperative and private banks which did not originate from a Foundation. Nevertheless, given the relative size of Foundation-originated banks, we believe the relative evolution of the two factors still has some relevance for our analysis. The chart confirms this intuition, showing:  High initial ratio – a decade ago, Foundations‟ capital stood at 1/3 of bank‟s capital, a high ratio in relative and absolute terms suggesting, in our view, the relatively low degree of emancipation of the banking sector at the time.  Banks lapping Foundations – from 2000 to 2012 banks have increased their capital by 98% (92% from 2000 to 2010) and Foundations by only 19% (42% from 2000 to 2010). The difference in Foundations‟ capital growth rate between 2000-10 and 2000-12 suggests that in the last two years of our analyses Foundations have eroded a relevant part of their capital, precisely 16% of €50bn 2010 capital. 05 February 2014 ◆ 5
  6. 6. Italian Banking Foundations  Foreign acquisitions and crisis-driven rights issues diluting the link – we note significant upward steps in the growth of banks capital, particularly in 2005 and 2011, and relatively smoother growth for Foundations. Apart from the scale of the chart, the reason is that in 2005 UCG‟s acquisition of HVB brought the bank‟s capital within the „perimeter‟, while in 2009 and 2011 the banks‟ rights issues attracted new resources. In the latter case, while banks reinforce capital, Foundations increase their equity and market risks in their portfolios. Unless bank share prices significantly re-rate, the consequence of such operations is a strengthening of banks‟ capital and the increase in risk of Foundation‟s portfolios. Chart 4 - Bank’s capital vs. Foundation’s capital (€bn) Italian Ban ks Capital Fo u ndations capital Fo u ndations capital/Bank capital (rh s) 300 35% 250 30% 25% 200 20% 150 15% 100 10% 50 5% - 0% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: ACRI, Bank of Italy Falling revenues and profits erode profitability Chart 5 plots the evolution of the revenues on the Foundations‟ total assets and of the return on assets (ROA) versus their respective adjusted versions (lhs) and the difference in the evolution of revenue and profit margins reported and adjusted. Adjusted factors account for recurring items only (core revenues: dividends, interest, pure trading profit; and core profits: core revenues minus core costs and taxes) and for the market value of total assets (as opposed to reported assets). We note:  Returns and profitability keep falling, 2011 the worst year – over the last twelve years, Foundations reported average revenues/assets and profits/assets of 5.2% and 4.5%, respectively. This result shows a deterioration in the last two years. Indeed, in the decade 2001-10 Foundations registered average revenue/assets of 5.6% and profits/assets of 5.1%. By contrast, in the period 2011-12 the two profitability indicators collapsed to 3.1% and 1.3%, respectively.  Profits falling more than revenues – on the right hand side of the following chart, we show how the gap between returns and profits has widened for Foundations, multiplying by 5-6 times in the last decade. This indicates that initially, returns from investments would largely feed down to profits. The increase can theoretically be due to: a) growing costs denting profitability, b) increasing provisions, c) increasing taxes. We exclude the latter option as Foundations operate in a quasi-tax free regime. Years of banks‟ extra dividends and years of particularly tough returns could require special provisions to be put on the side and released to smoothen bottom line. Finally, higher cost absorption would impair profitability explaining the delta. 05 February 2014 ◆ 6
  7. 7. Italian Banking Foundations  Average ROA 2009-12 at 2.6%, more than half the 2001-08 return of 5.4% - The average return on asset Foundations generated in the 2001-08 period stood at 5.4%, more than twice the 2.6% ROA generated in the following 4 years. The picture looks even more gloomy when calculated using adjusted figures. Chart 5 - Revenues and ROA over assets vs adjusted figures,% - revs/assets-ROA vs adj. equivalent, % 9% 8% 7% 1.8% Revs/assets Revs/assets adj ROA ROA adj revs/assets - ROA (revs/assets - ROA) adj 1.6% 1.4% 1.2% 6% 1.0% 5% 0.8% 4% 0.6% 3% 0.4% 2% 0.2% 1% 0.0% 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: Mediobanca Securities, ACRI Statutory bodies’ costs constrained, but total costs rising to 12% of annual grants Chart 6 shows the incidence of statutory bodies (dotted line) costs and total costs (blue line) of Foundations on grants. Statutory bodies costs on Foundations‟ activity on average stood at 1.7% for the 2003-12 period. This grew to 1.8-1.9% in 2011-12, signaling statutory bodies have constrained their remuneration with the falling grants. Running the same analysis on total costs, we find instead that these marked a 10.8% average incidence over the 2003-12 period, but showed an increase to 14-18% of grants in 2011-12, implying lower flexibility to contain costs in periods of low grant availability. Chart 6 - Statutory bodies and total cost over grants 2001-2012 19% 2.0% 1.9% 17% 1.8% 15% 1.7% 13% 1.6% 1.5% 11% 1.4% 9% 1.3% 1.2% 7% To tal co st/ Grants (lhs) Statuto ry bo dies/ Grants (rhs) 5% 1.1% 1.0% 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: Mediobanca Securities, ACRI Negative cash flows since 2009 eroding stability funds and capital Chart 7 below shows our top-down analysis of sustainability of the Foundations‟ system. We aim at identifying how core profits (real cash, tangible flows made of dividends, interest on investments 05 February 2014 ◆ 7
  8. 8. Italian Banking Foundations and trading profits, hence excluding cosmetic operations of sell and buyback ad other profit management operations) compare to reported profits and to grants approved (cash outflows). Looking at Chart 7 and comparing it with Re-foundation, in which we covered the time period 20012010, we note:  €7.3bn over representation of cash flow in 2001-12, only +€0.3bn vs 2001-10 Over the last 12 years, only in 2008 and 2011 reported profits undershot core profit. In every other year, reported profits overshot resources available to spend. On the rhs chart below we show in dark blue the annual spread between the two factors. We estimate €7.3bn from 2001 to 2012, up only €0.3bn in 2011-12.  Falling approved grants and increasing volatility – Grants approved have decreased in the two-year period 2010-12 lowering the 2001-12 average at €1.22bn vs. €1.27 in 2001-10. In addition, the volatility of grants approved has increased by 1% in the last two years increasing the 2001-12 standard deviation/mean ratio to 20% vs. 19% in the period 2001-10.  Negative net cash flow since 2009 – In the right hand side chart we show in light blue the spread between core profits and grants approved. Since 2009, when banks started to cut dividends, the net cash flow has gone negative and it has remained so in the following years. We calculate €0.7bn cumulative positive cash flow in 2001-12, half of what we have calculated during the period 2001-10 (€1.5bn), and corresponding to 2% of the initial €36bn total endowment of 2001. The picture is worse if we make the same analysis over the period 2010-12. Since the cash flow has gone negative for the first time, Foundations generated a cumulative negative cash flow of €2.1bn which translates in a 4% erosion of the €49.4bn total endowment of 2009. Finally, 2011 and 2012 generated average annual negative cash flows of €400m, comparing to +€361m in 2001-08 and €154m in 2001-10. Chart 7 – Core profits vs reported profits and grants approved Core profits-grants approved Core profits Grants approved (€ m) - 0.0% 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 -1,000 878 1,196 482 835 -296 -200 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: Mediobanca Securities, ACRI Insufficient diversification dented the real value of endowments by 43 p.p in 12 years... The lhs side of Chart 8 shows the comparison of cumulative performance of Foundations‟ comprehensive value of capital vs the major asset classes, rebased to 2000. Over the twelve years, the MTM value of Foundations‟ assets was down c.25% v.s 7% underperformance in the decade 200010 (2000-04 and 2011-12 estimated by MB, 2005-10 using the value provided by ACRI). By contrast, Italian inflation was up 37 p.p., government bonds and R.E. 140 p.p., commodities 290 p.p.. We believe the evolution of Foundations‟ asset values suggests a split in three segments: 1. -504 0.5% -767 -500 -532 1.0% 500 575 - 1.5% -578 2.0% 1,000 -109 1,500 77 500 2.5% 110 3.0% 2,000 1,000 364 221 3.5% 702 4.0% 2,500 849 1,500 164 4.5% 3,000 1,253 5.0% 1,415 2,000 3,500 822 917 Reported profit (€ m) Reported - core profits 161 Core profit/ MTM capital (rhs) Eur m 2000-05: equity and govies – Foundations performance is the average of the performance of equity and government bonds, suggesting a balanced exposure to the two asset classes, in our view. 05 February 2014 ◆ 8
  9. 9. Italian Banking Foundations 2. 2006-10: banks underperformance realign Foundations to equity – with the advent of the financial crisis, the high exposure to the banking industry prevailed, with Foundations asset value converging to the equities performance and underperforming it as banks lagged behind other sectors. 3. 2010-12: low diversification led to underperformance vs. global equities – with the improvement of global financial stability following the central banks‟ interventions, global equities experienced a relief rally, which however, has only partially benefitted banks. As shown in the rhs of Chart 8, Italian saving banks have underperformed the MS Global Equity Index by c.50%. Given their high equity concentration of Italian banks in their portfolios, Foundations partly missed the global equity rally. From the above, we conclude that Foundations have not been able to keep to the mandate of the law: a. Real value destruction - overall Foundations have dented the real value of their assets, underperforming the inflation rate by almost 43 p.p.. Only in 2006 and 2007, at the peak of the financial bubble benefitting bank prices, Foundations showed a positive cumulative performance vs Italian inflation. This betrays the law‟s goal of real value preservation. b. Lack of diversification – the high correlation of Foundations‟ returns with equities and the underperformance vs this riskier asset class during the financial crisis confirms Foundations maintained a high overall portfolio concentration in the banks. This is the main factor entailing the poor cumulative performance of Foundations and the high volatility of returns, in our view. Chart 8 - Returns comparison: Foundations vs asset classes– MS World Equity Index vs. ITA banks (2000=100) 325 Cmmdty 300 275 Govies 250 Equity ITA banks 160 140 120 225 R.E. 200 175 100 80 IT infl 150 125 Equity 100 60 40 20 75 Foundations 50 - 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: Mediobanca Securities, ACRI * equity: MS World index ...coupled with highly volatile investment returns Chart 9 shows the year on year evolution of the MB performance indicator aggregated for the five largest Foundations (Cariplo, CSP, CRT, CRV, CRP) from 2002-12. From 2002 to 2007 Foundations experienced growth in their MB performance indicator (see Appendix): 2008 has been the year of rupture with an average 30% real value destruction. 2009 and the temporary euphoria of the national bailout of banks partially recovered the previous year‟s tragedy, but 2010 and 2011 reiterated the 2008 issue. 2012 has returned a better MB performance indicator, practically flat (-0.4%). This shows how volatile Foundations‟ investment performance has been over a decade. 05 February 2014 ◆ 9
  10. 10. Italian Banking Foundations Chart 9 – Evolution of the MB performance indicator*, 2002-12, % aggregate level 30% 20% 10% 0% -10% -20% -30% 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: Mediobanca Securities, company data * see appendix Bank stakes main culprit for Foundations’ loss in investments’ worth In this analysis we estimate the split of the annual evolution of market value of investments of Foundations between the bank stake, the net cash flow generated (revenues – costs – grants - taxes) and the other investments. We adopt the following methodology: 1. We start from the first available market value of investments provided by the five largest Foundations; 2. We then calculate the delta market value generated in each year as the sum of the delta market values generated by the bank stakes and by other investments, plus the earnings retention (net cash flow=NCF); 3. We then attribute performance to the different factors as follows:  We either take the reported change in value of the bank stake or we estimate the average yearly holding of shares in the bank by dividing the Foundation‟s reported market value of the bank stake by the average bank‟s share price;  We then apply the performance of the bank‟s share price in year t to the average number of shares held and compare it to the same value in year t-1 to obtain the performance contribution from the exposure to the bank; We estimate the performance generated or lost by other investments by subtracting to the overall delta in market value the performance generated by the saving bank and the NCF. We summarise the aggregate results as follows:   16% value destruction in 2011-12, half due to the banks stakes – we calculate the aggregate MTM value fell by €3.7bn over 2011-12, for 18% fall on 2010 (-16% on reported figures). A half of this is attributable to the banks‟ stakes, c.10% to negative cash flow and 40% to the evolution of other investments;  Bank stakes lost €8bn value since 2001, €1.9bn in the last two years...: the evolution of the value of the cumulative bank stakes is in the light blue bars in Chart 10. We calculate that cumulatively, the bank exposure meant €8bn loss in value for Foundations, i.e. 35% of the €23bn market value of all investments in 2001YE. 2008 was the year of collapse, with €9.6bn cumulative losses, aggravated by the increase in the concentration of portfolios towards these assets through the capital increases launched by banks in the period.  other investments and NCF only compensated 23% of the bank value destruction: The dark blue bars show the evolution in performance of non-bank investments. We calculate a 05 February 2014 ◆ 10
  11. 11. Italian Banking Foundations cumulative gain of €0.6bn over the period 2001-12 vs €2bn over the 2001-10 period. This sharp collapse has happened in 2011 where total other investments generated a loss of €1.3bn. Given this negative performance in 2011, non-bank investments have offset only 8% of the losses taken through the bank exposure, vs. 25% offset during the period 2001-10. Accounting also for the retained NCF, total offset of bank exposure amount to 23%, well below the 55% level reached during the period 2001-10. We note a weak correlation between the bank stake and other investments, implying other investments not only did not offset the bank stake fluctuations, but partially magnified their impact to the fluctuation of overall investments‟ worth.  2001-06 banks up €3.4bn, other investments up €5.8bn: we calculate that in the precrisis period, banks generated cumulative performance for €3.4bn, i.e. 16% of the 2001 cumulative initial market value for Foundations; similarly, other investments grew by €5.8bn.  2007-12 banks down €11bn, other investments down €5bn: the period 2007-12 saw value destruction for €11bn on the banks stakes and €5bn for other investments, with a total loss of €16bn, i.e. 47% of the peak aggregate market value of investments reached at the end of 2006. The relative magnitude of losses reflects the risk concentration of Foundations on banks during the crisis – increased through rights issues - and the sector specific issues banks suffered from, in our view. Chart 10 – Foundations’ aggregate market value evolution: banks vs other investments 41,000 €m Marke t valu e 36,000 Savin g Ban k 31,000 Oth e r In ve stments 26,000 21,000 6,000 17,142 11,000 23,284 16,000 Mkt value Bank NCF Other Bank NCF Other Bank NCF Other Bank NCF Other Bank NCF Other Bank NCF Other Bank NCF Other Bank NCF Other Bank NCF Other Bank NCF Other Bank NCF Other Mkt value 1,000 01 02 03 04 05 06 07 08 09 10 11 12 Source: Mediobanca Securities, company data 05 February 2014 ◆ 11
  12. 12. Italian Banking Foundations Radical change is still needed Replaying the simulation... We learnt above that the Foundations‟ investment did not preserve their value in real terms over the last decade, with a further deterioration in 2011-12. This confirms our conclusions on Foundations‟ investments of Re-foundation. There, we estimated the alternative evolution of Foundations‟ investments worth under three hypothetical scenarios of evolution of banks‟ dividend streams. We showed the difficulty for Foundations to protect their assets with the status quo of investments. After two years, we re-run the same analysis to verify how reality has unfolded vs our three hypothetical scenarios depicted two years ago. We calculate the market value evolution under each DPS scenario by assuming: a. flat evolution of non-DPS revenues vs 2010 values; b. constant grants (those paid in 2010, therefore discounting a progressive fall in real grants, after inflation) and compensating for the zero growth assumption on non-bank dividends; c. 3% increase in annual operational costs. On bank dividends, we contemplate the following three scenarios:  Flat dividend: this scenario assumed banks would keep on paying annual dividends in line with those of 2010.  Consensus dividend: the dividend projection was based on the consensus estimates for the 2012-15 DPS. Later years assumed a 5% annual growth for the following two years and 3% annual growth thereafter. This scenario resembled the slow recovery trajectory, in our view.  Bull market: the „bull market‟ option was admittedly optimistic. We supposed banks would revert to the golden years, when they paid high dividends to shareholders. This scenario contemplated 2012 revenues at Foundations equal to peak revenues generated by Foundations from 2005 to 2008. For later years, we projected 5% annual growth until 2015 and by 3% thereafter. This scenario implicitly assumed not only that banks would overcome macro obstacles to profitability, but also that they would offset the additional regulatory burdens that were progressively being introduced. Our exercise admittedly excluded boosts to the market value of Foundations‟ assets from price appreciation, and limited this to the „retained‟ portion of cashflows generated by the bank. Our goal was in fact not to predict the actual evolution of the Foundations‟ worth, but rather to see if, and under which circumstances, maintaining the asset allocation stale could support their statutory goals. ...2011-12 proved harsher than our most cautious scenario Chart 11 shows the projection in the evolution of the market value of Foundations we had shown in the “Re-foundation” report with the addition of: 1) 2011 and 2012 MTM value of Foundations capital; 2) The potential 2013-16 scenario using DPS Bloomberg consensus as a rollover of the previous „consensus‟ scenario. We highlight the following: 05 February 2014 ◆ 12
  13. 13. Italian Banking Foundations  2011 and 2012 went below our worst case scenario – the evolution of the aggregate MTM of Foundations‟ capital was below the 2010 level and it undershot the trajectory of the most cautious „flat dividend‟ scenario we depicted two years ago.  2013-16 trajectory to confirm the hard times – we re-run the consensus exercise of two years ago, updating it for the current market estimates on banks‟ DPS into 2016. The trajectory depicted is below the previous „dividend flat‟ scenario and would confirm a meagre cash inflow for Foundations going forwards.  Small dividends imply unsustainability of Foundations – the flat dividend scenario, representing a Japanese-style evolution for the European economy, projects a relentless fall in Foundations‟ worth into 2030 with a 2-3% annual loss in the absolute value of Foundations‟ investments. This marks the unsustainability of the current asset allocation of Foundations as the implications for Foundations‟ stakeholders would be either the full loss in the support they have been used to receive, or a marked fall in the annual grants to the local community, before the erosion of inflation.  39% decrease of grants in 2012-16 needed to preserve current capital level – We have calculated the dividend Foundations will receive from banks in the period 2013-16 by taking DPS Bloomberg consensus for the next four years. We maintained all the other source of income (trading income, interests, etc..) stable at the 2012 level and applied a 3% increase in annual operational costs. This scenario would imply Foundations would need to cut grants by 39% over 2013-16 to maintain their capital stable at the 2012 level. This analysis suggests that the current portfolios of Foundations are not granting the recovery in value of the assets, potentially putting at risk the financial sustainability or the one of future grants. This suggests a change on the investment portfolios is required to preserve the Foundations‟ role as primary actors in the country‟s private, national welfare and charitable sector, in our view. Chart 11 – Market value evolution from 3 bank DPS scenarios, 2001-30e 40,000 35,000 30,000 25,000 co n sensus 20,000 15,000 10,000 Mkt Val avg 01-12 co n se nsus dividend 5,000 flat divide n d bu ll divide n d 2030 2029 2028 2027 2026 2025 2024 2023 2022 2021 2020 2019 2018 2017 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 - 2016 2013-16 co n se nsus p Source: Mediobanca Securities, Bloomberg ACRI 05 February 2014 ◆ 13
  14. 14. Italian Banking Foundations A very actual, old debate Digging into the Parliament’s archive we found that in 1998 - at the time of the discussion of the Ciampi law on Foundations, which gave a definitive legal framework and a role to Foundations - MPs debated harshly before approving the law. The private nature of Foundations and their disposal of bank stakes was taken for granted. Much of the debate was about the powers of control and guidance of the regulatory authority and on whether there should be external monitoring and enforcement of portfolio diversification. Hot topics were: a) the forced or incentivised divestment of bank stakes and the deployment of the proceeds, b) the degree of independence in managing investments and the potential restrictions in certain investments types, c) the powers of a potential regulating authority. The Lower House bill was tougher on these matters, while the final agreement reflected a watered down compromise which included the institution of a regulatory body which is yet to be formed, leaving the Finance Ministry as the temporary, but still empowered authority of reference. We propose a summary of the two year long debate to confirm that the issues we treated in this and in previous notes are deep rooted, had already been identified in the debate 15 years ago and remain very actual. This suggests the law did not resolve all the issues identified, in our view. Ten years of legislative innovation behind today’s structure The transformation of the Italian banking sector happened through a series of progressive transformations of the legal framework regulating banks (see the table below). 1990 - Amato law: from public entities to joint stock companies - The privatisation of banking Foundations was initiated in 1990 by Giuliano Amato. The Amato reforms produced a separation of credit business from philanthropic activities. All banking business was spun off and passed to the Savings Banks, already established as profit-making companies involved in private commerce and regulated by the Civil Code and banking standards as applied to ordinary banks. The activities concerned with social, cultural, civil and economic development remained with the newly-created Foundations. The law conceived Foundations to be trustees for the capital raised from privatisations and required them to maintain majority ownership of the banks. 1994 – Dini directive: incentives to reduce control on banks – introduced law 474/94. This removed the requirement for Foundations to retain control of the banks and provided fiscal incentives to Foundations which would diversify their portfolios by selling down their stakes. 1998-99 – Ciampi law: removing the umbilical cord - Law no. 461/98 (a.k.a. the "Ciampi" law), together with decree, no. 153/99, required Foundations to relinquish any remaining control in their respective banks - an obligation still in force today except for Foundations which have net assets with a book value under €200m in 2002 or are located in special statute regions. The reform fully defined the juridical framework of Foundations, providing their specifications under civil and fiscal aspects. The decree also forbid Foundations from appointing their board members in the banks‟ boards and required them to have separate organs for their strategic, administrative and control functions. 2001 vs 2003 – A definitive identity for Foundations – In 2001, Giulio Tremonti, minister of Finance, sponsored law 448/01, which limited the private nature and the statutory autonomy of Foundations. These reacted by appealing to the Constitutional Court which in September 2003 reaffirmed Foundations as "private, legal entities having statutory and management autonomy" and as being "among the members of an organisation of a free society". 05 February 2014 ◆ 14
  15. 15. Italian Banking Foundations Year Operation 1990 1993 1994 1994 1996 1997 1998 1998 1998 1998 1998 1998 1999 1999 1999 1999 1999 Amato Law Privatization Dini Directive Privatization Privatization Privatization Ciampi Law Privatization M&A M&A M&A M&A Privatization Privatization M&A M&A M&A Banks 1999 M&A 2000 2001 2001 2001 2001 2003 2005 2006 2007 2007 2007 2008 2008 2008 2009 2009 2009 2009 2009 2010 M&A SPI & Banco di Napoli Tremonti law M&A SPI & Cardine M&A UCI & Rolo Banca 1473 M&A BdR Constitutional Court ruling 300 and 301 M&A UCI & HVB M&A SPI & BIN M&A ISP & Carifirenze M&A UCG & CAP M&A MPS & Biverbanca RI: €3bn 'cashes' UCG Shareholders UCG M&A MPS & Antonveneta Zero cash DPS UCG Zero cash DPS ISP €0.01 DPS MPS RI: €4bn UCG RI: €1.9bn T-bond MPS New mgt UCG 2010 New mgt 2010 New mgt 2011 2011 % sold Seller Buyer Name @ date Today IRI market CI Foundations involved Unicredit Credito Italiano 55% COMIT IMI San Paolo 1 51% IRI 7% Treasury 23% CSP market block trade market COMIT IMI IBST ISP ISP ISP CSP BNL Ambroveneto & Cariplo San Paolo & IMI Unicredito & Credito Italiano UCI & CRTS MPS Mediocredito Centrale BIN & COMIT UCI & CariTro MPS & BAM 62% market BNL Banca Intesa (BIN) Sanpaolo IMI (SPI) Unicredito Italiano (UCI) UCI BNP ISP ISP UCG UCG MPS Unicredit ISP UCG MPS Cariplo, CRPa CSP CRT, CRV, CM CRT, CRV, CM, CRTS MPS BDR Cariplo CRT, CRV, CM, CRTS, CRTRO MPS Banca di Roma (BdR) UCG CRR, BDS SPI ISP CSP SPI UCI Capitalia (CAP) ISP UCG UCG CSP, CRPR, CRB, CRVe, CRUP, CRGo CRT, CRV, CM, CRTS, CRTRO, CRMonte CRR, BDS,CRRE UniCredit (UCG) Intesa Sanpaolo (ISP) ISP UCG MPS UCG UCG MPS UCG UCG MPS UCG MPS UCG UCG ISP ISP UCG MPS UCG UCG MPS UCG UCG MPS UCG MPS UCG CRT, CRV, CM, CRTS, CRTRO, CRMonte CSP, CRPR, CRB, CRVe, CRUP, CRGo, CARIPLO CSP, CRPR, CRB, CRVe, CRUP, CRGo, CARIPLO, CRF CRT, CRV, CM, CRTS, CRTRO, CRMonte, CRR, BDS, CRRE MPS, CRBIVC CRT, CRV, CM, CRTS, CRTRO, CRMonte, CRR, BDS, CRRE CRT, CRV, CM, CRTS, CRTRO, CRMonte, CRR, BDS, CRRE MPS, CRBIVC CRT, CRV, CM, CRTS, CRTRO, CRMonte, CRR, BDS, CRRE CRT, CRV, CM, CRTS, CRTRO, CRMonte, CRR, BDS, CRRE MPS, CRBIVC CRT, CRV, CM, CRTS, CRTRO, CRMonte, CRR, BDS, CRRE MPS, CRBIVC CRT, CRV, CM, CRTS, CRTRO, CRMonte, CRR, BDS, CRRE ISP UCG UCG CRT, CRV, CM, CRTS, CRTRO, CRMonte, CRR, BDS, CRRE UCG UCG UCG CRT, CRV, CM, CRTS, CRTRO, CRMonte, CRR, BDS, CRRE RI: €5bn ISP ISP ISP CSP, CRPR, CRB, CRVe, CRUP, CRGo, CARIPLO, CRF RI: €2.1bn MPS MPS MPS Management/ Shareholders MPS, CRBIVC CR Roma 27% 100% Treasury CRTS Fondazione MPS Treasury CariTro Foundations BAM Mediocredito Centrale & Savings Banco di Napoli Cardine Foundations Cassamarca BIPOP-Carire CRBIVC Santander market Banca di Roma Banco di Roma BIN UCI Libyan authorities buy a stake Libya and Abu Dhabi buy stakes Piccini: Italy country head GM: Morelli for Micheli / Chairman mgt board: Beltratti for Salza CEO: Ghizzoni for Profumo * CSP= Compagnia di Sanpaolo, BDR= Banco di Roma, CRB= Cassa di Risparmio di Bologna, CRV= Cassa di Risparmio di Verona, CRVe= Cassa di Risparmio di Venezia, CRUP= Cassa di Risparmio di Udine e Perdenone, CRGo= Cassa di Risparmio di Gorizia, CRPa= CaRiParma, CRF=Ente Carifirenze, CM=Cassamarca, CRTS= Cassa di Risparmio di Trieste, CRTRO= Cassa di Risparmio di Trento e Rovereto, CRMonte=Carimonte, BDS= Banco di Sicilia, CRBIVC= Cassa di Risparmio Biella e Vercelli, IBST=Istituto Bancario Sanpaolo di Torino 05 February 2014 ◆ 15
  16. 16. Italian Banking Foundations Ciampi law to fill the ambiguity of the Foundations’ role The third legislative intervention in the process of definition of the Foundations‟ legal framework became necessary to fill the normative gap of the Amato law. As per MP on.le Cambursano: “it became evident that we were missing adequate instruments when, identified the no profit goal as the sole raion d‟etre... the Italian legislative context could not provide adequate support”. The Ciampi law defined Foundations as: legal entities of private nature, with full statutory and managerial autonomy, only pursuing goals of social utility, temporarily supervised by the Finance Ministry. This ended the dispute on the public nature of Foundations which was assigned in the constituting law of 1990. In presenting to the Banking Association (ABI) in 1996, the then Finance Minister, Ciampi said the Amato law separated banks from Foundations “but not completely dethatching two souls which has been cohabitating in a single institute”. He continued saying the Foundations-banks system required a second reform, the one on the “disposal from Foundations of bank shares, so to allow to both entities to become permanently autonomous, both free to pursue, according to their nature, their, very different, goals”. As Senator Debenedetti put it, Ciampi acknowledged that “the Amato law, solving one problem, shed light on others: firstly the one of ownership”. Two years of Parliamentary gestation On 12 February 1997 the then Finance Minister, Ciampi, presented a decree to reform the law regulating Foundations. The lower House started the debate in March of the next year, approving a draft on the 18th with 271 votes in favour, 212 against. On 12 May 1998 the bill then went to the Senate, which approved it with significant changes on 11 November 1998 with 148 votes in favour, 11 against and 5 abstained. The Lower House then approved the new bill from the Senate a few days later, converting into law on 23 December. Government proposal: investment principles, regulatory authority The governmental decree proposed that Foundations followed the principles of: 1) efficiency in the management of funds, 2) capital preservation, 3) generation of adequate returns through portfolio diversification. The decree also confirmed the institution of a regulatory authority with the power to verify the management of assets, the adequate profitability and the conformity with statutory goals. Also, the authority would authorise operations of concentration and transformation, could commission the managing bodies and even dissolve the entities in case of irregularities in the management. From a harsh contrast in the Lower House... The Lower House hosted a tough debate on the bill. There was wide agreement on the private nature of Foundations and on the progressive disposal of bank shares. The contrast between majority and opposition was more related to practicalities such as what would happen during and post the sale process, how long it should take to carry this out, who if any would regulate and supervise these entities and whether the management of assets should be regulated and controlled, assigned to third parties or let in the full domain of the management of Foundations. The majority, composed of the centre-left parties, proposed the institution of a regulatory authority fixing parameters of adequacy of investment return and the monitoring of the principles of preservation and prudent management of capital. Also, they proposed the disposal of bank stakes over four years. Regarding the regulatory authority, MP on.le Agostini said: “one of the powers of the authority is to define the parameters linking the capital to the returns of the Foundation to devote defined resources to the pursuit of statutory goals... as capital preservation is the fundamental scope of a Foundation”. 05 February 2014 ◆ 16
  17. 17. Italian Banking Foundations On the disposal process of bank stakes, MP on.le Agostini, sponsor of the proposal for the majority group proposes that Foundations dispose of bank stakes within four years and that, at regime, they dedicate their entire activity to the pursuit of the social good. Very much opposed to this view, the conservative minority argued for a liberal solution, letting Foundations free to manage their assets independently and without the supervision of any authority. MP on.le Pace, in stating his opposition to the bill of the majority said: “there is the attempt to attribute the power to fix the return on investments to the regulatory authority... the higher the return, the higher normally will have to be the risk borne. The authoritarian determination... of the investment return implies the acceptance of a degree of risk and this risk is borne by Foundations, there is no aspect of the law which mentions what would happen in the case of doing so and obliging Foundations to externalise the management of their investments, depriving them from the possibility to manage it directly, these investments would go to (colloquially speaking) „snafuz‟ (from „a badly confused or ridiculously muddled situation‟)”. On 18 March 1998, the Lower House approved a draft bill consisting essentially of:  Exclusive pursuit of social good – the bill approved indicated Foundations would exclusively pursue goals of public good.  Indications on investments - the bill approved indicated the principles of efficiency, capital preservation and portfolio diversification to grant an adequate profitability of the invested capital and the conferral of asset management to authorised agents to grant adequate transparency also to stake disposals.  Restriction of instrumental activities – the bill approved indicated Foundations could control companies instrumental to fulfil statutory goals, exclusively in sectors like scientific research, education, art, healthcare.  Regulatory authority - the bill approved indicated Foundations would be subject to a regulatory authority which would verify the adherence to the law, the healthy and prudent management, the profitability of the investment portfolio and the effective keeping of statutory goals. This would have the power to remove administrative organs or even dissolve a Foundation in case of grave irregularities, after having consulted with the Foundation.  Fiscal treatment of bank stake disposals – the bill approved indicated that the privileged fiscal regime on the disposal of bank shares would lapse after four years if Foundations still held control on the bank. a wide agreement on a compromise in the Senate When the discussion of the matter went to the Senate, the harsh debate has been overcome, with relevant amendments to the bill approved in the Lower House. In particular, the agreement included:  The introduction of the local development among the scopes of Foundations;  A definition of return, net of operating costs and taxes, provisions to mandatory reserves;  The establishment of control as per the art. 2359 of the Civil Code of law;  The possibility for Foundations to buy stakes in the Bank of Italy;  The incompatibility for individuals to be part of Foundations‟ and banks‟ boards at once. In essence the approved deal diluted the powers of the regulatory authority and the indications on the investment activity. The agreement is reflected in the final vote: 148 votes in favour, 11 against and only 4 abstained. 05 February 2014 ◆ 17
  18. 18. Italian Banking Foundations Senator Debenedetti the main oppose to the compromise... The opposition to the final bill came from Senator Debenedetti, notwithstanding his belonging to the majority party. He was seeing the reform as a failed opportunity to provide the impulse to diversify the shareholder base of banks, removing the strong links with Foundations. He had a very clear idea of what to do: “it is now necessary that Foundations/associations overcome the identity crisis, rediscovering a precise social or cultural vocation. Foundations/associations, clearly belonging to the private sphere of law, will be able to construct the pendant of joint stock companies: the latter pursuing profit maximisation, the former regulated as not for profit entitites... Loyal to their origins, Foundations/associations will only invest their wealth with the objective to generate returns to fund their institutional, not for profit and to allow lasting interventions in the pursuit of their statutory goals. They will predominantly invest in a diversified portfolio of financial assets. They will be allowed to maintain stakes in banks and companies, but with no control. As guarantee, the management of financial resources of Foundations/associations will happen through a professional manager and Foundations‟ management will be responsible for how they have invested and how they have utilised the returns”. He also proposed a revision of the concept of control related to the voting behaviour at AGMs as opposed to the number of shares held, as per the art. 2359 of the Civil Code of law. On Foundations-banks relationship, he added: “converting the stakes of Foundations/associations in marketable securities, having separated the control from the ownership, having reoriented their activity on the prudent portfolio diversification and on the spending of returns which derive from it, will fall the main reason of the link with political power”. On the link with politicians, he highlighted the importance of the ownership structure of Foundations: “There is no doubt that a Foundation is a company: a company which does not distribute profits but which can pursue, and this is the difference, surpluses. Also, they do not receive contributions from private individuals, they originate from a separation, certainly not from private donations provided by a universe of agents, so that the Foundation is an organisation conceived for the wellbeing of the beneficiary of services which the Foundation offers and so it does not have to report to its contributors... the fact that administrators are largely appointed by politicians introduces for Foundations a particular category of agents which establish transactions with Foundations: politicians... Foundations do not belong to anyone as nobody has the right on their profits but they are controlled by administrators who are subject to their appointment by politicians”. He then linked the implication of the political influence on Foundations for financial markets: “it is then necessary to pose this question: what is the propensity to risk of Foundations‟ administrators? Low with respect to financial risk and low with respect to political risk... in conclusion, the absence of contributors and the power of appointment from politicians are non- trivial on the utility function of Foundations‟ administrators. If we introduce in financial markets operators who formulate their demand not through a risk-return equation, we distance the market from a condition of efficiency”. He therefore proposed Foundations should sell the bank stakes, diversify their investment portfolios to reap more stable returns to fund their grants and to remove the link with politicians. A regulatory authority should monitor that investments are coherent with capital preservation and diversification and they could remove administrators or even dissolve Foundations in case of improper behaviour. ...together with a few more Going through the Senate‟s documents, we also found a few individual proposals alternative to the agreement between majority and minority. Senator Sella di Monteluce proposed either the introduction of a fiscal incentive to dispose of bank stakes or the transfer of voting rights on bank shares to the Finance Ministry if, after four years, 05 February 2014 ◆ 18
  19. 19. Italian Banking Foundations these would not have sold the shares. Voting rights would be returned once the disposal would be completed. Senator Miglio proposed the partial utilisation of proceeds from the sale of banks‟ stakes into the reduction of the Italian public debt and summarised his worries about the new law as follows: “What will Foundations do with the colossal wealth they will administer with the disposals of bank shares? Foundations are about to become a formidable power centre...the only certain fact is that it will be about discretional decisions, made by party emissaries, not subject to any effective democratic, direct or indirect control, a power as strong as irresponsible... the most formidable instrument of influence-peddling and manipulation of consensus which has partitocracy has ever has is being introduced”. Lega Nord Padania and Rifondazione Comunista parties opposed the compromise. Senator Co‟ declared: “Foundations will be more and more destined to forget their goals of social welfare to transform in power centres inside the banking sector”. Today’s debate has not changed much It has been an extremely formative experience to retrace the topics and the evolution of the Parliamentary debate of the Ciampi law which is behind today‟s legal framework. We notice that much of the Parliament‟s attention went to issues such as portfolio diversification, divestment of banks shares, portfolio diversification, monitoring of capital preservation and adequacy of investment returns, political interference, outsourcing of portfolio management, conflict between investment goals and grant-making focus shows how: 1) The Parliament had already identified the crucial factors/risks 15 years ago; 2) Today‟s debate has not changed dramatically, implying the current framework did not solve all the criticalities which had been identified. 05 February 2014 ◆ 19
  20. 20. Italian Banking Foundations Pressure (to reform) is all around The IMF, the Bank of Italy and the Government have affirmed their support to a reform of Foundations involving: 1) portfolio diversification; 2) leverage cap; 3) stricter governance. This suggests that Foundations should: a) reduce their stakes in banks and diversify their investment portfolios; b) reduce the risk of interference into the bank or from politicians. This shows the level of the debate has raised from national to the international scene, increasing the pressure on Italy to reform ahead of the implementation of the Common European Regulator. IMF recommending a reform of Foundations... The IMF 2013 Article IV Consultation published by the IMF last September included a chapter titled „Reforming the corporate governance of Italian banks‟. This includes an analysis of the current system of Foundations and provides recommendations of reform to foster corporate governance. Lights and shadows of the Foundations’ system The IMF analysis of the Italian banking system composes of the following points:  Concentrated ownership of Italian banks – Italian banks‟ ownership structure is concentrated with the largest shareholder controlling on average 45% of the capital or 18% when weighted by market capitalisation. This can facilitate decision making but in Italy there are „minority shareholders that exercise control beyond their ownership through legal devices such as joint lists, coalitions with other shareholders (formalized or not), voting rights ceilings and cross-holdings. These shareholders are also often linked to nonprofit foundations, whose governance differs from a standard corporation‟.  Foundations propelled Italian banks forward... – Foundations supported two consolidation waives, giving rise to three large banking groups. They also supported the recapitalisation of banks in the crisis, providing 20% of the capital needs since 2008.  ...but they have also dragged their feet – Foundations have dropped their bank ownership to 40% in 2012 but they are still major shareholders in four of the top 10 banking groups. Despite the indication of the law to lose control of banks, Foundations appoint the majority of board members in the two largest banks.  Governance challenges – „Local politicians dominate the boards of several foundations‟. „Foundations do not follow basic corporate governance practices. For example, the appointment of governing bodies is often non-transparent and foundations do not follow uniform accounting and disclosure rules. In addition, there has been little oversight of the foundations, despite the law‟. „Despite provisions in law 461/98 that require diversification of obligations, some large foundations still have portfolios heavily concentrated in their ―original bank, with stakes varying from 30 to 90 percent. Some foundations have also made use of bank credit (mortgages, credit lines) to fund miscellaneous expenditures, such as capital increases, real estate acquisitions or restructuring. Others have invested in risky derivative products‟.  Implications for banks of Foundations’ ownership – The concentrated, risky investments mentioned in the above point „increased the riskiness of their portfolio and raised pressure on banks to generate dividends to support the weak financial position of the shareholder foundation. The IMF‟s FSAP stress test found that „banks influenced by foundations are particularly vulnerable to slow growth or adverse macroeconomic conditions. In the adverse scenario [...] the CET1 and Tier 1 capital shortfalls of this category of banks would be respectively, €3.2 and €5.4 billion (0.2 and 0.3 percent of GDP), accounting for 40–50 percent of the shortfall of all Italian banks in the test. Banks 05 February 2014 ◆ 20
  21. 21. Italian Banking Foundations that have the highest proportion of foundation ownership display higher NPL ratios, lower NPL provision coverage and lower capital ratios. This is confirmed by a BoI study that indicates that bank performance has been negatively correlated to the proportion of foundation ownership‟. The report suggests the implementation of the following reforms for Foundations: 1. the introduction of strict divestment procedures for Foundations. 2. the diversification of investment portfolios and the requirement of minimum reserves invested in safe assets to provide a buffer. 3. the introduction of a leverage cap to prevent levered acquisitions of risky assets. 4. the introduction of „term limits for foundation board members and of a cooling off period between a political office and the appointment to a foundation – a provision currently left to the „Code of Ethics‟‟. 5. „the implementation of strict oversight with prompt corrective actions‟. ...the government and BOI are on a similar page... F. Saccomanni calling for unpleasant changes in the Foundation-Bank link in 2012... In a speech to Foundations in June 2012, Fabrizio Saccomanni, then General Manager of the Bank of Italy, provided the following recipe for the banking sector and for Foundations:  Foundations should diversify their investment portfolios;  Banks would need to cut costs to weather the storm of the crisis abandoning the federal organisational model;  Banks should constrain remuneration and dividends to strengthen capital. These measures would entail:  The dilution of Foundations‟ control over banks;  The absorption of the local banks pertaining to the larger groups into the parent company, implying the removal of local brands, board seats and presence;  The structural fall of dividend yield for an investment in bank equity. All the three above implications should have sounded unpleasant for Foundations whose presence in the capital of banks aims at maintaining the attention of the company on the needs of local households and SMEs and whose grant making activity requires cash generative investments. ...and for a reform of the Foundations’ law in 2013 In 2013, Saccomanni became Finance Minister in the Letta government. Over the year, a number of Foundation-controlled banks went into problematic situations and a few scandals involving Foundations broke out. The Italian press has reported his agreement with the Bank of Italy to propose a reform of the law ruling Foundations based on four pillars: 1. Abolish the control of banks by Foundations; 2. Ensure effective portfolio diversification of investments through a cap of 30% of the total portfolio in a single investment; 3. Forbid the underwriting of rights issues with leverage; 4. Forbid to invest in derivatives and hedge funds. There has been little recent update on this, but if confirmed, it would pursue the recommendations provided by the IMF last September. 05 February 2014 ◆ 21
  22. 22. Italian Banking Foundations agreement with the Bank of Italy In October 2013, Ignazio Visco, governor of the Bank of Italy, provided the following indications when talking about Foundations: „Banking Foundations should have diversified their portfolios to reduce their dependence on the results of their reference bank. Some have not done so, they will have to adapt, taking market conditions into account‟. This confirms the Bank of Italy‟s expectation that Foundations without diversified investment would be potentially suffering from a financial standpoint as fixing the problem could imply the recognition of financial losses or of material dilution in the equity stake in the reference bank. ...and Draghi’s suasion were the prelude to today’s state Mounting pressure for Foundations to put banks and the country before their interest... Former BOI governor Mario Draghi exercised his moral suasion on the banks‟ as well as on Foundations‟ management. Table 1 reports extracts from the Governor‟s speeches at the World Saving Day, an annual event organised by ACRI, Italy‟ association of banking Foundations. The beginning of the crisis marks the beginning of a recurring explicit reference made by the Governor on the role Foundations should have in the banks. The Governor‟s requests and expectations from the banks progressively escalated over the years:  2007 – No mention in the speech of Foundations and of their role in the banks.  2008 – The Governor‟s call is for a generic wish of having Foundations accompanying banks on the journey of growth, providing them with firm roots. There is not explicit reference to capital increases.  2009 - The Governor‟s request is explicitly to: support the upcoming capital increases, refrain from interfering with management and take a long view on the return on their investments. The tone has changed markedly on the previous year and is a call to arms, in our view, with little gratification in exchange.  2010 – The Governor‟s intervention sets low expectations on the perspective of the Foundations‟ investments in the banks; they are called to sacrifice and to suffer together with „their‟ banks. Moreover, Foundations are asked to revise their governance on top of putting further capital at the banks‟ disposal „without flinching‟. The Governor does not envisage a good ROI but effectively warns that the alternative is the nationalisation of the banks, recalling the poor luck of the country with state-owned banks.  2011 – The Governor anticipates that the EBA test will hit Italian banks on their sovereign bond exposure and warns about further rights issues coming up. He once again exerts his pressure on Foundations to keep on underwriting the inevitable capital increases. ...and to take a more painful role than what institutional investors are asked to do The above confirm the mounting pressure the former Governor of the Bank of Italy put on Foundation‟s management regarding the responsibility as strategic shareholders in Italian banks. His messages implied Foundations must put the health of the banks, of the banking sector, and the country‟s economy before their interest (ROI, diversification, etc). This principle, applied to today‟s situation could imply the risk of dilution of Foundations‟ stakes into the potential coming rights issues from minor banks and their investment repositioning outside of the banking sector, in our view. 05 February 2014 ◆ 22
  23. 23. Italian Banking Foundations Table 1 – Extracts on Foundations from Governor Draghi’s speeches at the World Savings Day Date Role Rec c omendation Oct-07 no mention no mention Oct-08 Large shareholders but with diversified portfolios "As shareholders in banks, the Foundations are called upon to show dynamism and foresight in performing their role. They have the chance to accompany I taly‟s banks on their journey of growth, providing them, as before, with firm roots in the variegated local realities of the country." Oct-09 - "The Foundations have been an anchor for I talian banks. Foundations need "to continue to accompany the strengthening of capital and They have accompanied them through the worst storms of the reserves and to persevere in the role of shareholders who are present but do not financial crisis, strengthening their capital and reserves; they are interfere with management, which has been the basis of their success in recent supporting them now in the weak recovery that is projected. Many years. The Bank of I taly hopes that the Foundations will continue to demonstrate have accepted sacrifices in the short term, thus contributing to the the same farsightedness that kept them tied to their traditional strategic values soundness of the system, the ability of banks to supply credit to the at the height of the crisis, and that they will be able to take the long view and economy, and the enhancement of their own investment in the long contribute to the development of a sound banking system ready to face the term." challenges of international competition." - Foundations have gone beyond the function of institutional investors and maintained a long-term view. - "Following the important mergers of two years ago, the I talian banking system needs stability to meet the management and strategic challenges that exiting the crisis will pose." Oct-10 "The I talian experience of banking foundations is positive [...] for "Just as the future promises to be challenging for banks, it will be challenging for the role they have played as stable, solid shareholders in banks; a their largest shareholders as well. The foundations will have to act on three key role filled in other countries by institutional investors, which are fronts: their own governance, the recapitalization of banks and self-discipline in rare in I taly. During the crisis, the foundations‟ long-term view of their relationship with banks‟ managements. For the action of banks‟ control banks‟ prospects and their roots in the territory – factors driving bodies to be adequate, it is necessary that the development at local, regional and national level – were crucial. When boards of their main shareholders, which help to elect them, be equally adequate. other shareholders, such as investment funds, until the eve of the For the reasons described earlier, they will be asked to make a significant effort crisis so vociferous in demanding efficiency gains and changes of to strengthen banks‟ capital, an effort to be faced without flinching. The management, vanished, often for good, it was the foundations that foundations must continue to take a long view; they must understand that they subscribed for the repeated capital increases that made it possible cannot sacrifice the prospects of their banks and the economies they serve to to weather the storm unscathed." the desire for immediate monetary returns, which, besides, are now harder to obtain. The I talian experience of public banks is vivid in our memory. Certain relationships between local economic groups, public banks and politics ultimately proved disastrous for the banks and deleterious for civic mores; in more than one case, local development was hindered rather than helped. With great, conscious Oct-11 "At European level, the largest banks are expected to equip "We are fully confident that, as in the past, the banking foundations will shoulder themselves with adequate buffers of high-quality capital by the their share of responsibility. I f necessary, adequate backstops will be identified middle of next year. The amount is determined for each bank taking and put into operation in a timely manner." its exposure to sovereign risk into account. The request for temporarily higher capital ratios is necessary in order to address investors‟ current worries, with benefits for banks‟ funding on the wholesale markets. Our banks are up to this new challenge." Source: Mediobanca Securities, Bank of Italy 05 February 2014 ◆ 23
  24. 24. Italian Banking Foundations CoCo: transit to portfolio diversification The CoCo market is developing as regulatory frameworks for banks are stabilising and investors are hungry for yield. The removal of the fiscal asymmetry in Italy should open the market for Italian banks too. We see CoCos as the tool to bridge Foundations to portfolio diversification from their current concentration into bank equity stakes. In fact, swapping Foundations’ equity stakes into CoCos would: 1) boost the cash flow generation and the visibility of the investment yield for Foundations; 2) solve the governance anomaly of the current Bank-Foundations model; 3) while having a neutral impact to banks’ regulatory capital ratios. Foundations would not abandon banks in a difficult moment, but could plan the future portfolio diversification over time and with higher investment yield visibility. Matching bank capital needs with investors yield hunger... The contingent capital (CoCo) market is developing The issue of the new form of bail-inable Tier 1 and Tier 2 CoCos has gathered pace since the last summer, as banks have tested the Basel III compliant Additional Tier 1 (AT1) capital market and also boosted Basel III compliant Tier 2 capital. This has been driven by local leverage rules (UK and Switzerland) and in some cases, consideration of the proposed EU bank bail-in rules. Table 2 lists all CoCo issuance to date. We have taken note of $11bn issuance of AT1 in 2013. The most recent issue is CS $2.25bn CoCo. And significant further issuance is expected The volume of issuance is likely to increase quite markedly this year. A recent presentation by HSBC‟s Treasurer said the bank would issue US$15bn to US$20bn of AT1 capital in the years to come and CoCo bonds are now part of the capital landscape. In addition, Deutsche Bank has stated that it will issue €5bn of AT1 by 2015. The large Swiss banks, which have already been very active this year in issuing AT1 and Tier 2 CoCos, will also be more active in 2014 as they seek to get to their 2019 leverage target of 4.2% early. The Italian fiscal anomaly has been removed We do not find Italian names among the issuers of CoCos thus far. This is because until December, CoCos did not benefit from tax deductibility of interest. This has now been amended and we expect banks will consider this as an alternative instrument to a rights issue to boost capital ratios without diluting share count. Attractive risk/reward for yield seekers This new asset class of CoCos has a clearly defined risk profile, providing exposure to bank debt while embedding equity tail risk. The market is set to become much more liquid, in our view. In addition, the regulators are moving Core tier 1 ratios up to levels above the individual bank‟s Basel III minimums with the use of Pillar 2 and counter-cyclical buffers. This suggests that breaching the triggers of between 5% and 7% will take another major market hiatus. This makes these bail-in bonds attractive for those seeking yield and offer an attractive risk/reward profile for investors looking for credit risk exposure. The instrument for levered banks with depressed profitability and valuation For the fifth consecutive year we are living in an environment of record low interest rates coupled with more and more demanding regulatory hurdles. For banks with depressed profitability and valuation, this can represent an important value trap as meeting the regulatory demands via rights issue at deep discount to BV can imply a large drag to valuation. CoCos can provide a bridge for banks running on cyclically low profitability to meet regulatory constraints today without diluting share count. These instruments effectively allow levered banks to build up capital over time. 05 February 2014 ◆ 24
  25. 25. Italian Banking Foundations Table 2 – AT1 CoCo issuance monitor Issue Date Bank Type Currency Amount (m) Amount (US$m) 09/11/2011 Rabobank AT1 09/05/2013 BBVA 04/09/2013 Credit Suisse 06/09/2013 Last Price CT1 Trigger Coupon Maturity Description Options 110.705 8.0% 8.400% Perpetual Capital Type Coco Tier 1 Call Option 6-YR USD 2,000 2,000 AT1 USD 1,500 1,500 107.5 5.125% 9.000% Perpetual Capital Type Coco Tier 1 AT1 CHF 290 322 104.402 5.125% 6.000% Perpetual Subordinated Hybrid Tier 1 Société Générale AT1 USD 1,250 1,250 108.125 5.125% 8.250% Perpetual 10/10/2013 Banco Popular AT1 EUR 500 683 112.014 5.125% 11.500% 20/11/2013 Barclays AT1 USD 2,000 2,000 104.5 7.0% 8.250% 10/12/2013 Barclays AT1 EUR 1,000 1,366 104.326 7.0% 11/12/2013 Credit Suisse AT1 USD 2,250 2,250 106.625 5.125% Total AT1 11,371 Fitch S&P BBB NR Call Option 5-YR BB- NR Call Option 5-YR BB+ NR Subordinated Hybrid Tier 1 Call Option 5-YR BB BB+ Perpetual Subordinated Hybrid Tier 1 Call Option 5-YR NR NR Perpetual Basel III Tier 1 Cocos Call Option 5-YR BB+ B+ 8.000% Perpetual Basel III Tier 1 Cocos Call Option 5-YR BB+ B+ 7.500% Perpetual Basel III Tier 1 Cocos Call Option 5-YR BB+ BB- 8.328% Perpetual Source: Mediobanca Securities 05 February 2014 ◆ 25
  26. 26. Italian Banking Foundations ...fitting the new Foundations-banks needs Portfolio diversification remains the final objective... In Re-Foundation, 28 May 2012, we concluded that the lack of portfolio diversification of Foundations, excessively concentrated on holding equity stakes in the banks of reference, could put their financial sustainability in jeopardy. As solution to the problem, we proposed to implement investment portfolio diversification to provide the stable, superior returns to allow Foundations to plan their long-term grant making activities with more comfort instead of having to cutting them. ...but a transitory period may be needed... Given the low net cashflow generation of current investment, implementing portfolio diversification would entail actively selling bank shares to buy other securities. We understand the reluctance of doing so while these companies are still in the midst of a serious crisis, both in the hope of extracting more value in the future, and with the sense of responsibility of not abandoning the ship while it is navigating in difficult waters. We therefore look for a transitory phase which could provide Foundations with their primary need of yield, without depriving banks of their support. ...which could be embodied by a dedicated CoCo for equity swap... We believe a swap of Foundations stakes into banks into a CoCo could satisfy the governance reform needs of the Foundation-banks liaison while: 1. 2. 3. giving Foundations the time to transition towards portfolio diversification allowing Foundations to enjoying higher and more stable and visible yield supporting banks out of the current regulatory and macroeconomic woods. ...immediately ticking the governance and yield stabilisation needs The CoCo/Buyback operation would not solve all issues at once (diversification, higher yield, income stability/predictability), but it would provide an immediate solution to: a) the governance issues; b) the lack of investment yield and visibility Foundations have been suffering from for several years. Would minority shareholders rights be stepped over? We would not see a problem of shareholders rights to the Foundations stakes‟ swaps into CoCos. The next chapter shows how the operation would be beneficial to minority shareholders but anyhow we have seen similar operations which have been dedicated to single shareholders (POP and SAB recent rights issues). Even with Foundations there is a precedent. The emergency rights issue of UCG in 2010 through the issuance of €3bn CASHES was subscribed by Foundations and by the Libyan investor. In hindsight this has been a very favourable operation for minority shareholders. 05 February 2014 ◆ 26
  27. 27. Italian Banking Foundations Buyback neutral to capital ratios We simulate the implication of a conversion of Foundations’ equity stakes into CoCos at par for UCG and ISP. This operation, neutral to capital ratios, results in 14-30% EPS upgrade as the increased interest expenses of the CoCos are more than compensated by the amount of share buyback due to the current below-BV valuation of both banks. As a result, RoTE expands 2-5 p.p. and yield by 1 p.p.. This would imply a win-win-win scenario for: Foundations (certainty of yield), banks (governance, profitability), minority shareholders (profitability, yield), while it is neutral to the government’s too big to fail risk. We calculate CoCos would generate a 3% annual investment yield premium vs the current ATM covered call alternative, securing a higher visibility and sustainability of the Foundations’ grant making activity. Had Foundations held CoCos instead of bank equity over the last 12 years, they would have cashed in €22bn extra profits after costs and grants (over 50% boost to the current total capital), implying they could have made 140% more grants over the same period. At the same time, we see the post Buyback/CoCo operation leaving ISP and UCG with TE/TA well above retail peers, hence at no compromise to the risk profile of the banks. 8.3% coupon for UCG and ISP Our analysis of the AT1 CoCo issuance outstanding implies that for the rating of UCG and ISP, a coupon of 8.3% should suffice to satisfy the market‟s demand (see Table 2). 28% of ISP and 11% of UCG at stake Table 3 summarises the stake of ordinary shares owned by Foundations in ISP and UCG. We identify 25 Foundations hold shares in ISP for 28% cumulative stake and 11 in UCG for 11% ordinary shares. Table 3 – summary of Foundations stakes (% of ordinary shares) in ISP and UCG ISP Compagnia di San Paolo Fondazione Cariplo Fondazione C.R. Padova e Rovigo Ente C.R. Firenze Fondazione C.R. in Bologna Fondazione Cariparma Fondazione C.R. di Udine e Pordenone Fondazione di Venezia Fondazione CR di Ascoli Piceno Fondazione C.R.di Gorizia Fondazione C.R.di Pistoia e Pescia Fondazione C.R. di Forlì Fondazione CR Della Spezia Fondazione CR Pisa Fondazione CR Cuneo Fondazione CR Carpi Fondazione C.R. Lucca Fondazione CR Livorno Fondazione VarroneC.R. Rieti Fondazione C.R. Carrara Fondazione Banca Nazionale delle Comunicazioni Fondazione CR Città di Castello Fondazione CR Bolzano Fondazione CR Terni e Narni Fondazione CR Fano Fondazione Cassa di Risparmio di Verona, Vicenza e Belluno Carimonte Holding Spa Fondazione Cassa di Risparmio di Torino UCG 9.71% 4.95% 4.51% 3.32% 2.02% 0.71% 0.50% 0.45% 0.35% 0.31% 0.31% 0.26% 0.25% 0.07% 0.07% 0.06% 0.05% 0.04% 0.04% 0.02% 0.02% 0.01% 0.00% 0.00% 0.00% 3.53% 3.00% 2.51% 05 February 2014 ◆ 27
  28. 28. Italian Banking Foundations Cont Fondazione Cassa di Risparmio di Modena Fondazione Manodori Fondazione Cassa di Risparmio di Perugia Fondazione Cassa di Risparmio di Trieste Fondazione Banco di Sicilia Fondazione del Monte di Bologna e Ravenna Fondazione Cassa di Risparmio di Pisa Fondazione Cassa di Risparmio di Lucca ISP UCG 0.65% 0.48% 0.36% 0.34% 0.12% 0.03% 0.02% 0.01% Source: Mediobanca Securities An unprecedented buyback... In Table 4 we simulate the conversion of Foundations‟ stakes in ISP and UCG into CoCos as the combination of: 1. The buyback of the equity stakes owned by Foundations 2. And the issuance of CoCos matching the capital bought back This implies 28% equity buyback at ISP and 9% at UCG, corresponding to €14bn and €5.8bn simultaneous buyback/CoCo issuance, respectively. Table 4 – ISP and UCG CoCo for equity swap ISP Current Foundations holding BV 2013e Core capital 2013e Buyback/Coco Buyback/CoCo Coupon New NII Post-tax impact % of 2015e adj. profits Old share count New share count EPS impact Old 2015e adj. profits New 2015e adj. profits Old 2015e EPS New 2015e EPS EPS change % TE vs RoTE impact Goodwill+intangibles TE post CoCo TEPS post CoCo 2015e RoTE post CoCo 2015e RoTE pre CoCo Yield impact 2015e payout ratio Old 2015e DPS ord. New 2015e DPS ord. DPS change % Old div. yield New div. yield UCG 28% 49,289 32,102 9% 62,588 21,516 13,820 8.33% -1,151 -737 -18% 16,434 11,826 6,885 8.33% -573 -367 -10% 5,789 5,153 4,034 3,297 0.25 0.28 14% 3,857 3,490 0.52 0.68 30% 14,822 20,647 1.75 16% 11% 15,971 39,732 7.71 9% 7% 44% 0.10 0.12 23% 5.2% 6.4% 40% 0.23 0.27 19% 3.9% 4.6% Source: Mediobanca Securities 05 February 2014 ◆ 28
  29. 29. Italian Banking Foundations ...costing 10-18% of 2015e adj. profits, but boosting EPS by 14-30% We foresee an extra interest income cost of €1.1bn at ISP and €0.5bn at UCG by applying a coupon of 8.3%, taking 2015e profits to €3.3bn at ISP (from €4.0bn) and to €3.5bn at UCG (from €3.9bn). At the same time, share count should fall to 12bn at ISP (from 16.4bn)and 5.1bn at UCG (from 5.8bn). The result should be an EPS upgrade of 14% at ISP and 30% at UCG, reflecting the buyback at more discounted price at UCG (0.7x 2014e TE) vs ISP (0.9x 2014e TE) and implying a more than proportionate cancellation of shares compared to the absolute loss in profits. RoTE up 2-5 p.p. ... We calculate that the buyback would imply new TEPS of €1.8 at ISP and €7.8 at UCG. Consequently, 2015e adj. RoTE should go to 16% and 9% at ISP and UCG from 11% and 7%, respectively, reflecting the beneficial gearing effect to returns. ...and yield up c.1 p.p. We simulate what dividend yield would do, were ISP and UCG to keep the payout ratio stable. We calculate that DPS could rise by c.20%, for c.1 p.p. higher yield in the 5-6% region. A deal ticking all the boxes Despite the magnitude, we believe that the operation would be a positive evolution for all stakeholders involved:  Foundations would gain higher and more visible cash investment yield;  Banks would confirm their capital ratios while gaining EPS upgrades, dividend yield and governance;  Minority shareholders would gain EPS and DPS upgrades and better governance;  The regulator and the government would not compromise on the too big to fail risk of the bank, while accommodating the suggestions of the IMF. Banks: levering up, without compromising on the risk profile The Buyback/CoCo operation implies a significant gearing up of ISP and UCG balance sheets. shows the comparison of the CASA, CA Group, Natixis, BPCE Group, and ISP and UCG leverage (TE/TA) and regulatory capital ratios (T1) before and after the Buyback/CoCo operation. We selected the two French peers as benchmark given their peculiar position on regulatory capital which bases on the implied guarantee from the mother companies (CA Group for CASA and BPCE Group for Natixis) in case of capital need. In fact, the French regulator validated the fairly geared business models of the listed entities (CASA and Natixis) – 1.4% and 2.8% tangible equity/tangible assets ratio (TE/TA), respectively – given the solid capital base of their controlling shareholders who would stand behind their subsidiaries in case of trouble. We note that the post Buyback/CoCo ISP and UCG would still land at leverage and regulatory capital ratios well above the ones of CASA (1.4%) and Natixis (2.8%) and in line with the one of the safer delisted retail groups, CA Group (3.2%) and BPCE Group (4.3%). This implies to us that the operation should be acceptable from a regulatory standpoint. 05 February 2014 ◆ 29
  30. 30. Italian Banking Foundations Chart 12 – TE/TA vs T1 ratio comparison 6% TE/TA (lhs) 14% T1 ratio (rhs) 12% 5% 10% 4% 8% 3% 6% 2% 4% 1% 2% 0% 0% CASA CA Group KN BPCE ISP CoCo Group ISP UCG CoCo UCG Source: Mediobanca Securities Foundations: annual investment yield 3% above the ATM call, accretive from year 2 Swapping an equity stake for a CoCo in essence implies swapping the opportunity of cashing in the volatile premium on the sale of a call option on the stake for the certainty of cashing in the high CoCo coupon. Chart 13 shows the annual yield from selling at the money (ATM) calls on ISP and UCG vs the yield of the CoCo we simulated. Only in the first year the current conditions would provide the seller of the ATM call a return above the one of the CoCo. From year 2 onwards, the CoCo would generate excess returns vs the covered call sale. Over a 10 year period, we calculate an 3% annual premium in favour of the CoCo, implying a structurally higher sustainability of cash flow. Clearly this scenario does not keep into account the potential equity upside on share price that the stake would provide vs the CoCo, likewise, it does not account for the potential downside the equity exposure could give. Chart 13 – ATM call vs CoCo annual yield 12% ISP UCG CoCo annual yield 10% 8% 6% 4% 2% 0% 1 2 3 4 5 year 6 7 8 9 10 Source: Mediobanca Securities, Bloomberg Simulation: CoCos core profits above reported ones in the last 12 years... Chart 14 shows the evolution of Foundations‟ core profits and grants approved in the 2001-12 period, contrasted with the simulation of what hypothetical core profits would have been had investments delivered a return in line with the CoCo coupon, maintaining costs and tax rate in line with reported results. We calculate that: 05 February 2014 ◆ 30
  31. 31. Italian Banking Foundations  Core profits with CoCos would have always largely exceeded grants approved;  Core profits with CoCos would have always exceeded reported core profits. The above imply that: 1. Foundations generated €16.2bn cumulative core profits over the period 2001-12 vis-à-vis €15.5bn grants, implying no net reserves have been built over a twelve year period; 2. the hypothetical financial sustainability of Foundations would have been superior to the actual one as Foundations would have accumulated a buffer of capital vis-à-vis the same grants made. Chart 14 – Core profits (CoCo and reported) vs grants approved Eur m 4,000 Core profits Grants approved (€ m) Core profit CoCo 3,500 3,000 2,500 2,000 1,500 1,000 500 - 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: ACRI, Mediobanca Securities ...for €22bn extra profits or 140% more grants Chart 15 shows the core profits – grants approved under the reported and the CoCo scenario for the 2001-12 period. We calculate CoCos-like returns would have generated €22bn extra profits, implying: 1. A potential boost to the aggregate Foundations‟ capital of over 50%; 2. A 140% boost to the cumulative 2001-12 approved grant pool of €15.5bn. Chart 15 – Core profits – grants approved (reported vs CoCo simulation) 2,500 2,000 1,500 1,000 500 CoCo -500 Status quo -1,000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: ACRI, Mediobanca Securities 05 February 2014 ◆ 31
  32. 32. Italian Banking Foundations Appendix Mediobanca Performance Indicator When making investments, Foundations keep into consideration three factors: 1) capital preservation (risk); 2) cash flow generation (yield) to finance annual grants and cover the structure‟s expenses; 3) pure investment return (capital appreciation). To grasp a synthetic indicator of investment performance we created the MB performance indicator similar to a total return calculation but creating a level playing field on performance calculation which adjusts for the asymmetric generosity in grant making. We defined it as: Where the return in any given year is the ratio between: a) the sum of the net cash flows generated by investments (dividends, interest and trading results minus the costs of the Foundation) and the capital appreciation of investments, and b) the sum of the market value at the end of the previous year plus the grants made in the previous year. This way we keep into consideration:  Yield maximisers, traders and diversified portfolios: core revenues incorporate all aspects of the different investment types, so that we avoid favouring one model over the other (e.g., internal investment office vs externally managed diversified portfolio / concentrated portfolio of stakes vs diversified portfolio / yield maximising portfolio vs capital appreciation investments).  Efficiency: we deduct core costs (employee salaries, BoD remuneration, consulting expenses, G&A, amortisation) to capture the benefit of lean and efficient structures vs more cost-intensive ones (e.g., an internal investment office could have higher costs and higher revenues as these could exclude investment fees which would instead be consolidated as negative revenues for investments in externally managed funds).  Asymmetric grant generosity: we add back to the denominator the grants made in the previous year to create a level playing field between Foundations more generous on their grant making policy and those which adopt more conservative concessions of grants. 05 February 2014 ◆ 32