UniCredit SpA posted second-quarter profit that topped the highest analyst estimate and said it would set aside less than expected to cover bad debt, signaling strength just as the bank starts talks to take over long-troubled lender Banca Monte dei Paschi di Siena SpA.

Second-quarter profit more than doubled from a year earlier as asset-management fees climbed and loan loss provisions fell, according to a statement Friday. The bank also cut its full-year target for how much it will need to set aside for soured loans, indicating growing optimism about the economic recovery.

Improving asset quality at Italys second-largest lender is boosting new Chief Executive Officer Andrea Orcel, whos due to unveil a strategy shift in the fourth quarter aimed at generating sustainable higher profitability. The CEO is already making changes to the management structure, and the lender said Thursday it had

entered talks with the Italian government to buy Monte Paschi in the first major M&A move of his tenure.

Bank Strategy

We have made significant early progress in simplifying the business, Orcel said in the statement. We have more to do, and our focus will be on continuing to reduce complexity, increasing the pace of digitalization and ensuring that client outcomes are at the heart of every decision we make.

Net income increased to 1.03 billion euros ($1.22 billion), beating the 715.6 million-euro average analyst estimate. The bank reiterated full-year guidelines on costs, revenue and profit. It expects an adjusted profit in 2021 above 3 billion euros.

Orcel has been tasked with laying out a growth strategy after doubts over the banks direction led to the exit of his predecessor Jean Pierre Mustier. The executive said in May his aim is to move UniCredit away from restructuring, with deals as one potential option to reach strategic goals faster.

UniCredit and the Finance Ministry have approved the prerequisites for a transaction involving the commercial operations of Paschi with a defined perimeter and appropriate risk mitigation, the bank said in a statement late Thursday.

A deal will ensure capital neutrality of the transaction, the exclusion of the banks bad loans and all the extraordinary litigation, as well as adequate protection from other potential credit risks, UniCredit said.

Monte Paschi

Siena-based Monte Paschi, the worlds oldest bank, has become a burden to the Italian state since it was first bailed out in 2009. By taking it on, UniCredits new CEO may also be signaling his readiness to reshape the Italian banking sector, which has been dogged by weak profitability and soured loans.

During the due-diligence period, we will perform detailed analysis and assess whether we are able to design a transaction that can meet those agreed parameters, Orcel said in a Thursday call. Then, and only then, will we have the elements to decide whether to proceed.

Talks with UniCredit for a possible takeover were halted earlier this year amid a government reshuffle and the exit of Mustier. During preliminary contacts between Orcel and the finance ministrys representatives, the CEO set costly conditions for a purchase, according to people familiar with the matter.

As designed by UniCredit, the deal will allow the bank to materially strengthen our competitive position in Italy and allow us to generate material synergies, Orcel said.

Orcels reach for domestic prizes continues an uptick in merger activity among Italian banks. Intesa Sanpaolo SpAs takeover of smaller rival UBI Banca kicked off the season last year, followed by the takeover of Credito Valtellinese SpA by the Italian unit of Credit Agricole SA in April.

At the same time, the spurt in Italian M&A underlines the lack of action on a cross-border basis in Europe. Policy makers and executives have consistently emphasized the need for bank mergers to challenge the U.S. giants that have grabbed market share since the financial crisis.

Asset Quality

Since taking over in mid-April, Orcel has reorganized businesses in regions where the group operates and reshuffled top executives, as part of an overhaul aimed at reducing complexity. The CEO is also working on a plan that will permanently allow its non-branch employees to work from home 40% of the time, once post-pandemic work arrangements are put in place.

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Cleaning up the bank remains one of the main management objectives. UniCredits non-performing loan ratio fell to 4.7% at the end of June from 4.8% at end of March. Signaling expected better asset quality, UniCredit said its 2021 underlying cost of risk, a metric showing how much the bank needs to set aside to cover losses, will be lower than 40 basis points, down from previous guidance of less than 60 basis points.

Asset quality is benefiting from prudent underwriting and provisioning in prior quarters and from a better macro scenario than expected thanks to the successful vaccine roll-out, the bank said.

In the last three years, UniCredit has halved the amount of soured loans on its books to around 21.5 billion euros as of the end of the second quarter. The bank is also preparing to sell non-performing loans with a face value of about 2 billion euros, people with knowledge of the matter said in July.

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UniCredit Readies $2.4 Billion Bad-Loan Sale Backed by State

While regulators are wary of a new wave of defaults on mortgages, business loans and other debt as a result of pandemic support measures being phased out, bank executives are striking a much more optimistic tone about the need to put cash aside for future troubled credit. Lower provisions are boosting profit figures, and the outlook for dividend payments to investors, across the region.

(Updates with Paschi deal details starting from sixth paragraph.)

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