Old bad habits die hard: The dangerous relationship of mutual dependence between governments and banks.
By Don Quijones, Spain, UK, & Mexico, editor at WOLF STREET.
In June, as the ECB cut back on its purchases of Italian government bonds, Italian commercial banks added to their holdings, continuing a trend that began in May, analysts at Dutch bank ABN report. Total holdings in June rose by €17 billion to €381 billion. That came on the heels of a €28 billion surge in May, which was the single largest month of Italian bank purchases of Italian bonds in history, according to Deutsche Bank
For the first time in a long time, Italian banks’ purchases of Italian bonds dwarfed those of the Eurosystem (the ECB and the national central banks of Eurozone countries), which in May and June bought a comparatively paltry €3.6 billion and €4 billion of multiyear Treasury bonds (BTPs) respectively, though the average maturity of its cumulative purchases was higher at just under 8 years. This happened as pressure on Italian government bonds rose following the unexpected formation of an anti-EU coalition government. In the space of two months the yields on 10-year bonds surged from 1.8% to 3.1%, and are now just below 3%.
It’s a big jump by today’s standards but still far lower than the 7.56% the Italian government was paying in November 2011, during the peak of the Eurozone debt crisis. Nonetheless, a two-year trend appears to be in the process of reversing.
By March this year, the Bank of Italy, on behalf of the ECB, had bought up over €350 billion of BTPs. At one point the scale of its holdings even overtook those of Italian banks, which had 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 now, Italian banks are once again buying BTPs hand over fist.
ABM Amro posits two possible reasons for the banks’ sudden newfound interest in Italy’s sovereign bonds:
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… 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 eurozone crisis.
In other words, what’s back in full swing is the so-called “Doom Loop” — when shaky banks hold too much of their country’s shaky government debt, raising the fear of contagion across the financial system if one of them stumbles. It represents a dangerous relationship of mutual dependence between governments and banks.
According to a study by the Bank for International Settlements in March, Italian government debt represents nearly 20% of Italian banks’ assets — one of the highest levels in the world. Italian banks hold around 18% of all of Italy’s public debt.
In terms of regulatory Tier 1 capital, at Italy’s two largest lenders, Unicredit and Intesa Sanpaolo, Italian government debt represents the equivalent of 145% of their tier 1 capital. At Italy’s third largest bank, Banco BPM, it’s 327%, at Monte dei Paschi di Siena’s (MPS) it’s 206%, at BPER Banca 176%, and Banca Carige 151%. If there is a problem with the Italian government debt, the banks get in trouble.
The latest quarterly earnings revealed that spiking Italian bond yields — and by definition dropping bond prices — are already eroding lenders’ capital buffers. State-owned Monte dei Paschi’s common equity Tier 1 capital ratio plummeted 140 basis points to 13% in June, partly due to the rise in government bond yields. Intesa Sanpaolo also blamed Italian bond market jitters for a 35-basis point drop in its CET1. Large Italian insurers such as Generali were also affected.
According to analysts at Equita SIM, Italy’s 10 biggest listed banks face on average a 40 basis point hit for every 100 basis point rise in the spread between Italian and German debt. That would be enough to drag the Tier 1 capital ratio of weaker lenders, such as Monte dei Paschi or Banca Carige, down to around 10% when measured on a fully-loaded basis, at which point investors begin to worry.
The spread between Italian and German debt has already risen by roughly 130 basis points since April, to 247 basis points, and is likely to edge higher, especially with the current Italian government threatening to use “tough tactics” in upcoming budget negotiations with Brussels. Last week demand for Italian bonds was apparently so weak that Italy’s Treasury Department felt compelled to buy back €950 million of BTPs.
In 2011 the spread exceeded 500 basis points. That was at the height of the Eurozone debt crisis. Shortly after, Mario Draghi promised to do “whatever it takes” to safeguard the European project — a pledge that led to the ECB’s enormous bond-buying program that included corporate and sovereign debt.
This has helped preserve a dangerous relationship of mutual dependence between governments and banks — the “Doom Loop.” When banks invest heavily in government debt, they become dependent on the government’s good performance, which is far from a given, especially in the Eurozone. Meanwhile, the governments depend on the banks to continue purchasing their debt despite the massive artificial boost to sovereign bond demand provided by the ECB’s quantitative easing program.
Both the governments and banks are also now dangerously dependent on the ECB’s largess. The ECB is already stepping out of the fray and will taper its purchases to zero later this year. Market players are expected to take up the slack. If not, bond prices will take a hit. But when it comes to a country like Italy, there are few willing market players left, other than the country’s banks and other financial institutions, but they do so at great risk to their own exceedingly fragile financial health. By Don Quijones.
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