Europe Credit Research

14 March 2012

Italian Banks
New Capital, New Collateral... Old Problems
We revise our expectations on asset quality trends and we foresee an increase of loan loss charges similar to the one experienced in 2008/2009 based on expectations that the austerity measures introduced in H211 increase the probabilities of an economic recession. We highlight that on the previous occasion Italian banks managed to withstand asset quality deterioration and maintained their investorfriendly policies, but this time we note that BPIM, MONTE and UBIIM are showing depleted loan loss reserves, hence we think are likely to suffer more. In spite of 17.5bn of capital raised together with the more recent liability management exercises, we note that solvency shortfalls persist for the 2nd tier institutions. We highlight that ISPIM and UCGIM are now in compliance with EBA requirements and UBIIM is also likely to bridge its capital deficit by exercising the option on its 1bn convertible. However MONTE and BPIM still face a 3bn and 2.5bn shortfall respectively, which in our view represents a challenge relative to their respective market capitalisations. Ultimately we see a risk of these issuers having to resort to the issuance of contingent convertible instruments, as designed by the EBA, triggering an embargo on Tier I coupon payments and on calls of all subordinated debt. Recent measures taken by the government and the Bank of Italy contributed to build a solid buffer of central bank eligible assets that should safeguard senior investors. The issuance of 60bn of government guaranteed bonds helped manufacture collateral ahead of the first 3yr LTRO, while relaxed collateral requirements should have generated an additional 70-90bn buffer, taking estimated unencumbered assets for Italian banks post February LTRO up to 136-156bn. In light of the weak capital position and potential issuers with regard to the availability of collateral, we decided to downgrade MONTE from Overweight to Neutral (5Yr Senior CDS at 389/399bp). While we note that the potential sale of a significant participation by the main shareholder, Fondazione Montepaschi, together with the recent change of CEO might improve corporate governance, we think that it is unlikely to bridge its capital shortfall on its own.
Table 1: Italian banks recommended buy list
ISIN XS0545782020 XS0527624059 XS0324790657 XS0243399556
Source: J.P. Morgan.

European Credit - Financials Enrico Longato

AC

(44-20) 7777-3147 enrico.longato@jpmorgan.com

Roberto Henriques, CFA

(44-20) 7777-4506 roberto.henriques@jpmorgan.com

Alan Bowe
(44-20) 7325-6281 alan.m.bowe@jpmorgan.com J.P. Morgan Securities Ltd.

All prices as of March 13th, 2012 at 4pm GMT

Issuer ISPIM UCGIM ISPIM ISPIM

Sub T1 T1 LT2 LT2

Ccy EUR EUR GBP EUR

Coupon 9.5 9.375 6.375% 3m+25bp

Post-call coupon 3m+757bp 3m+749bp 3m+135bp 3m+25bp

1st call date 01/06/16 21/07/20 12/11/2012 20/02/2013

Maturity Perp. Perp. 12/11/2017 20/02/2018

Amt (mn) 722 339 250 750

Price 92.25 / 93.25 91.5 / 93.5 93.06 / 95.94 89 / 89.25

See page 15 for analyst certification and important disclosures.

J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. www.morganmarkets.com

Enrico Longato (44-20) 7777-3147 enrico.longato@jpmorgan.com

Europe Credit Research 14 March 2012

Summary and trade ideas

The sovereign crisis has increased the differential between ISPIM and UCGIM on the one hand and MONTE, UBIIM and BPIM on the other hand

In our opinion since the outset of the sovereign crisis, the differential among Italian banks has been widening, highlighting two tiers of institutions; 1st tier institutions such as Intesa San Paolo and Unicredit, and 2nd tier banks, such as Montepaschi, UBI Banca and Banco Popolare. We think that the most important differences among these two groups can be found in their relative levels of capitalisation, as stressed by the shortfalls shown by the European Banking Authority (EBA) as well as the ability to access the market at economically viable levels. In addition we also note that as asset quality deterioration advances, the 2nd tier institutions will be more exposed to the downturn given their depleted loan loss reserves at a point where the credit cycle threatens to turn down again. In our view this set of challenges will pose particular pressure on MONTE, UBIIM and BPIM, resulting in potential suboptimal outcomes such as extension risk and coupon deferral. However, medium-term we believe that senior bondholders will be safe-guarded by the significant liquidity guaranteed by the ECB and by the substantial amount of unencumbered assets eligible for refinancing operations.

Table 2: Relative value recommendations across the capital structure

UCGIM Recommendation Overweight Senior Lower Tier II Tier I (high probability of call) UCGIM displays solid capitalization after the 7.5bn rights issue concluded in 2012. Considering the issuance of senior unsecured from ISPIM, we think that UCGIM can currently access the market, even if levels are unfavorable. Calls on LTII bonds should still be exercised as highlighted by the 2011 calls, while TIs should still pay coupons, as stated by the management, in spite of the zero dividend policy for 2011. Tier Is might get a slightly better treatment at UCGIMs given the softer language in the tender offer memorandum; speaking of future calls UCGIM mentions best interest rather than economic incentive" as a reason for exercising its options (high probability of call) The bank shows no capital shortfall, and has recently accessed the senior unsecured market with two benchmark issues (1.5yr and 5yr). Profitability has proven stable over the cycle and the management has always kept an investor-friendly attitude, making us confident that LTII will be taken out at first call date and TIs will keep paying coupons (low probability of call) X We do not expect losses on LTII No call expected in the near future. Senior should be supported by ECB instruments, but calls are fairly unlikely Instruments might suffer from an liquidity even if there is sporadic market given the economic conditions and a embargo on coupon payments as there is access possible embargo if the EBA deadline is a high probability of missing the EBA missed deadline (low probability of call) X We do not expect losses on LTII Senior should be supported by ECB No call expected after the LME and instruments, but calls are fairly unlikely liquidity even if there is no market access previous statements from the bank given market conditions (very low probability of call) X We do not expect losses on LTII No call expected in the near future. instruments, but calls are extremely Instruments might suffer from an Senior should be supported by ECB unlikely after the LME, the previous embargo on coupon payments as there is liquidity even if there is no market access deferrals and the possible embargo if the a high probability of missing the EBA EBA deadline is missed deadline

ISPIM

Neutral

MONTE

Neutral

UBIIM

Neutral

BPIM

Underweight

Source: J.P. Morgan.

We like ISPIM and UCGIMs high coupon tier Is for their attractive risk-return profile

Under these circumstances we recommend ISPIM 9.5% 16 and the UCGIM 9.375% 20, as they provide a significant yield-to-maturity (just below 11%) as well as yield-to-call (~11% as well) with the extension risk being effectively mitigated by the high post-call spread of these instruments. In particular we note that both instruments were subject to liability management with limited acceptance thereby reiterating investor confidence in these structures and also leaving sufficient liquidity in the outstanding instruments.

Enrico Longato (44-20) 7777-3147 enrico.longato@jpmorgan.com

Europe Credit Research 14 March 2012

Table 3: Recommended buys in Tier Is

ISIN XS0545782020 XS0527624059
Source: J.P. Morgan.

Issuer ISPIM UCGIM

Sub T1 T1

Ccy EUR EUR

Coupon 9.5 9.375

Post-call coupon 3m+757bp 3m+749bp

First call date 01/06/2016 21/07/2020

Maturity Perp. Perp.

Amt (mn) 722 339

Price (ask) 93.25 93.5

YTC 11.60 10.57

YTM 10.82 10.65

ZTC 1023 861

ZTM 753 794

Figure 1: ISPIM 9.5% 16 vs. SUSI Banks Tier I Index

ASW bp

Figure 2: UCGIM 9.375% 20 vs. SUSI Banks Tier I Index

ASW bp

2,000 1,500 1,000 500 0 Feb-11

ISPIM - Index ISPIM 9.5% 16 SUSI Banks Tier I Index

1,500 1,250 1,000 750 500 250

UCGIM - Index UCGIM 9.375% 20 SUSI Banks Tier I Index

Apr-11

Jun-11

Aug-11

Oct-11

Dec-11

Feb-12

0 Feb-11

Apr-11

Jun-11

Aug-11

Oct-11

Dec-11

Feb-12

Source: J.P. Morgan.

Source: J.P. Morgan.

As opposed the market we believe that ISPIM will keep calling its LTII instruments, maintaining its positive track record

Looking at the coming calls we highlight two ISPIM lower tier IIs, the ISPIM 6.375% 12-17 and the ISPIM FRN 13-18 that we believe will get called at the first call date. We believe this will be the most likely scenario as the bank has kept calling all its instruments so far, regardless of the currency they were issued in and regardless of the stress in the wholesale funding market. We remind investors that Intesa called the ISPIM 5.5% $ 11-16 in December, just prior to the 1st 3yr LTRO. Furthermore, we note that, as the Bank of Italy removed the restriction on liability management exercises by removing the pre-funding requirement which will allow banks the option of calling capital instruments without having to explicitly refinance. Under these circumstances we think that ISPIM may use ECB liquidity for early repayment of senior subordinated instruments, maintaining its positive track record.

Table 4: Recommended buys in Callable Lower Tier IIs

ISIN XS0324790657 XS0243399556
Source: J.P. Morgan.

Issuer ISPIM ISPIM

Sub LT2 LT2

Ccy GBP EUR

Coupon 6.375% 3m+25bp

Post-call coupon 3m+135bp 3m+25bp

First call date 12/11/2012 20/02/2013

Maturity 12/11/2017 20/02/2018

Amt (mn) 250 750

Price (ask) 95.94 89.25

YTC 12.40 13.45

YTM 4.31 3.60

ZTC/ DM 1149 1258

ZTM/ DM 247 273

Enrico Longato (44-20) 7777-3147 enrico.longato@jpmorgan.com

Europe Credit Research 14 March 2012

Figure 3: ISPIM 6.375% 12-17 vs. SUSI Banks Lower Tier II Index
Yield-to-call %

Figure 4: ISPIM FRN 13-18 vs. SUSI Banks Lower Tier II Index
Yield-to-call %

40.0 30.0 20.0

ISPIM - Index ISPIM 6.375% 12-17 SUSI Banks Lower Tier II Index

40.0 30.0 20.0 10.0

ISPIM - Index ISPIM FRN 13-18 SUSI Banks Lower Tier II Index

10.0 0.0 Feb-11

0.0 -10.0 Feb-11

Apr-11

Jun-11

Aug-11

Oct-11

Dec-11

Feb-12

Apr-11

Jun-11

Aug-11

Oct-11

Dec-11

Feb-12

Source: J.P. Morgan.

Source: J.P. Morgan.

The slowdown of the Italian economy will stress differences

The Italian economy is expected to be in a recession in 2012/13

Figure 5: Italian GDP forecasts

%

2 0 -2 -4

1.2 0.6 -0.7 -1.8

0.4

The deterioration of the European macroeconomic environment and the implementation of the austerity measures are expected to be a drag on Italy; according to both official estimates and our Economic Research team, the country should be in a recession in both 2012 and 2013. Yet, we note that our economics research colleagues expect the downturn to be milder that the one seen in 2008/2009, after the collapse of Lehman Brothers; in their base case, the Italian GDP is expected to decline by 1.8% and 0.7% in 2012 and 2013 respectively (see Nicola Mai Money and credit flag downside risk for Italian growth). The clear consequence on Italian banks will be substantial asset quality deterioration and consequently higher loan loss provisions, marking a clear reversion of current trends. Under the circumstances outlined above, and assuming that there is no tail event like a breakup of the Euro Area, we believe that it is fairly conservative to forecast an increase of the cost of risk comparable to that one seen in between Q4 08 and Q4 09.

-6 -5.2 2009 2010 2011 2012 2013 2014

Source: J.P. Morgan estimates.

Table 5: Cost of risk (maxima in bold)

bp Q4 07 BPIM BPIM standalone* ISPIM MONTE UBIIM UCGIM 112 54 n/a 71 39 Q1 08 32 34 n/a 25 44 Q2 08 59 43 n/a 39 41 Q3 08 76 88 50 42 68 Q4 08 192 99 112 128 83 Q1 09 62 72 76 68 104 Q2 09 64 108 105 100 157 Q3 09 84 79 83 92 82 143 Q4 09 99 104 109 98 110 139 Q1 10 70 68 78 83 53 120 Q2 10 84 83 83 77 75 116 Q3 10 88 77 72 76 52 111 Q4 10 65 92 90 74 96 115 Q1 11 83 81 69 71 40 102 Q2 11 77 71 84 72 60 77 Q3 11 77 73 70 72 51 124

Source: J.P. Morgan estimates, Company data. Note (*): BPIM standalone excludes Banca Italease. Note: see Appendix for full updated asset quality tables.

Enrico Longato (44-20) 7777-3147 enrico.longato@jpmorgan.com

Europe Credit Research 14 March 2012

Figure 6: Average cost of risk vs. GDP growth

bp (LHS), % (RHS)

140 120 100 80 60 40 20 0 Q4 07 Estimated Avg cost of risk - Best & worst case (LHS) Q4 08 Q4 09 Q4 10 Q4 11 Q4 12 Avg. cost of risk (LHS) GDP % q/q saar (inverted scale - RHS)

-15 -10 -5 0 5

Source: J.P. Morgan estimates. Average of for the banks in our coverage (BPIM, ISPIM, MONTE, UBIIM and UCGIM).

Potential losses should be a marginal risk, on the basis of 2008/09 performance, however some will suffer more than others

Looking back at asset quality figures and the financial performance of the institutions in our coverage (see charts from Figure 8 to Figure 12) we note that impact of the previous downturn has been relatively contained and it mainly affected second tier banks, i.e. MONTE, UBIIM and BPIM. Nevertheless we highlight that banks remained committed to their bondholder-friendly policy and kept paying coupons on their Tier Is all the way through the period, even after they received the governments support in the form of Tremonti Bonds. What in our view will be different this time is that the previous recession depleted the stock of provisions, as highlighted by the sharp decline in coverage ratios over the past years. Hence we think that our second tier banks, and BPIM and UBIIM in particular, will be more exposed than peers to the cycle, resulting in a more marked differential between their performance and that one of ISPIM and UCGIM.
Figure 7: Italian banks evolution of coverage ratios from 2007 to Q3 11
70% 65% 60% 55% 50% 45% 40% 35% 30% 25% 66% 52% 62% 50% 51% 44% 33% 55% 50%

in fact the decline in coverage ratios for MONTE, BPIM, and UBIIM implies smaller buffers, leaving them more exposed to the downturn

30% BPIM **

ISPIM

UCGIM 2007 2008

MONTE * 2009 2010

UBIIM Q3 11

Source: J.P. Morgan estimates, Company data. Note (*): BPIMs 2007 and 2008 data is pre-Italease consolidation.

Enrico Longato (44-20) 7777-3147 enrico.longato@jpmorgan.com

Europe Credit Research 14 March 2012

Figure 8: ISPIM Quarterly net profit vs. cost of risk

million, bp

Figure 9: UCGIM Quarterly net profit vs. cost of risk

million, bp

2,000 1,500 1,000 500 0 -500 -1,000 -1,500 Q1 08 Q3 08 Q1 09 Q3 09 Q1 10 Q3 10 Q1 11 Q3 11 Net income

Source: J.P. Morgan estimates, Company data.

120 100 80 60 40 20 0 Cost of risk

2,000 1,500 1,000 500 0 -500 -1,000 -1,500 -2,000 Net income Cost of risk
-10.6bn

180 160 140 120 100 80 60 40 20 0

Q1 08 Q3 08 Q1 09 Q3 09 Q1 10 Q3 10 Q1 11 Q3 11 *

Source: J.P. Morgan estimates, Company data. Note (*): Q311 includes 8bn goodwill writedown.

Figure 10: MONTE Quarterly net profit vs. cost of risk

million, bp

Figure 11: UBIIM Quarterly net profit vs. cost of risk

million, bp

700 600 500 400 300 200 100 0 -100 -200 -300 Q1 08 Q3 08 Q1 09 Q3 09 Q1 10 Net income
Source: J.P. Morgan estimates, Company data.

120 100 80 60 40 20 0 Q3 10 Q1 11 Q3 11 Cost of risk

400 300 200 100 0 -100 -200 -300 -400 -500 -600 Q1 08 Q3 08 Q1 09 Q3 09 Q1 10 Net income
Source: J.P. Morgan estimates, Company data.

140 120 100 80 60 40 20 0 Q3 10 Q1 11 Q3 11 Cost of risk

Figure 12: BPIM Quarterly net profit vs. cost of risk

million, bp

Table 6: Recent rights issues

billion

400 300 200 100 0 -100 -200 Q1 09 Q3 09 Q1 10 Net income Q3 10 Q1 11 Q3 11 Cost of risk

120 100 80 60 40 20 0
MONTE UCGIM
Source: J.P. Morgan.

Amount issued BPIM UBIIM ISPIM 2 1 5 2 7.5

Announcement date October - 2010 April - 2011 April - 2011 April - 2011 November - 2011

Source: J.P. Morgan estimates, Company data.

Enrico Longato (44-20) 7777-3147 enrico.longato@jpmorgan.com

Europe Credit Research 14 March 2012

and capitalisation issues will point in the same direction

There has been some improvement, especially with regards to capitalisation levels: 17.5bn of capital raised and 4 liability management exercises out of 5 banks

Together with our renewed concerns about asset quality, we believe that the old capitalisation issues are still lingering, even though notable steps forwards have been made. Firstly, we note that the sector has undergone a series of recapitalisations that, together with the latest effort from UCGIM, contributed to a total capital raise for the system of about 17.5bn. Secondly we highlight that the changed stance of Bank of Italy (BoI) with regards to liability management exercises on subordinated debt, prompting an unprecedented series of tender offers for cash, in an attempt to add precious basis points to their Core Tier I ratios. However, in spite of these efforts we estimate that MONTE, BPIM and UBIIM still have to raise approximately 7bn of capital to meet the requirements set by the European Banking Authority (EBA) on December 8th, and we believe that our 2nd institutions are likely to face difficulties correcting their capital deficit.
Figure 13: Italian banks Basel 2.5 capital under ratios before and after EBA sovereign buffer
12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% ISPIM UCGIM* Core Tier I (B2.5)
Source: J.P. Morgan estimates.

Yet second tier banks still have to address their EBA capital shortfalls

10.0%

9.2%

9.9% 9.4%

9.2% 6.0%

8.4%

7.5%

6.5% 6.1%

MONTE

UBIIM

BPIM

Core Tier I (B2.5) post EBA sovereign buffer

The EBA highlighted a 15.4bn capital shortfall that has only partially been addressed

EBA: Setting the benchmark As Italian banks were started to address their capitalisation issues, the sovereign crisis spread to Italy, and the EBA came up with the ill-fated decision of stressing government bonds held in the banking books of financials across Europe. As a result the authority concluded that the main five Italian banks still needed 15.4bn of fresh capital to compensate for the transition from Basel 2 to Basel 2.5 and to have sufficient support for their holdings of government bonds, de-facto implying a nonzero risk-weight for Italian Treasuries. The operation made Unicredits management announce a 7.5bn rights issue that, despite market challenges , was completed in 2012, leaving MONTE, BPIM and UBIIM as the only institutions with a capital gap. Now, while we note that UBI Banca can almost erase the gap with the conversion of its 1bn convertible bond, we also conclude that it will be challenging for Montepaschi and Banco Popolare to fill the gap without taking extraordinary measures.

Enrico Longato (44-20) 7777-3147 enrico.longato@jpmorgan.com

Europe Credit Research 14 March 2012

Table 7: EBA sovereign stress results: capital shortfalls and banks' plans
Bank UCGIM MONTE Shortfall 7.97bn 3.27bn Current shortfall 0bn 2.98bn Update - 7.5bn rights issue - 2.4bn from restructuring of CASHES for inclusion in Core Tier I (0.6bn remain as Tier I capital) - No dividend paid for 2011 - 0.29bn from the conversion of FRESH 2003 into equity - MONTE aims to meet the requirement by obtaining the inclusion of its FRESH 2008 instruments (950mn) into Core Tier I, expanding the use of advanced internal rating models, asset disposals and possible revaluation of assets - An estimated 0.22bn from the liability management exercise - The bank plans to use its 1bn soft mandatory convertible and to adopt internal rating models that should generate an 80bp increase of its capital ratios (equal to 0.77bn capital increase). Additional capital management actions will also be taken into consideration, but a rights issue has been excluded so far - UBIIM expects to meet requirements thanks to its convertible bond (1bn), the progressive migration to the advanced internal rating models, deleveraging action currently underway; and capital accretion

BPIM UBIIM

2.73bn 1.39bn

2.51bn 1.39bn

Source: European Banking Authority and J.P. Morgan estimates.

It is difficult to see how MONTE and BPIM can fulfil their requirements by June

At the moment the capital shortfalls of Montepaschi and Banco Popolare, 2.98bn and 2.51bn respectively, still remain way behind their earnings generation capability and any clearly executable measure like restructuring the FRESH 2008 for MONTE or exercising the option on the 1bn convertible for BPIM cannot provide a comprehensive solution to any of the two institutions. Under these circumstances we believe that these two are likely to require the issuance of contingent convertible instruments, as prescribed by the EBA; this will then trigger state-aid resolutions from the European Commission, and ultimately put an embargo on coupon payments on Tier Is and on the exercise of call options on subordinated instruments. With regards to Montepaschi we also note that the ownership structure is being partially reshuffled, as Fondazione Montepaschi, the main shareholder with 49.1%, is being forced to sell a 15% stake in order to partially repay its creditors; yet we do not believe that this will be a game changer for the bank and for its EBA capital requirement. While this event should be seen as a positive, as it can limit the impact that the financial situation of the Fondazione has on the bank, we think that there will be a fragmented sale to various investors, ranging from private equity funds to Italian entrepreneurs; furthermore, Fondazione Montepaschi would still remain the main shareholder of the bank, with a ~34% stake, and it is then likely to remain the kingmaker, making an eventual impact on corporate governance relatively limited. Liability management: when it rains it pours While capital shortfalls were still gripping Italian banks the Bank of Italy has finally decided, at the end of January, to change its rules on debt buybacks, prompting a sequence of tender offers for cash on subordinated debt, and in particular on institutional Tier Is.

The reshuffling of MONTEs shareholders composition will be a small positive but not enough to turn around the situation

While the EBA chose to stand by its decision the Bank of Italy has eased its regulation of LMEs, in an attempt to generate additional capital

Enrico Longato (44-20) 7777-3147 enrico.longato@jpmorgan.com

Europe Credit Research 14 March 2012

Table 8: Italian banks: tender offers

ISIN Sub UCGIM (24-Jan-12) DE000A0DD4K8 T1 DE000A0DYW70 T1 XS0231436238 T1 XS0231436667 T1 XS0527624059 T1 XS0470937243 T1 XS0372556299 T1 XS0367777884 UT2 XS0241369577 UT2 XS0241198315 UT2 BPIM (6-Feb-12) XS0304963290 T1 XS0304963373 T1 XS0255673070 T1 XS0223454512 T1 XS0259400918 LT2 XS0256368050 LT2 XS0276033510 LT2 XS0284945135 LT2 XS0464464964 LT2 XS0555834984 LT2 XS0632503412 LT2 XS0215451559 UT2 ISPIM (6-Feb-12) XS0545782020 T1 XS0456541506 T1 XS0371711663 T1 UBIIM (7-Feb-12) XS0108805564 T1 XS0123998394 T1 XS0131512450 T1 Coupon 6 7.5 4.028 5.396 9.375 8.125 8.5925 6.7 3.95 5 6.156 6.756 2.769 6.742 3m + 55bp 3m + 40bp 3m + 45bp 3m + 35bp 5.473 6 6.375 4.625 9.5 8.375 8.047 8.17 8.364 9 75.0 76.8 78.0 86.1 85.4 82.3 80 80 80 66.3 68.4 31.3 74.4 n/a 74.8 74.1 73.1 84.1 83.6 81.2 75.0 90 91 88 5.0 3.2 2.0 Price (preoffer) 34.7 34.3 59.0 56.5 67.2 69.2 61.5 78.5 79.0 73.5 70 71 43 78 75 78 78 76 89 91 90.5 90 3.9 5.6 5.7 EUR EUR EUR Tender price 50 50 71 66 79 81 72 87 86 75 3.7 2.6 11.7 3.6 n/a 3.3 3.9 2.9 4.9 7.4 9.3 15.0 EUR EUR EUR 96 186 73 Premium 15.3 15.7 12.0 9.5 11.8 11.8 10.5 8.5 7.0 1.5 EUR EUR EUR EUR EUR EUR EUR EUR EUR EUR EUR EUR 1,000 1,500 1,250 96 186 73 Ccy EUR EUR EUR GBP EUR EUR GBP EUR EUR GBP 269 279 145 487 76 235 168 181 318 950 600 298 1,000 1,500 1,250 10/03/2010 15/02/2011 27/06/2011 Amt out (preoffer, local mn) 250 150 750 270 500 750 318 1,000 900 450 269 279 145 487 76 235 168 181 318 950 600 298 01/06/2016 14/10/2019 20/06/2018 29 41 29 Amt out (preoffer, mn) 250 150 750 325 500 750 383 1,000 900 542 21/06/2017 21/06/2017 06/06/2016 30/06/2015 28/06/2011 15/06/2011 22/11/2011 08/02/2012 Bullet Bullet Bullet Bullet 278 494 454 29 41 29 First call date 28/10/2011 22/03/2012 27/10/2015 27/10/2015 21/07/2020 10/12/2019 27/06/2018 05/06/2018 01/02/2016 01/02/2016 193 140 79 127 11 70 11 57 32 218 264 6 278 494 454 23% 18% 28% Acceptance (local mn) 152 99 470 244 161 165 140 165 82 90 193 140 79 127 11 70 11 57 32 218 264 6 28% 33% 36% Acceptanc e (mn) 152 99 470 294 161 165 168 165 82 108 71% 50% 54% 26% 14% 30% 6% 31% 10% 23% 44% 2% Takeup 61% 66% 63% 90% 32% 22% 44% 16% 9% 20%

Source: J.P. Morgan estimates, Company data.

LMEs offer a chance for capital structure optimization, taking the responsibility for missed calls off the issuer

We believe this represents both a chance to achieve a better capital structure, as the regulators attention shifts to the Core Tier I ratio, and an attempt to offer a way out to investors, so that banks can decline any responsibility in the event of missed call for economic reasons. With this regards we note that the common denominator of all these offers, aside from UCGIMs, is the economic incentive language with regards to future calls. While we do not exclude the chance of a better treatment in case of a significant improvement of market conditions, we believe that these offers will be fundamental in addressing future calls, as they will allow even the better geared issuers to claim that their benevolent tender was a sufficient effort to keep an investor-friendly behaviour. A similar argument can in our view apply to Unicredit that stated that its decisions will be taken on a best interest basis; this language is in our view slightly more accommodating to investors as it leaves the door open to non-economical considerations like reputation or a good relationship with investors. Consequently we think that any consideration with regards to the potential call of Italian Tier I instruments and on Tier II bonds issued by MONTE, UBIIM and BPIM should be based on cost of funding and eligibility criteria, while we still expect that UCGIM and ISPIM will keep calling their Tier II bonds, as the have been doing so far.

Going forward, each call, with the exception of those of UCIGM and ISPIM LTIIs should be judged on an economic basis

Enrico Longato (44-20) 7777-3147 enrico.longato@jpmorgan.com

Europe Credit Research 14 March 2012

We expect MONTE to follow its peers, with a tender offer across the whole capital structure, but we believe premia will be limited

With regards to the quality of the offers we note that while the first buyback launched by Unicredit carried a significant premium, it also fuelled a rally among other Italian tier Is contributing to lower premia on subsequent offers. We also note that among the institutions in our coverage Montepaschi is the only one that has not taken any action yet, but in our view a similar operation is imminent. In this sense we expect the bank to propose a buyback of not only on Tier I instruments, but also on Upper Tier II and Lower Tier II bonds, given that the these categories represent a larger component of the subordinated bonds issued by the institution. However we expect that given the precedents the premia would be fairly small, in the 2-3pts area. A direct exchange offer into equity would also contribute to a more significant capital benefit for Monte.

Table 9: Montepaschi: candidates for tender and potential gain

ISIN Sub Ccy Coupon XS0121342827 T1 EUR 7.99 XS0131739236 T1 EUR 3m + 310bp XS0122238115 T1 EUR 3m + 375bp IT0004352586 UT2 EUR 3m + 250bp XS0255820804 UT2 EUR 4.875 XS0255817685 UT2 GBP 5.75 XS0503326083 LT2 EUR 5 XS0236480322 LT2 EUR 3m + 40bp XS0540544912 LT2 EUR 5.6 XS0238916620 LT2 EUR 3m + 40bp Total potential pre-tax gain from 50% take-up
Source: J.P. Morgan estimates.

Post-call coupon 3m + 630bp 3m + 630bp 3m + 630bp

First call date 07/05/2012 27/03/2012 21/03/2011

3m + 100bp 3m + 100bp

30/11/2012 15/01/2013

Maturity Perp. Perp. Perp. 15/05/2018 31/05/2016 30/09/2016 21/04/2020 30/11/2017 09/09/2020 15/01/2018

Amt out (local mn) 350 220 80 1,603 750 200 500 500 500 150

Take-up (hypothesis) 50% 50% 50% 50% 50% 50% 50% 50% 50% 50%

Discount to par 26% 32% 1% 1% 3% 19% 6% 18% 4% 20%

Implied pre-tax gain (mn) 46 35 1 8 10 23 15 45 9 15 207

Liquidity should provide support

While the senior unsecured market should be open for ISPIM and UCGIM, the smaller issuers will have to rely on the ECB

In spite of the tentative improvements on capital and the threats posed by worsening asset quality we still remain confident that Italian banks have access to sufficient liquidity to withstand the crisis. On the one hand we note that ISPIMs recent issuance of a 1.5yr and a 5yr senior unsecured bonds for a total of 2.5bn, together with UCGIMs and MONTEs highlights that, regardless of the levels, first tier institutions can still access the market, while on the other hand the 3yr LTRO and the sizable amount of ECB eligible assets, together with occasional market access, should still provide the broader sector with the support needed. With this regards we highlight that even if the Italian banking system has increased its reliance on the ECB, there is still a substantial pool of unpledged assets, and there is potential for the creation of further liquidity via the issuance of covered bonds.
Table 10: New senior unsecured
Bank ISPIM ISPIM UCGIM MONTE
Source: J.P. Morgan.

Date 31-Jan-2012 20-Feb-2012 29-Feb-2012 29-Feb-2012

Tenure 1.5yr 5yr 5yr 2yr

Amount issued 1.5bn 1bn 1.5bn 1.25bn

Price MS+295 MS+355 MS+345 MS+365

The government issuance of government guarantees and the relaxed collateral requirements have expanded the pool of ECB eligible assets substantially

Recent statistics from the Bank of Italy show that reliance on the central banks funding has increased significantly over the past few months, raising questions on the amount of eligible collateral still available. However we note that both the government and the regulator have been supporting the banks effort to expand the pool of resources, the first one by setting up a new government guarantee scheme and the second one by relaxing the collateral requirements.

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Enrico Longato (44-20) 7777-3147 enrico.longato@jpmorgan.com

Europe Credit Research 14 March 2012

The Italian government instituted a government guarantee scheme that provided the fostered issuance of 60bn of new bonds to be retained and pledged as additional collateral

With regards to the guarantee scheme we note that the government implemented the plan presented by the European Commission on December 1st, 2011, giving to the banks the possibility of manufacturing additional ECB eligible collateral, as we already outlined in The power of money. As a result, over the span of less than two months, Italian banks issued 60bn worth of new government guaranteed paper, and pledged it as collateral at the two 3yr LTRO auctions in December and February. We note that the programme technically allows for a total issuance of more than 200bn1, however we do not expect further significant issuance, given that each additional bond increments the already vast pile of government debt, and the strained Italian public finances cannot be stretched further. Under these circumstances we believe that the existence of this option remains just as a form of an indirect safety net that could be reactivated in case of a new exacerbation of the sovereign crisis. On the other hand we believe that the action taken by the Bank of Italy, following the new stance of the ECB, is much more effective, as it exits from the sovereign-bank loop. At the end of January, BoI decided to relax its collateral requirements and to start accepting bank loans with probability of default below 1% as a guarantee for its refinancing operations. But while this decision seems to have the potential of unleashing a vast amount of assets we note that the regulator, under recommendation of the ECB, is applying severe haircuts to compensate for the illiquidity of the collateral and to prevent banks from pledging lower quality assets first. As a result, according to what stated by the governor of the BoI, the regulator expects this new change to increment the pool of eligible assets by an estimated 70-90bn2.

BoI relaxed collateral requirements, adding another 70-90bn of central bank eligible asset

Table 11: New eligible assets haircut applied by BoI

Residual maturity 0-1ys 1-3ys 3-5y 5-7ys 7-10ys >10ys
Source: Bank of Italy.

Haircut 42% 62% 70% 78% 78% 80%

Figure 14: Italian banks: ECB/National Central Bank eligible assets and utilisation
billion

400 350 300 250 200 150 100 50 0

60 280 70-90

297

357

70 147-167

~80 136-156 Estimated net Estimated total use of 2nd 3yr unencumbered LTRO assets (Mar-12)

Eligible (Nov-11) Government guaranteed issued

Source: Bank of Italy and J.P. Morgan estimates.

Eligible (Jan-12) Utlised (Jan-12)

New Unencumbered Estimated unencumbered assets pre-2nd increase in assets 3yr LTRO eligible assets

The maximum issuance of government guaranteed bonds that each bank can issue is capped to the amount of total regulatory capital. 2 Estimate from Bank of Italy (see http://www.bancaditalia.it/interventi/integov/2012/forex18022012/en_Visco_180212.pdf).
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Europe Credit Research 14 March 2012

We can estimate the ECB eligible assets on a bank specific basis only relying on several assumptions

Now, while on a sector-wide basis we know that the amount of collateral available is quite substantial, we have to rely on estimates to be able to draw any conclusion for single institutions. Looking back at the data presented by the banks when reporting Q3 11 results we note that Unicredit and Montepaschi were the banks in which the utilisation of ECB liquidity versus the amount of unencumbered assets was more pronounced. However, taking into consideration the 3yr LTRO and the relaxed collateral requirements we believe that the differential among institutions is being reduced and we estimate that MONTE and, to a smaller extent, BPIM are the banks in our peer group that show an above average utilisation. In particular we note that the issuance of government guaranteed bonds allowed for a substantial rollover of short term operations and we estimate that part of the second 3yr LTRO was used to decrease the amount of repo with other counterparties, contributing to a further lengthening of the debt maturity profile. Furthermore, we estimate the benefit of the expanded collateral requirements to be proportional to the relative size of the loan books of the institutions, even if we acknowledge that this approach does not take into consideration the peculiarities of each bank.

We believe that a large chunk of the first LTRO has been used to roll already existing facilities

Table 12: Estimates of ECB utilisation by bank

billion Estimates pre 3yr LTROs Est.1st 3yr LTRO take-up Gross Net ECB ECB taketakeup up 12.5 5 12 4.8 10 10 10 4 6 2.5 50.9 25.8 60 30 Est. 2nd 3yr LTRO take-up Gross Net ECB ECB taketakeup up 10 10 24 18 10-15 0 3 3 6 6 53-63 37 116 81 Estimates post 3yr LTROs Additional collateral created by BoI Unencu New mbered Loans (% eligible collateral system) collateral (Mar-12) 24% 17-21 39-50 16% 11-14 34-37 7% 5-6 10-11 4% 2.7-3.4 8-9 4% 3-4 15-16 54% 38-49 106-123 100% 70-90 136-156

UCGIM* ISPIM MONTE** BPIM *** UBIIM Total System

Pledged 20 18.5 15 3.6 3.5 60.6 220

Unencu mbered 7-17 33.5 5.4 6.5 7.6 60-70 77

Total eligible 27-37 52 20.4 10.1 11.1 121-131 297

Pledged 35 41 25 14 12 127 361

Unencu mbered 22-28 23 5 6 12 68-74 66

Total eligible 57-63 64 30 20 24 195-201 427

Source: J.P. Morgan estimates. Notes: (*) UCGIM unencumbered and total eligible assets estimates encapsulate the deduction of 38.8bn repos with clients and 32.8bn repos with banks; (**) estimates based on Q3 11 data; (***) pre 3yr LTRO estimates related to the beginning of Dec-11.

We note that there is scope for further creation of collateral through issuance of new covered bonds

Furthermore, while we note that the amount of unencumbered collateral is on a declining trend, we believe that there is still room for the creation of high quality assets, through the issuance of new covered bonds. Specifically we highlight that Italian banks should have enough room for manoeuvre, as the ratio of covered bonds to loans outstanding is extremely low, even for Unicredit that has a stronger track record due to its German operations. Finally we can conclude that our thesis is clearly supported by the recent inauguration of a 25bn retained covered bond programme by Unicredit and a smaller one (1.9bn) by Banco Popolare, both with the sole purpose of increasing the pool of eligible securities.

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Enrico Longato (44-20) 7777-3147 enrico.longato@jpmorgan.com

Europe Credit Research 14 March 2012

Figure 15: Covered bonds still remain a small portion of funding so there is scope for an increase
billion

200 180 160 140 120 100 80 60 40 20 0

167 130 6% 50 21 ISPIM UCGIM Securities issued 65 9 MONTE Covered bonds 9% 7% 6% 55 7 BPIM 48 6 UBIIM 6%

12% 10% 8% 6% 4% 2% 0% Covered bonds as % of lonas

Source: J.P. Morgan estimates, Company data.

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Enrico Longato (44-20) 7777-3147 enrico.longato@jpmorgan.com

Europe Credit Research 14 March 2012

Appendix
Table 13: NPL ratios
% Q4 07 BPIM BPIM standalone* ISPIM MONTE UBIIM UCGIM 4.9 4.8 n/a 2.8 6.2 Q1 08 4.6 4.8 n/a 3.0 6.0 Q2 08 5.2 4.9 n/a 3.0 6.0 Q3 08 5.7 5.1 7.7 3.2 6.0 Q4 08 7.2 5.7 8.5 3.8 6.6 Q1 09 7.6 6.0 9.4 4.1 7.2 Q2 09 7.9 7.3 10.5 4.9 8.1 Q3 09 Q4 09 Q1 10 Q2 10 Q3 10 Q4 10 Q1 11 Q2 11 Q3 11 12.2 13.3 13.6 12.7 13.0 13.1 13.4 13.6 14.1 8.2 9.5 9.9 9.3 9.9 10.0 10.4 10.2 10.6 7.9 8.8 9.2 9.2 9.2 9.4 9.5 9.8 10.0 10.8 10.7 11.0 11.7 12.1 11.9 12.6 13.0 13.5 5.2 6.4 6.6 6.6 6.9 7.1 7.5 7.6 8.1 9.0 9.7 10.1 10.8 11.0 11.6 11.6 11.1 12.0

Source: J.P. Morgan estimates, Company data. Note (*): BPIM standalone excludes Banca Italease.

Table 14: Coverage ratios

% Q4 07 BPIM BPIM standalone* ISPIM MONTE UBIIM UCGIM 55 66 n/a 50 62 Q1 08 46 63 n/a 49 63 Q2 08 42 63 n/a 26 63 Q3 08 40 63 51 24 63 Q4 08 45 60 51 48 59 Q1 09 42 58 49 46 58 Q2 09 41 54 44 42 56 Q3 09 Q4 09 Q1 10 Q2 10 Q3 10 Q4 10 Q1 11 Q2 11 Q3 11 35 34 30 27 31 32 31 34 30 38 35 34 33 33 34 33 34 32 52 48 49 51 51 51 52 51 52 46 45 45 44 45 46 46 45 44 41 37 36 37 35 36 35 34 33 55 51 52 50 50 49 49 49 50

Source: J.P. Morgan estimates, Company data. Note (*): BPIM standalone excludes Banca Italease.

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Europe Credit Research 14 March 2012

Analyst Certification: The research analyst(s) denoted by an AC on the cover of this report certifies (or, where multiple research analysts are primarily responsible for this report, the research analyst denoted by an AC on the cover or within the document individually certifies, with respect to each security or issuer that the research analyst covers in this research) that: (1) all of the views expressed in this report accurately reflect his or her personal views about any and all of the subject securities or issuers; and (2) no part of any of the research analyst's compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by the research analyst(s) in this report.

Important Disclosures

Market Maker/ Liquidity Provider: J.P. Morgan Securities Ltd. and/or an affiliate is a market maker and/or liquidity provider in UniCredit, Banco Popolare, UBI, IntesaSanpaolo, Monte Paschi di Siena. Lead or Co-manager: J.P. Morgan acted as lead or co-manager in a public offering of equity and/or debt securities for UniCredit, Banco Popolare, IntesaSanpaolo, Monte Paschi di Siena within the past 12 months. Other Significant Financial Interests: J.P. Morgan owns a position of 1 million USD or more in the debt securities of UniCredit, Banco Popolare, UBI, IntesaSanpaolo, Monte Paschi di Siena. Company-Specific Disclosures: Important disclosures are available for compendium reports and all J.P. Morgancovered companies by visiting https://mm.jpmorgan.com/disclosures/company, calling 1-800-477-0406, or emailing research.disclosure.inquiries@jpmorgan.com with your request.

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Europe Credit Research 14 March 2012

UniCredit - J.P. Morgan Recommendation History Date 27 May 11 Rating Overweight Instrument 5yr CDS

Recommendation changes made by J.P. Morgan Credit Research Analysts in the subject company over the past 12 months (or, if no recommendation changes were made in that period, the most recent change). Banco Popolare - J.P. Morgan Recommendation History Date 27 May 11 Rating Underweight Instrument 5yr CDS

Recommendation changes made by J.P. Morgan Credit Research Analysts in the subject company over the past 12 months (or, if no recommendation changes were made in that period, the most recent change). UBI - J.P. Morgan Recommendation History Date 27 May 11 Rating Neutral Instrument 5yr senior CDS

Recommendation changes made by J.P. Morgan Credit Research Analysts in the subject company over the past 12 months (or, if no recommendation changes were made in that period, the most recent change). IntesaSanpaolo - J.P. Morgan Recommendation History Date 20 Feb 06 Rating Neutral Instrument CDS

Recommendation changes made by J.P. Morgan Credit Research Analysts in the subject company over the past 12 months (or, if no recommendation changes were made in that period, the most recent change). Monte Paschi di Siena - J.P. Morgan Recommendation History Date 27 May 11 Rating Overweight Instrument 5yr CDS

Recommendation changes made by J.P. Morgan Credit Research Analysts in the subject company over the past 12 months (or, if no recommendation changes were made in that period, the most recent change).

Explanation of Credit Research Ratings: Ratings System: J.P. Morgan uses the following sector/issuer portfolio weightings: Overweight (over the next three months, the recommended risk position is expected to outperform the relevant index, sector, or benchmark), Neutral (over the next three months, the recommended risk position is expected to perform in line with the relevant index, sector, or benchmark), and Underweight (over the next three months, the recommended risk position is expected to underperform the relevant index, sector, or benchmark). J.P. Morgan's Emerging Market research uses a rating of Marketweight, which is equivalent to a Neutral rating. Valuation & Methodology: In J.P. Morgan's credit research, we assign a rating to each issuer (Overweight, Underweight or Neutral) based on our credit view of the issuer and the relative value of its securities, taking into account the ratings assigned to the issuer by credit rating agencies and the market prices for the issuer's securities. Our credit view of an issuer is based upon our opinion as to whether the issuer will be able service its debt obligations when they become due and payable. We assess this by analyzing, among other things, the issuer's credit position using standard credit ratios such as cash flow to debt and fixed charge coverage (including and excluding capital investment). We also analyze the issuer's ability to generate cash flow by reviewing standard operational measures for comparable companies in the sector, such as revenue and earnings growth rates, margins, and the composition of the issuer's balance sheet relative to the operational leverage in its business.

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Europe Credit Research 14 March 2012

J.P. Morgan Credit Research Ratings Distribution, as of January 6, 2012

EMEA Credit Research Universe IB clients* Overweight 28% 57% Neutral 49% 64% Underweight 23% 54%

Represents Ratings on the most liquid bond or 5-year CDS for all companies under coverage. *Percentage of investment banking clients in each rating category.

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