Italian Banks' Sovereign Debt Link Evokes Doom Loop Memories

(Bloomberg) -- The ups and downs of Italian government bonds are making the country’s banks queasy.

UniCredit SpA and its smaller competitors are seeing their financial resilience being eroded after government bond values declined. The country’s banks hold by far the most state debt among lenders in Europe and with yields moving in reaction to politicians’ declarations, it’s not hard to see more risk ahead.

Evoking memories of the 2011 debt crisis, Italian bond yields have swung wildly since national elections in March led to weeks of negotiations and a government whose members have suggested they may flout European Union budget rules. Investors are nervous about Italy’s commitment to staying in the euro, prompting fluctuations in bond prices, and that’s hurting banks.

“The link between the banking business and sovereign bonds is still there; indeed, the second-quarter earnings showed how much Italian lenders are exposed to the country risk,” said Stefano Girola, a portfolio manager at Alicanto Capital SGR. “A persistent decline of Italian bonds hurt the banks’ capital base and, in the long term, might also trigger an increase of the cost of risk.”

The capital hit due to Italian sovereign debt was higher than expected in the last quarter for the more fragile Banca Monte dei Paschi di Siena SpA as well as Banco BPM SpA. While fluctuations in sovereign bond values doesn’t affect the bottom line at banks, the changes are accounted for quarterly in the capital levels.

Italian Banks' Sovereign Debt Link Evokes Doom Loop Memories

Italian banks got a clear warning in 2011 and 2012 when Italy, along with Spain, was struggling to weather the euro zone’s sovereign-debt crisis. Yields on benchmark 10-year Italian bonds breached 7 percent in November 2011, raising concern the state wouldn’t be able to roll over its debt.

Instead of backing away from what proved to be a volatile asset, Italian banks used much of the funding later injected by the European Central Bank to buy even more sovereign debt rather than using it to boost lending in a recession-hit economy. While the total amount of state debt by Italian lenders has fluctuated, the share of total loans has soared and now stands at three times higher than the average for euro-area banks.

The exposure got the attention of regulators, who put pressure on banks to reduce their Italian debt holdings, causing the total to decline over the last couple of years. However in May, at the peak of the country’s political mess, banks increased their sovereign debt exposure by 11 billion euros.

“The behavior of the Italian banks during the sell-off suggests that they are willing to step in when other investors are selling, just as they did during the euro-zone crisis,” said Tom Kinmonth, a strategist at ABN Amro Bank NV. “It could be that Italian banks saw value in the securities following the sell-off, or they could have been acting as a force to stabilize the market.”

Italian Banks' Sovereign Debt Link Evokes Doom Loop Memories

Despite the current volatility, Italian banks and the state are in better shape to avoid a so-called doom loop cycle of harming each other than they have been in the past. Although growth is anemic, the Italian economy is no longer in recession and its political leaders have walked back earlier statements indicating they might flout EU rules on state deficits. Italy’s major banks have dramatically improved their balance sheets -- some through state intervention -- and there are signs that lending is recovering.

Even with the risk to capital, there are still reasons why investing in Italy’s bonds still makes sense. Italian banks get a much higher yield, and hence greater revenue, from their state’s debt than their counterparts do in countries like France and Germany, said Fabrizio Bernardi, an analyst at Fidentiis Equities. The asset is also risk-free barring a state default, and in that scenario the banks would have bigger worries than their bond holdings anyway, he said.

While total bond holdings remain high, some of the Italian banks have hedged their risks by using asset and interest-rate swaps to make their bond holdings less sensitive to price swings. Intesa said earlier this month it shortened the duration of its Italian bond portfolio to about 3 months from 4.8 years by hedging it. That limits the risk of declines, but also reduces any potential profit should bond prices rebound.

Still, “their holdings increase the risk of a contagion between state and the banking sector,” in particular for smaller and less sophisticated banks, according to ABN’s Kinmonth.

Italian Banks' Sovereign Debt Link Evokes Doom Loop Memories

©2018 Bloomberg L.P.