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. They include 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.