Fitch downgraded eight medium sized Italian banks because of its view that they face the structural challenge of operating in an environment where operating profitability has shrunk amid low interest rates and higher funding costs. The banks are on negative outlook.

Covered bond issuer Credito Emiliano was downgraded from A to BBB+ and Banca Popolare di Milano from A- to BBB. OBG programmes of Credito Emiliano and Banca Popolare di Milano are rated AAA on Rating Watch Negative.

The rating agency expects loan impairment changes to remain high, and said banks will need to maintain a higher degree of liquid assets on their balance sheet, and operate with higher capital levels. Fitch said the negative outlooks reflect its view that the operating environment for the banks might deteriorate further given downside risks in the current market environment.

“Asset quality has deteriorated fast for all Italian banks since 2008 amid the domestic recession followed by a slow recovery,” said Fitch. “Given the weak outlook for the economy, a renewed acceleration of asset quality deterioration is a real risk, and increased impairment charges would weigh on the already weakening profitability of the banks.

“Only one of the Italian mid-sized banks increased its capital in 2011 to date (Banca Popolare di Milano) but all set up medium term plans to reinforce capitalisation,” it added, “mostly by issuing convertible bonds, through internal capital generation and reduced dividend payout ratios.”

The eight mid-sized banks are trying to become more cost efficient, said Fitch, but it does not see them being able to reduce their cost bases drastically given that their business models are based on costly branch networks.

Fitch noted that Italian mid-sized banks have generally maintained sound structural funding, which benefits from good access to retail customer funding. It said banks would be able to attract funding at costs that are well below government bond yields.

“All banks have been focusing on improving their short term liquidity for several quarters,” it added, “including through the lengthening of funding maturities, reduction of credit lines to larger corporate and the creation of assets that are eligible for refinancing with the European Central Bank.”

The rating agency said that ECB utilisation is likely to rise further in the coming quarters as some banks might choose to substitute part of maturing long term funding with ECB facilities.