Despite Years of ECB’s QE (Ending Soon), Italy’s “Doom Loop” Still Threatens Eurozone Financial System

Even banks outside Italy have an absurdly out-sized exposure to Italian sovereign debt.

By Don Quijones, Spain, UK, & Mexico, editor at WOLF STREET.

The dreaded “Doom Loop” — when shaky banks hold too much shaky government debt, raising the fear of contagion across the financial system if one of them stumbles — is still very much alive in Italy despite Mario Draghi’s best efforts to transfer ownership of Italian debt from banks to the ECB, according to Eric Dor, the director of Economic Studies at IESEG School of Management, who has collated the full extent of individual bank exposures to Italian sovereign debt.

The doom loop is a particular problem in the Eurozone since a member state doesn’t control its own currency, and cannot print itself out of trouble, which leaves it exposed to credit risk.

The Bank of Italy, on behalf of the ECB, has bought up more than €350 billion of multiyear Treasury bonds (BTPs) in recent years. The scale of its holdings overtook those of Italian banks, which have been shedding BTPs since mid-2016, making the central bank the second-largest holder of Italian bonds after insurance companies, pension funds and other financials.

But Italian banks are still big owners of Italian debt. According to a study by the Bank for International Settlements, government debt represents nearly 20% of banks’ assets — one of the highest levels in the world. In total there are ten banks with Italian sovereign debt holdings that represent over 100% of their tier 1 capital (or CET1), according to Dor’s research. The list includes Italy’s two largest lenders, Unicredit and Intesa Sanpaolo, whose exposure to Italian government bonds represent the equivalent of 145% of their tier 1 capital. Also listed are Italy’s third largest bank, Banco BPM (327%), MPS (206%), BPER Banca (176%) and Banca Carige (151%).

Banks that hold such large, concentrated portfolios of their own government’s bonds can pose a serious threat to financial stability. The Bank of International Settlements (BIS) imagines a scenario in which sovereign exposures worth up to 100 percent of required capital would maintain their zero risk-weight, while holdings over that limit would require more capital. But every attempt to put an end to the doom loop by removing the risk-free status of certain sovereign bonds has, for obvious reasons, encountered stiff resistance from banking lobbies and politicians from countries like Spain, France and Italy.

Dor’s research shows that even beyond Italy’s borders many banks have an absurdly out-sized exposure to Italian sovereign debt. They include Belgium’s publicly owned too-big-to-fail and already twice collapsed and bailed-out Dexia whose holdings of Italian public debt represent a staggering 320% of its tier 1 capital. That is dwarfed by the holdings of the French public bank Société de Financement Local, SFIL, which was set up following the last bailout of Dexia. Its total holdings of Italian sovereign debt instruments reach a mind-watering 480% of its tier 1 capital.

Two other foreign banks that are dangerously exposed to Italian sovereign debt are Portugal’s Caixa Central de Crédito Agrícola Mútuo, with holdings worth almost double its Tier-1 capital and Spain’s Banco de Sabadell (102%). Deutsche Pfandbriefbank AG, a German lender that specializes in real estate and public sector financing, has 82% exposure, Commerzbank, 42%, BNP Paribas, 25% and Spain’s BBVA, 25%.

Clearly, the threat of contagion from a banking crisis in Italy remains a problem, thanks in no small part to the ECB’s tireless efforts to underpin both Europe’s biggest banks (by providing them with an endless supply of free money) and its bond markets (by acquiring corporate and sovereign bonds).

This has helped preserve a dangerous relationship of mutual dependence between governments and banks. When banks invest heavily in government debt, they become dependent on the government’s good performance, which is clearly not a given, especially in the Eurozone. Meanwhile, the governments depend on the banks to continue purchasing their debt despite the massive boost to sovereign bond demand provided by the ECB’s quantitative easing program.

The only thing that has really changed in this equation is that the “doom loop” now contains three, instead of two, main players, as both governments and banks have also become dangerously dependent on the largesse of the ECB, which, through its affiliated national central banks, now holds 18% of all Italian treasury bonds. In the fourth quarter of 2017 Italian banks sold an unprecedented €40 billion worth of Italian sovereign bonds (10.5% of outstanding stock) to the ECB, in what bears all the hallmarks of a mass rush to the exits as the ECB ponders ending its bond purchase program.

The problem here is that the ECB is now the only net buyer of Italian bonds left standing. In fact, in October last year the central bank was buying seven times more Eurozone sovereign bonds than the euro-area governments added to the market, according to calculations by Deutsche Bank economist Torsten Slok. Even today, the ECB’s tapered QE program is three times larger than total net issuances, whereas the Federal Reserve’s QE program at its peak was never more than 90% of total issuance of Treasuries. As the Spanish economist Daniel La Calle points out, in such an environment it’s impossible for the ECB to know what the real demand for bonds is once the central bank steps away. By Don Quijones.

Years after the banking crisis was “solved” in Spain, it keeps going on. Read…  Toxic Debt Still Plagues Spanish Banks (and Taxpayers Will End Up Paying for It)

Enjoy reading WOLF STREET and want to support it? You can donate. I appreciate it immensely. Click on the beer and iced-tea mug to find out how:

Would you like to be notified via email when WOLF STREET publishes a new article? Sign up here.

  26 comments for “Despite Years of ECB’s QE (Ending Soon), Italy’s “Doom Loop” Still Threatens Eurozone Financial System

  1. They’re good for it, for at least $10.

    Quick case-study in Irv Fisher debt-deflation:

  2. Rates says:

    Ah but the BIS is more concerned about China, Hong Kong and Canada:

    They have to know something we don’t.

    “The indicators currently point to the build-up of risks in several economies,” analysts Inaki Aldasoro, Claudio Borio and Mathias Drehmann wrote in the BIS’s latest Quarterly Review published on Sunday.

    The study offered some surprising results: for example, Italy wasn’t shown as being at risk, despite its struggles with a slow-growing economy and banks that are mired in bad debts.

    Or maybe they are biased, since they are Europe based.

    • Wolf Richter says:

      Italy has been in the middle of a banking crisis for a few years already and is trying to emerge from it. Maybe the BIS was looking into the future not the present :-]

      • caradoc says:

        Wolf, so what will change for Italy in future.

        “Maybe the BIS was looking into the future not the present :-]”

      • Robert says:

        Demographics is ultimately the chrysalis, from which Italy (and many others) will not successfully emerge. No matter what is done, the future has been firmly baked into the present.

        Gonna be fun, he said grimly !

      • Rates says:

        Yes, but pretty sure Don is looking at the future as well i.e. with the ECB the only buyer, is it really a long term fix?

        And if that’s a fix, why is it a problem for China, Hong Kong and Canada? They have Central Banks as well no?

        One thing we can be sure is in the future, it will be “fixed” in one way or form :)

  3. EH says:

    “Deutsche Pfandbriefbank AG, a German lender that specializes in real estate and public sector financing, has 82% exposure, Commerzbank, 42%, BNP Paribas, 25% and Spain’s BBVA, 25%.”

    Sorry for my naive question, but where do you get those numbers from?

  4. Nick Kelly says:

    ‘and cannot print itself out of trouble..’


    An attempt to return to the lira in these straits is barely imaginable. It might not even be convertible, i.e. it wouldn’t be money outside Italy.
    Would it be money inside Italy? Before the euro large purchases like real estate were priced in US$.

    Things have gone down hill since then. An attempt now by Italy to print itself out of trouble might result in a situation like many African countries where the local currency is an absolute last resort, with barter for almost anything preferred.

    I realize that the phrase quoted is not necessarily a suggestion that Italy SHOULD start printing, it is an aside in the larger topic.

    I bring it up because of the few but persistent comments on this site (the Guardian is awash in them) who actually maintain that the state can print its way to prosperity.

    Saying that Italy can’t leave the euro zone NOW is not the same as saying it should never have entered.
    But it did, and has wasted the breathing space of the ECB’s big gun to borrow a lot more money, denominated in euros so any return to a relatively worthless lira would result in a massive default.

    No doubt the idea of default has fans.

    But at some point this stuff gets serious. When the Marxist Greek Minister of Finance ( author of a book on Game Theory) walked off in a huff and called for a referendum, the Red Cross had to scramble to line up supplies of insulin that Greece doesn’t make and couldn’t buy.

    Some drug companies agreed to take Greece’s IOU.
    Swiss giant CIBA?

    • caradoc says:

      I have long suspected the IMF (French lead) and BIS (Continental European Based) will go to great lengths to avoid criticising the EURO construct or ECB.

      Handing over monetary sovereignty isn’t a panacea.
      Italy does have large gold holdings though.
      One way or another it will have to work it’s way through.

  5. Jagis says:

    Maybe this situation demands the immunity from prosecution that Draghi has.

  6. John Henderson says:

    These debts ,to my mind,are proof that no matter what Italian electors vote for they cannot change the circumstances their government is in.
    So do they just keep voting?

  7. Drango says:

    If the ECB is lucky, there will be a financial crisis in some other part of the world it can try to pin the blame on. Even though in reality, a crisis anywhere will reveal all of the family secrets the central banks have been trying to hide.

  8. raxadian says:

    Couldn’t they just make Italy borrow money so it buys back it’s debt? Then just tie Italy into drakonian economic conditions like Greece has.

    • Javert Chip says:

      Italy is a whole different kettle of slime compared to Greece:

      Total EU population: about 511,000,000 (inc UK)
      Greece population: about 11,000,000 (about like a big city & 2.2% of EU)
      Italy population: about 61,000,000 (11.9% of EU)

      Oh yea, in 2017,the EU reached the milestone where organic population growth (no new countries) was almost exactly stable. Without immigration, the EU could go he way of Japan – declining population, increasing elderly…plus zombie banks.

  9. cdr says:

    I don’t see the problem.

    Yes, everything you say is true, and, in a normal world with actual rules that involve consequences, Italy and the ECB would be in big trouble.

    But, here you have some of the most creative financing in the world, a central bank that is willing and able to enthusiastically print and print some more, and a challenge that requires creativity.

    The challenge “How to allow the ECB to print away the troubles in such a way it can look smug and arrogant about how anyone could have assumed any problems existed. No Real Money must be used in the solution … if any is used, take it from those with the least recourse and create a PR campaign to make them look like they deserve it”

    Here are some puzzle pieces that can be used in any conceivable, yet helpful, order that require no real money to be used:

    A Bad Bank or two
    A Bad Intermediary Central Bank Subsidiary to be created, capitalized by the ECB and printed money
    New Financial Laws suitable for support
    Old Laws in the way go away
    Endless money printing and debt purchases
    Making It Illegal to complain about the ECB and its practices
    … not a complete list by any means

    • cdr says:

      In other words, it’s really a money laundering problem that requires turning the money printer to 1100 and dispensing it through a multitude of subsidiaries in such a way it looks legitimate … assuming you are a flunky business reporter, an economist, or a beneficiary of the laundering.

      • cdr says:

        In simpler terms … think of it as the ECB selling a dead parrot with all of the creative explanation as to why the parrot isn’t really dead.

        • Argus says:

          I would love to see a comedy series in which John Cleese and the rest of the Python crew depict the European PTB.

    • Nick Kelly says:

      Draghi (an Italian) is leaving as head of the ECB and a German who has been critical of the printing (they all are) is taking over.

      So I guess we’ll see.

      • cdr says:

        Rule 1 in the EU: Never use actual money to support a financial issue. Either create a ‘facility’ such as they did years ago, or perhaps a bad bank today and capitalize it with printed money, properly laundered. Or, just print and make it up as you go along.

        All are sub-strategies of Kick the Can.

        A German may frown menacingly at this, but I have no doubt kick the can wins by a mile over paying the bill with real money for all Germans.

        Kick the Can should be on the EU flag as a motto, strategy, and way of life. Show me a track record to the contrary.

        • cdr says:

          If you could look into the secret places of where top EU leaders learn how to properly assimilate with the ideals of the EU, you would likely see a large poster using large type that states …

          KICK THE CAN
          LEARN IT!
          LIVE IT!
          LOVE IT!

          That poster would be in every room on every wall.

        • Javert Chip says:

          I’m not sure of the exact mechanics, but ECB money-printing just doesn’t happen in the dark of night, and then spring forth at dawn.

          I believe this “printing” ends up as debt in the various EU nations’ ECB accounts, based on economic size (read: Germany gets the biggest chunk).

          Switching to a German banker could indeed be interesting.

        • cdr says:

          Javert Chip

          This falls under ‘Change the Laws’, as in a law gets changed so that some debts financed by printed Euro money do not have to be repaid. This, of course, would be a major scandal – doubly so because I believe member countries ‘guaranty’ the debt.

          I’m also not an expert. I just know good comedy.

          But, you must remember the #1 EU rule is Kick the Can, with the #1 expression of that rule is ‘Never Use Real Money’.

          After that, you’re just selling a dead parrot.

      • d says:

        True but Draghi has Deliberately left a messy situation, that effectively ties the new heads hands, that benefits mainly Italy.

        To do other than the mafiosi dictates, for some time, invites much financial mayhem, all of which will be LOUDLY blamed on.

        The new German (??) head..

  10. cdr says:

    Javert Chip,

    Or debt could be refinanced endlessly at negative rates, until the magic of negative compound interest erases it. Any loss could be refinanced by a facility using properly laundered printed money. Or, perhaps it’s refinanced for 100 years at negative rates that approximate the actual payment due each year over 100 years – self liquidating debt. Any embarrassing accounting entries go into new creative accounts and are proclaimed as ‘perfectly ok’ by the EU leadership. Kick the can.

Comments are closed.