The Sovereign-Bank `Doom Loop' Won't Let Italian Markets Escape

(Bloomberg) -- As investors scrambled for more clarity on the Italian budget plan that roiled its markets on Friday, at least one thing was clear: Ten years after the financial crisis, the sovereign-bank “doom loop” still haunts Europe.

A selloff that started in government bonds quickly spread to the debt and shares of the country’s lenders as investors latched onto a problem policy makers have been unable to resolve in that decade -- the potentially vicious cycle between over-indebted governments and the weak banks that funded them.

The Sovereign-Bank `Doom Loop' Won't Let Italian Markets Escape

It’s a repeat of market volatility seen earlier this year, and another sobering reminder of 2011 and 2012 when Italy, along with Spain, was struggling to weather the euro zone’s sovereign-debt crisis. This time around the trigger was news late Thursday that the populist coalition had won a key battle with Finance Minister Giovanni Tria over increasing the fiscal deficit -- raising questions about the sustainability of the nation’s debt load.

“We expect Italy to enter a prolonged period of volatility,” Fabio Fois, analyst at Barclays Plc, wrote in a note on Friday. He cited the likelihood of “increasing tensions with the European Commission, pending rating agency decisions, risks of snap elections and concerns over public debt sustainability.”

While about two weeks remain before Italy must deliver a draft of its 2019 spending plans to the European Commission and the budget could change, markets showed little confidence it would.

Halted

The yield on 10-year Italian government bonds surged 26 basis points to 3.15 percent on Friday. The cost to insure the country’s debt for five years through credit default swaps jumped 30 basis points.

That move was tracked by CDS contracts for banks including UniCredit SpA and Intesa Sanpaolo SpA, whose shares were among a number halted on Friday as they fell by the most allowed by the exchange. The FTSE MIB Index tumbled 3.7 percent, the most since June 2016.

“Italy is facing a sovereign-bank doom loop that can lead to a crisis similar to the one Italy faced in 2011,” Luigi Zingales, a professor of finance at the University of Chicago Booth School of Business, said during the Banca Ifis’ NPL conference in Venice on Friday.

“Since 2011, nothing has changed at the European level,” Zingales said. “Without completion of banking union and backstop measures, Italy risks a negative spiral as happened in 2011. Uncertainty is increasing bond spreads, thus affecting the banks’ balance sheets and their cost of funding and ultimately their ability to give credit.”

Suffering From Exposure

While the balance sheets of Italian lenders are much-improved since 2011, banks used much of the funding later injected by the European Central Bank to buy even more sovereign debt. The country’s financial institutions hold by far the most state obligations among lenders in Europe.

The Sovereign-Bank `Doom Loop' Won't Let Italian Markets Escape

The European banking union, alongside other policy efforts, have failed to erase market fears given the strong interdependence between financials and sovereigns in the euro region. The European Commission in May proposed pooling government-bond securities to shield the region from future crises -- receiving a hostile response in Berlin.

European officials disagree with the idea reform efforts have proved lackluster. Policy makers have subjected bank balance sheets to aggressive stress-tests, and spurred lenders to raise capital and consolidate franchises in order to cushion losses.

Contagion from the Italian selloff looked contained on Friday; the Markit iTraxx Europe Subordinated Financial Index, a gauge of CDS tied to junior debt sold by lenders across the the region, rose, but only by the most in about a week.

Meanwhile, there are some who fret what happens when the doom loop loosens its grip. Goldman Sachs Group Inc. in August pointed out that Italian banks often provide a steady source of demand at times of crisis, but that mounting political risks and regulatory changes may make them more reluctant to step in.

©2018 Bloomberg L.P.