Italian banks are expected to post aggregate earnings of €457 million this quarter, down 45 percent from Q1 according to Carlos Tommaselli and Dominic Watt at Societe Generale SA (OTCMKTS:SCGLY), though the sector is still doing considerably better than last year when Italian banks posted an aggregate loss of €1 billion.

SG Italian Banks

Italian banks continue to go through the deleveraging process, and total loans are expected to drop slightly, about 0.4 percent from last quarter, though Tommaselli expects a slight improvement in the top line. He also notes that cost of funding has dropped, improving margins and slightly offsetting losses due to deleveraging, and that core revenue has proven to be resilient to difficult market conditions.

SG IT core revenue

Italian banks and the Texas ratio

Asset quality is expected to worsen, and the Texas ratio (net impaired loans after provision/tangible equity) should rise from 114 percent to 116 percent. “A Texas ratio exceeding 100 percent is a sign of a distressed situation and the need for repair by either bad loan reduction, provision increases, or a capital hike,” says Tommaselli.

Italian Banks scrutinized by Eurozone’s AQR

While the focus right now is surely on the large drop in earnings, Tommaselli expects markets to refocus on bad debt when the Asset Quality Review (AQR) comes out later this year. “The Asset Quality Review (AQR) in 2014 is likely to shift the market focus from Italian banks’ sustainable profitability back to capital due to the extremely heavy bad loans inventory,” he said.

The AQR is part of the Eurozone’s creation of a banking union that is meant to prevent the near bankruptcies and sovereign debt crises that have plagued Europe over the last few years, particularly hitting Italy and other southern European nations.

In light of these issues, Societe Generale SA (OTCMKTS:SCGLY) has cut estimated 2013-2015 earnings estimates by 11 percent, though there are still signs that the Italian banking sector is recovering from the economic crisis. “The outlook on net fees should improve thanks to asset management commissions. We expect further improvements in terms of operating cost, as many banks could put in place further cost cutting measures,” said Tommaselli.