A plan by the Italian government to support borrowers in financial difficulty could damage banks’ efforts to off-load nonperforming loans as bad debt investors would face more uncertainty.

Banks have shifted soured debt off their balance sheets in recent years with the help of the Garanzia sulla Cartolarizzazione delle Sofferenze (GACS), a scheme that offers a state guarantee on the least-risky tranche of debt in a securitization. Since the scheme’s introduction in 2016, banks’ stock of problem loans declined from more than 18% of total net loans to 2.77% by 2022, according to data from S&P Global Market Intelligence.

Plans to revive GACS, which expired in mid-2022, are said to be on hold. The government is now reportedly finalizing a new legislation that would give struggling borrowers the option to repay debts that soured in recent years for a fraction of their nominal value, allowing them to clean up their credit status and gain access to new financing amid persistent inflation.

The planned borrower-friendly measure, however, could weigh on banks’ ability to dispose of bad loans and add downside risks to their asset quality, analysts at Scope Ratings said.

Under the proposed legislation, households and small businesses will have the option to repurchase impaired loans between 2015 and 2021 that were sold by banks to third-party debt servicers by the end of 2022. Borrowers would have to pay a 20% premium to the transaction price if recovery proceedings had not started, or 40% otherwise, according to Fitch Ratings.

While it is unclear how many borrowers would exercise the option, the plan could cause disruptions in the nonperforming loans (NPL) market, which has been instrumental to banks’ balance sheet cleanups. The retroactive nature of the measure could raise the operational burden for debt servicers, result in substantial revisions of existing business plans by servicers and purchasers, and impact the profitability of existing investments in NPLs, Fitch analysts said.

This retroactive element also creates ambiguity among investors and market participants, and as a result, the appetite for Italian NPL sales will likely plummet as legal uncertainty is priced in, analysts at Scope Ratings said.

Between 2015 and 2022, Italian banks offloaded nonperforming exposures (NPEs) — which includes NPLs, debt securities and certain off-balance sheet exposures — with a gross book value of €350 billion. These were sold to investors for a market value totaling about €83 billion, according to data from bad loan manager Banca Ifis SpA.

The government’s latest bad loan plan comes on the heels of a controversial windfall tax on banks’ excess profits that rocked markets and drew criticism from the European Central Bank, which said it could harm investor confidence and that its retroactive application could fuel perceptions of an uncertain taxation framework and lead to “extensive” litigation.

Italian banks’ aggregate NPL ratio of 2.77% was higher than the EU average of 1.8% as of 2022-end. It is also above than the national average in France and the UK but is lower than Spain’s 3.62%.

Another proposed measure that would require banks to include in bad loan sale contracts the price of individual loans sold in bulk, a move intended to support the initial NPL plan, was recently rejected by two parliamentary committees, Reuters reported. The committees ruled that the latest proposal, which would require amending a decree to impose a windfall tax on banks, was “impracticable.” The measure would have made investors unable to go to court to recover bad loans if the contracts did not meet the proposed requirement.