Moody’s has downgraded Italy’s Banca Popolare di Milano from A3 to Baa3 because it considers the bank’s corporate governance structure will make it difficult to improve or even maintain its low profitability. All else being equal the rating action is likely to lead to a downgrade of the covered bonds.

The rating action, carried out on Friday, concludes a review for possible downgrade initiated on 5 May. The rating agency also downgraded the issuer’s bank standalone financial strength rating (BFSR) by one notch to D+. The outlook on all ratings is negative.

Covered bonds issued by BPM are on review for possible downgrade, with Moody’s in May having said that a downgrade of the issuer below A3 could lead to the covered bonds’ rating being constrained under its Timely Payment Indicator (TPI) framework.

BPM covered bonds are assigned a TPI of “probable”, meaning that a Baa3 issuer rating would, all else being equal, cap the covered bonds at A1 under Moody’s TPI methodology.

“The decision to downgrade BPM’s ratings primarily reflects Moody’s concern that the bank will be structurally challenged by its specific governance structure to maintain a sufficient cost flexibility also compared to its domestic peers,” said Moody’s.

It considers such cost flexibility to be paramount for the bank’s management to be able to navigate the bank through a very challenging operating environment that has already impacted the system’s funding costs and is likely to put further pressure on the Italian banking system’s asset quality.

The rating agency said that that improvements have been made in response to the Italian regulator’s demands, but that it remains concerned that the bank’s corporate governance structure will still make it challenging to improve or even maintain its low profitability.

Moody’s said that in June 2011 the bank’s annualised pre-provision income was a modest 1.14% of risk-weighted assets, and that a 9% annual growth rate of revenues envisaged by bank’s business plan until 2013 was uncertain and difficult to achieve. It also noted the bank’s difficulty in cutting costs, with the business plan envisaging a 1.3% compounded annual growth rate of costs until 2013.

“Nevertheless the bank will improve capital adequacy,” added Moody’s, “with a Core Tier 1 ratio expected at 8.3% at the year end, assuming the completion of the ongoing share issue (fully underwritten by a pool of banks) and the conversion of a mandatorily convertible bond. It is also worth noting that BPM’s liquidity is satisfactory, which has allowed the bank to cope with the current difficult market funding conditions all the more so since its funding is largely retail-deposit based.”

It said that the negative outlook on the ratings is driven by a difficult operating environment and the bank’s resistance to change.