<p>Banks<br/>Hard times<br/>With a relatively defensive business model, Italian banks should manage to<br/>struggle through the recession. However, we believe the market's perception of<br/>the banks' resilience lags reality on more than one issue, so we see scope for a<br/>sector downgrade.<br/>Key forecasts<br/>Stress tested<br/>MtM TCE<br/>P/St<br/>MtM TCE ‘Normal’<br/>Base case<br/>TCE P/TCE<br/>Rec TP Price Downside 09F 10F 09F 10F RoTCE 09F 10F 09F 10F<br/>ISP Hold 2.20 2.35 (6)% 2.0 2.1 1.2x 1.1x 14% 2.2 2.3 1.1x 1.0x<br/>MPS Sell 0.80 1.04 (23)% 1.1 1.0 0.9x 1.0x 10% 1.2 1.3 0.8x 0.8x<br/>UBI Hold 9.10 9.11 (0)% 8.2 8.0 1.1x 1.1x 13% 9.6 10.1 0.9x 0.9x<br/>UCG Sell 1.10 1.33 (17)% 2.2 2.0 0.6x 0.7x 10% 2.6 2.6 0.5x 0.5x<br/>Priced intraday on 6 February 2009.<br/>Source: ABN AMRO forecasts<br/>Reality setting in<br/>Except for UniCredit, first-round markdowns have had only a limited impact on Italian banks,<br/>thereby strengthening the market’s belief that the sector is defensive. However, with the<br/>credit crunch centre stage, negatives are starting to become clearer: 1) outstanding credit<br/>volume growth is slowing down sharply and we believe it will turn negative (already the case<br/>in residential mortgages); 2) higher than historical wholesale funding costs for a sector more<br/>wholesale reliant than is commonly perceived; 3) few chances for the asset management<br/>industry to recover from a depleted asset base and lower margins; and 4) loan losses will<br/>almost certainly rise from very low historical levels, driven by SMEs (42% of national GDP)<br/>and a negative real estate cycle.<br/>Asset quality: the known unknown<br/>A historical analysis of the Italian banking system shows three years of cumulative losses<br/>were as high as 460bp in the relatively modest downturn in the early 1990s. Furthermore, we<br/>believe recent trends in Central and Eastern Europe (14% UCG loans; 8% ISP) indicate the<br/>possibility of a crisis of untested magnitude. A benchmark analysis tracking historical NPL<br/>trends, near-term expectations (sovereign CDS spreads, GDP consensus) and FX<br/>movements reveals how ISP is generally exposed to less-risky geographies than UCG.<br/>Broadly, with net NPLs/2008F tangible equity at 14% and 13%, respectively, we think ISP<br/>and UBI look relatively defensive.<br/>Capital: the prime currency<br/>Capital seems to be in short supply following a string of mergers and acquisitions over the<br/>past three years. Banks are now trying to sell assets in very difficult markets, while credit<br/>losses, asset markdowns, FX devaluations and declining revenues are hitting the sector<br/>hard. Government intervention might save the day, but at a cost. We estimate the capital gap<br/>at MPS and UCG is close to 50% of market value and hence see high dilution risk at both<br/>banks.<br/>Valuation: weighing the odds<br/>Capital resiliency now seems more important than earnings growth, so we stress test using<br/>cumulative peak provisioning estimates to calculate our target prices. On this basis, we move<br/>ISP to Hold, retain our Sell rating on UCG, resume coverage on MPS with a Sell (from Hold)<br/>and initiate coverage of UBI at Hold.</p><p>Contents<br/>Hard times 3<br/>We do not question the Italian banks’ ability to survive the current downturn; but we<br/>believe their presumed defensiveness will be challenged as the credit crunch<br/>dispels the market’s illusions, leaving scope for a sector downgrade.<br/>3<br/>Reality setting in 7<br/>Italy stands out for having a low level of retail debt vs other major EU economies,<br/>yet banking product sales and household mortgages are dropping at an alarming<br/>rate. Italian banks also depend more on wholesale funding than is commonly<br/>perceived.<br/>7<br/>Asset quality: the known unknown 13<br/>Italian banks have enjoyed a comfortable slide from the write-off peak of the early<br/>1990s, but empirical evidence suggests the credit losses come in bulk. A historical<br/>analysis of various banks allows us to draw some dividing lines.<br/>13<br/>Capital: the prime currency 17<br/>In the wake of M&A euphoria, Italian banks were left with a suboptimal capital layer<br/>at a time of cyclical distress. Asset sales are not easy in a market of falling knives,<br/>while hidden losses (IAS 39) are likely to continue being priced in by the market.<br/>17<br/>Valuation: weighing the odds 18<br/>It is difficult to assess the extent of the current downturn and its capital impact, but<br/>we believe any investment decision should take into account a worst-case outcome.<br/>Our valuation is based on four probability-weighted scenarios.<br/>18<br/>Company profiles<br/>Banca Monte Dei Paschi 20<br/>Intesa Sanpaolo 24<br/>UBI Banca 28<br/>UniCredit 32</p><p></p><p> <br/></p><p></p>