Photographer: Alessia Pierdomenico/Bloomberg

Bank-Sovereign Link Poses Extra Risk to Italy Amid Brexit

  • Italian banks own large share of their country’s public debt
  • Nation seen vulnerable in post-Brexit flight to quality

Italy is particularly vulnerable to fallout from a Brexit, with its banks holding more of their own country’s public debt than lenders in any other euro-area nation.

Financial institutions in the region’s third-largest economy are already waging a very public battle to cut 360 billion euros ($404 billion) of troubled loans. They’re further burdened by 419 billion euros of sovereign debt that could suffer if the U.K. votes next week to leave the European Union, triggering an investor flight to safer assets.

The yield spread between Italian 10-year government bonds and their German peers widened to a four-month high Tuesday, while Italian banks have been among the worst stock performers in the euro area, foretelling the potential market reaction to a Brexit. On Wednesday, the spread narrowed three basis points to 148 basis points and bank shares rebounded, paring the losses of the previous trading sessions.

Italian banks have suffered a sell-off as they are seen as riskier than euro-area peers given the amount of non-performing loans and holdings of public debt.

“Italy’s banks are in a difficult position already and that would become worse in a Brexit scenario,” said Rotterdam-based Jeroen Blokland, portfolio manager at Robeco Group, which manages 262 billion euros of assets.

Bad Loans

“Italian non-performing loans are clearly far too high for comfort,” said Chris Scicluna, economist at Daiwa Capital Markets Europe in London. “And there are other obvious weaknesses, too, not least the euro area’s lowest potential growth rate and the vulnerability of such high public debt, to which the banks are excessively exposed.”

“Given its low potential growth rate, it typically takes only a modest shock to send Italian gross domestic product into reverse,” Scicluna said.

Flight to Quality

Italy’s public debt, which rose in April to a record 2.23 trillion euros and amounts to more than 130 percent of gross domestic product, may favor investors’ switch from Italian holdings to safe-haven assets such as German bunds.

Italy’s government bonds have declined this week with yields on the 10-year German bonds dropping below zero for the first time. The yield on the 10-year Italian bond rose to 1.51 percent, leaving the spread or difference with the equivalent German bunds at 151 basis points on Tuesday.

The European Central Bank’s quantitative easing has so far limited the impact of unfavorable market conditions on Italy and other so-called peripheral countries in the region.

"Italy has been vulnerable for some time but has effectively been backstopped by the ECB," said Nicholas Spiro, a strategist at London-based firm Lauressa Advisory. "The real question is whether the fallout from a Brexit would undermine the ECB’s ability to shore up peripheral bond markets."

Possible Restriction

A possible EU restriction on holdings of sovereign bonds that banks are allowed to have could add to the already challenging outlook. The possible limit has been discussed by EU authorities.

Changes to the capital treatment of sovereign bonds may force European banks to raise as much as 171 billion euros in new capital or sell 492 billion euros of the securities, Fitch Ratings said in research published on June 8.

“In a flight-to-quality scenario after a ‘Leave’ victory, Italian banks would find themselves exposed to a contagion from the sovereign and risk being oversold,” said Andrea Goldstein, managing director of Bologna-based economic researcher Nomisma. “That, without taking into account that Germany and European institutions would likely boost their call for a limit to lenders’ holdings of government securities.”

“One area which I am interested to look at is whether we should limit the banks’ exposure to their own country’s public debt,” European Commission Vice President Jyrki Katainen said last week in interview with Bloomberg Television, when asked about possible changes to the EU financial rules.

That would help break “the vicious circle between the taxpayers and the banks,” he said.

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