• Renzi says he will veto efforts to curb sovereign holdings
  • Germany resists banking union until risks are reduced

A drive to tighten rules over how much sovereign debt banks are allowed to own has raised the alarm in the home of the euro region’s largest bond market.

Italy’s prime minister, Matteo Renzi, vowed last month to veto any attempt to cap holdings, putting him at odds with Germany. Italian government securities account for 10.4 percent of the country’s bank assets, the most among major European economies and compared with 3.2 percent in Germany, the latest European Central Bank figures show.

A limit would mean “altering the balance of the Italian banking system,” said Francesco Boccia, a lawmaker from Renzi’s Democratic Party who heads the budget committee in Italy’s lower house of parliament. “Banks are already struggling to lend money to small- and medium-sized companies,” he said. “This would be the final blow.”

In essence, the euro region’s biggest debtor is on a collision course with its biggest paymaster over how to fix the failures of the past.

‘Doom Loop’

Having financial institutions willing to finance the government is vital to most countries, but especially in Italy. The country has outstanding debt of 2.17 trillion euros ($2.36 trillion), more than anywhere else in Europe. It amounts to 133 percent of its economic output, the largest ratio except for Greece. 

The problem in Berlin is that it highlights Europe’s “doom loop,” the too-tight connection between sovereigns and their lenders that fueled the debt crisis and landed Germany with the biggest bill. Chancellor Angela Merkel’s government has been leading the campaign to tackle the practice of banks treating the debt as risk-free.

Buying Bonds in Size
Buying Bonds in Size

Germany has resisted moving toward closer financial ties, including initiatives such as a common euro-area deposit insurance system, until progress is made on reducing risk. Among Germany’s proposals was an an automatic maturity extension for bonds of nations that apply for aid from the European Stability Mechanism crisis fund. 

Another possibility is a 25 percent limit on the sovereign bonds some banks can hold risk-free as a share of eligible capital, according to two people with knowledge of the deliberations.

‘Pure Folly’

The German proposals are “pure folly,” and would amount to Italy “hitting itself over the head with a hammer,” said Mario Baldassarri, chairman of the Economia Reale think-tank and a former head of the Italian Senate’s finance committee. 

The row about sovereign holdings is part of a wider spat with other EU nations, according to Francesco Galietti, head of the Rome-based consulting firm Policy Sonar.

“There’s a massive arm-wrestling match going on between Italy and the rest of Europe,” he said. But Renzi’s threat to wield the veto is “an insane way of conducting the negotiation. Italy’s debt is what it is. Growth is zero, and inflation has become deflation,” he said.

Issues that are open between Italy and its European partners include Renzi’s desire to ramp up spending to stimulate an economy that expanded 0.2 percent in the third quarter. There’s also the question of a towering pile of 360 billion euros of doubtful and non-performing loans at Italian banks that spooked investors this year.

Italy’s banks held 410 billion euros of domestic government securities out of a 445 billion-euro total government bond portfolio as of January, according to the ECB.

“Thinking of solving the issue with a regulatory change that limits banks’ holdings of sovereign debt is really thinking about the symptoms rather than the cause of the illness,” said Filippo Taddei, an economist and adviser to Renzi. “Not only do I not understand the technical reasons for the proposal, but its timing is rather less than ideal.”

While Italian 10-year yields have been falling on the expectations the ECB will step up its stimulus program, Italian banking stocks have sunk. The FTSE Italia All-Share Banks index has dropped 24 percent this year.

“The vulnerability of Italian sovereign debt has risen exponentially over the past few years,” because banks rather than households own so much of it, said Galietti. “Banks are publicly listed, and so are constantly assessed by investors and by rating agencies,” he said. “I’m quite concerned about the way this is going.”