Central bank issued the instructions after conducting confidential inspections at 30 largest lenders

The Bank of Italy has told some of Italy’s biggest banks to hike bad loans provisions after a sector audit showed they were vulnerable to defaults from small firms struggling in a deep recession, banking sources said.

The central bank issued the instructions after conducting confidential inspections lasting two to three months at 20-30 large listed and unlisted banks, both sources said.

With Italian banks staring to report earnings this week, the level of their coverage of non-performing loans is set to take central stage as the country faces another year of contraction.

The central bank has warned institutions against issuing dividends — the main source of revenues for a myriad of banking foundations that own stakes in Italian banks — if their Tier 1 capital ratio is below the 8 per cent minimum level, one of the sources said. The Bank of Italy declined to comment.

“The Bank of Italy is drafting new guidelines (on NPLs coverage). With this exercise, the bar is set higher, towards a level that looks like a more reasonable benchmark for the system,” said one of the sources, who did not give more details about the new central bank requirements.

The second source confirmed the audit took place and that the central bank was asking Italian lenders to put aside more provisions against bad loans.

“Depending on the bank, the exercise has led to some rigorous corrections,” said one of the two sources. Banking analysts have singled out rising bad debts, mostly due to small companies struggling to pay back loans, as the biggest risk for the banking system. The soundness of the country’s real estate sector is also being questioned, even though Italy does not face a Spanishstyle property crisis.

The sources said the central bank has told banks to be more rigorous when assessing the value of real estate assets, which do not always reflect the fall in real estate market prices.?

Total gross bad loans rose to €125 billion in Italy at the end of 2012, up 16.6 per cent from a year earlier, data from banking association ABI showed last month. ABI expects the growth rate of bad loans, which totalled just under €78 billion two years ago, to peak in the first half of this year. At 40 per cent, Italian banks’ coverage of doubtful loans is well below the European average of 53 per cent and a 60 per cent coverage for Spanish banks, Mediobanca Securities analysts say, adding that they see scope for €21 billion of additional loanloss coverage in the sector.

But such cross-country comparisons are disputed by senior Italian bankers who say the Bank of Italy applies stricter criteria than other countries to classify bad debt.

According to a confidential report from PriceWaterhouseCoopers commis- sioned by ABI, the coverage of non-performing loans at Italian banks was 47 per cent and could rise to 49 per cent if adjusted for different write-off practices in different countries. This was slightly above the coverage for bad debt in Germany but well below levels seen in Spain, France and Britain. One of the sources said the Bank of Italy was also stressing the need for banks to exercise some restraint when issuing dividends. The guidelines suggested not distributing dividends for lenders with a Tier 1 capital ratio below the minimum threshold of 8 per cent, with more flexibility for those with a capital ratio of between 8 and 10.5 per cent. “Those with a capital ratio of 10.5 per cent or above are free with regards to their dividend policy,” the source said.

Italy’s economy has been in recession since the middle of 2011. In its Financial Stability Report published in November, the Bank of Italy had said it was intensifying its assessment of the adequacy of provisions against bad loans.

Intesa Sanpaolo and UniCredit, the country’s two biggest lenders, and smaller bank Credito Emiliano have relatively high provisions against risky loans.

But the same is not true for banks such as Banco Popolare, which warned late on Monday it expected a net loss for 2012 of €330 million ($429 million) after it raised provisions on non-performing loans in the fourth quarter to €650 million, from €602 million in the first nine months.