The Italian “Doom Loop” is a noose around Europe’s neck

The “doom loop” is the term used by the World Bank to describe the co-dependence between highly indebted governments and the often fragile banks which hold their bonds. Italy is not the only country in this predicament, writes Victor Hill.

Italian tremors

I didn’t really want to write about Brexit per se this week, but it is hard to avoid it right now as the tsunami unleashed by the earthquake of 23 June 2016 is about to crash upon our shores …Instead I want to revisit a theme I have pursued of late – the state of the banking system in the eurozone and its periphery. Things are coming to a head there too.

This week, the Cassandras at the Bank of England, fresh from issuing harrowing warnings about the eviscerating outcome of a no-deal Brexit, turned their woeful gaze to Italy. The problems of Italian lenders, the BoE opined, could have huge impact on the standing of French and German banks which still have high exposures to Italy. They, in turn, could toxify UK banks and thus the UK economy.

Never miss an issue of Master Investor Magazine – sign-up now for free! Read the latest Master Investor Magazine

Further to the ongoing tussle between Brussels and Rome over the populist government’s 2019 budget, yields on Italian government bonds have spiked. This morning the 10-year Italian bond is yielding 3.18 percent (well down from highs of nearly 3.50 percent in October) as compared with the yield on 10-year German Bunds of just 0.24 percent.

The “critical” spread level between German and Italian government bonds is considered to be 400 basis points – a level reached in 2011 when France and Germany engineered the accession of EU technocrat Mario Monti as Italian PM. So there is some way to go before the markets decide to dump Italian bonds altogether.

The proposed budget featured both tax cuts and spending rises which would have driven up the Italian budget deficit towards three percent of GDP or thereabouts. The Italian debt-to-GDP ratio is already around 132 percent (second highest in the eurozone only to Greece) and, if the proposed budget were passed, would inevitably rise further next year.

Italian banks hold huge volumes of Italian sovereign debt as they were able to borrow funds at near-zero interest rates from the European Central Bank (ECB) and invest these in government bonds for a massive positive carry with – theoretically – minimal risk. Government debt now accounts for about ten percent of Italian banks’ total assets. But as the ratings associated with Italian government debt have declined so Italian banks have been required, under the Basel III bank capital adequacy framework, to allocate additional capital against these assets.

Most recently, Italian sovereign debt was awarded a BBB rating by Standard & Poor’s with negative outlook on 26 October, and a rating of Baa3 (just above junk status) with stable outlook by Moody’s on 19 October. In the weird world of financial risk management the Moody’s rating maps to a probability of default of 0.08 percent (given its recent history of downgrades). That does not sound like much. But in terms of capital allocation it means that banks have to put up over €12 of capital for every €100 of Italian government bonds they hold – as compared with just over €2 for holding €100 of German government bonds of equivalent maturity.

The more banks have to allocate to their capital buffers, the less they have available to lend out to customers. It is therefore not surprising that Italian banks are cutting back on lending – a dangerous move at a moment when the Italian economy is already nearly in recession. Mortgage rates have already risen, directly impacting household incomes and prospectively pushing some home-owners into negative equity.


What is more, Italian banks already had the highest non-performing loan ratios in Europe even before the current populist government came to power in June. In fact, Italian banks account for about one quarter of all the non-performing loans across the eurozone. That level is now set to rise.

What is a default? The technical definition varies according to jurisdiction. But essentially, even one late payment of interest on a bond issue and certainly a late payment of redemptions coming due constitute default. Once an entity is deemed in default by a rating agency its rating falls to the lowest possible level – C in the case of Moody’s; and the capital allocations by banks effectively become 100 percent.

In a nutshell, if the Italian state signalled that it would not meet all its debt service obligations on its outstanding issues, the entire Italian banking system would be plunged into crisis overnight. No doubt there would be efforts by the EU and the ECB to trigger the intervention of various stabilisation mechanisms (to which, by the way, Britain will still have commitments so long as it remains attached to the EU in any transition period).

But it is by no means clear that these emergency measures could be effective without the cooperation of a pliant Italian government which undertook to impose a round of Greek-style austerity – something the Luigi Di Maio (5 Stelle) stroke Matteo Salvini (Lega) coalition has pledged never to do. Italy might be too big to fail: but it also might be too big to save.

The question then becomes: what is the risk that an Italian banking crisis could spread financial contagion across Europe? It is now clear that the risks are very high: it is not scare-mongering to speak of a potential European banking crisis.

Dismay in Brussels

The EU rejected Rome’s draft budget back in late October – the first time a eurozone state has been so treated. But Rome’s populist government has so far refused to comply with Brussels’ requirements beyond a few minor concessions, risking fines being imposed which could amount to 0.5 percent of GDP.

The economist, Paulo Savona, who was vetoed as Italian Finance Minister by the President when the coalition government was being formed, has described the single currency as “a German cage”. He was made Europe Minister instead, the finance portfolio going to the less outspoken Giovanni Tria. Signor Salvini has gone further than Signor Savona by describing the euro as “a crime against humanity”. Italy’s GDP per capita, when adjusted for inflation, is lower than it was in 2000 – and this is fuelling huge resentment. One in four Italians aged 15-34 neither works nor studies; and youth unemployment is 35 percent (nearly double that in the agricultural south). But whether the populist government will resort to the nuclear monetary option of launching its own parallel currency is still open to question.

Never miss an issue of Master Investor Magazine – sign-up now for free! Read the latest Master Investor Magazine

The Italian budget deficit next year will be, the Italians claim, 2.4 percent of GDP – though Brussels disputes that. This is not exceptional by comparison with Italy’s peers and neighbours. The French only succeeded in getting their deficit below the three percent threshold last year.

The ECB is reckoned to hold about 15 percent of outstanding Italian government bonds. Of course, central banks cannot go broke because they can print money to bail themselves out (though that might stimulate inflation). That is because European banks have been unloading their Italian bonds – and the ECB has been virtually the only buyer outside Italy. That gives the ECB huge clout over Italian government policy.

After Herr Juncker had bid farewell to Mrs May in Brussels on 24 November he sat down to a working dinner with Signor Conte, the compromise Italian Prime Minister, to discuss Italy’s alleged breach of EU budget rules. When Herr Juncker emerged from his dinner with Conte, he said: “Ti amo Italia”, adding that Italy’s leaders should love the EU more. That reminded me of what the Chinese say to the Tibetans: You should love China more…

As if to besmirch its image in Brussels even further the Italian government on 03 December sacked every member of the country’s health advisory board, raising fears about the long-term impact on public health. The reason cited was their scepticism about the use of vaccines[i]. The founder of the 5 Stelle Movement, Beppi Grillo (who is not in the government) is known to be keen on quack medicine.

But you cannot accuse the populist government of quack economics – they are simply trying to revitalise a moribund economy.

Italian banks

Shares in Italy’s two largest banks, UniCredit SpA (BIT:UCG) and Intesa Sanpaolo (BIT:ISP), have lost a third of their value this year. Banca Monte dei Paschi di Siena (BIT:BMPS) – founded in 1472 and the oldest bank in the world – had to be bailed out by the government in 2017. Its share price has fallen by more than 60 per cent since then.

Other major Italian banks which are under the hammer include Banco BPM SpA (BIT:BAMI) which has holdings of Italian government bonds equal to two-and-a-half times its capital according to the FT. The share price charts of all these banks show a relentless decline. As I write Banco BPM’s shares are trading just above €2.

France

The larger French banks have huge exposures to Italian sovereign debt. BNP Paribas (EPA:BNP) held €9.8 billion of Italian government bonds at the end of 2017; Groupe BPCE (France’s second largest banking network which has a cooperative structure) owns €8.5 billion; and Crédit Agricole (EPA:ACA) €7.6 billion. A smaller state-owned bank, Société de Financement Local, active in the export credit sector, is also highly exposed.


As we know, the French financial system is currently being destabilised by the eruption of violent popular uprisings in the streets of Paris which could yet get worse. Hedge fund managers fleeing London because of Brexit expecting to be welcomed on Monsieur Macron’s tapis rouge will be greeted at the Gare du Nord by the acrid smell of burning tyres, broken glass and the hostile glances of the gilets jaunes. 1789. 1830. 1848. 1871. 1968…2018?

Who are the yellow flak jackets? They are the army of semi-skilled artisans who in the UK would have become self-employed tradespeople. These are the people who are now disproportionately hit by Monsieur Macron’s ecology taxes. Imagine if the millions of white van men in the UK suddenly rose up and turned on the state. Mind you, if Philip Hammond had had his way and raised NICs on the self-employed that might well have happened.

Other European banks

Never miss an issue of Master Investor Magazine – sign-up now for free! Read the latest Master Investor Magazine

Commerzbank (ETR:CBK) seems to be the German bank with the highest exposures to both the Italian sovereign and banking sectors. This year Commerzbank’s share price has fallen from €13.71 in late January to €6.93 on 06 December. Other European banks with large exposures to Italy include Dexia SA (EBR:DEXB) of Belgium, Caixa Central de Credito Agricola Mutuo of Portugal (a mutual), and Spain’s Banco Sabadell (BME:SAB).

Talking of Belgium, there is another doom loop there which perhaps we should call the mussels and chips doom loop. Belgian national debt stands at just under 106 percent of GDP. The debts of Fortis Bank, which was rescued by the Belgium government in 2008, were briefly included in the national debt. However, the government sold Fortis to BNP Paribas in exchange for shares in the acquiring bank, which then became an asset held by the government.

Dexia is another bank that had to be bailed out by the Belgian government with the help of the governments of France and Luxembourg. As a result the Belgium government became a major shareholder. As of the end of August 2018, state guarantees for Dexia’s debts amounted to €34.25 billion. This constitutes part of Belgium’s national debt.

UK banks

UK banks, in contrast, own relatively little Italian sovereign debt but are highly exposed to French and German banks which would be dramatically impacted in an Italian meltdown.

One chink of light in the BoE’s apocalyptic no-deal Brexit scenario published last week was that it foresaw that UK banks would have sufficient capital to ride out that storm. The report envisaged an immediate eight percent drop in GDP and a 30 percent drop in house prices – the latter being largely due to interest rates being raised to 5.5 percent to support a crashing pound. (Roger Bootle, a contrarian, thinks that, if a no-deal Brexit turns out to be less disruptive to supply chains than the BoE assumes, then the pound could actually rise.)


Former BoE Governor Lord King explained on Wednesday (05 December) in the Daily Telegraph that Mr Carney’s “worst case scenario” was based on two questionable assumptions. The first was that UK productivity will fall due to lower trade. The second was that trade frictions (queues of trucks for interminable customs checks) will last indefinitely. That is not realistic (thankfully). Sooner or later – within six months of no-deal – a modus vivendi would be established whereby goods could continue to flow on WTO just as they do in gigantic quantities between China and the EU today.

Arguably, most of the downward pressure on the pound and the London market right now is not fear of Brexit – but fear of Mr Corbyn and his hordes. There is no doubt that the torpid Brexit endgame has put major investment decisions on hold in the UK. If Mrs May’s deal does go through parliament next week then we can be sure that the pound will surge.

But that’s not going to happen.

Enjoy the week ahead!

I was hoping to keep my Brexit powder dry until after the House of Commons’ meaningful vote next Tuesday evening (11 December) – but investors cannot ignore the elephant sitting on their sofa slurping their gin-and-tonic. As I write, it seems very likely that the May-Barnier Withdrawal Agreement will be decisively rejected – probably by a majority of over 100. This outcome, I am told, has already been priced into the value of the pound and gilts. That means that the much vaunted “TARP scenario” (when Congress was forced to rethink its reaction to the Financial Crisis of 2008 by the negative sentiment of the markets) is not a useful analogy. There will not be a second House of Commons vote on the deal.

On Tuesday this week (04 December) Mrs May’s government completely lost control of the House of Commons – very possibly for good – losing three critical divisions. This is because the Tory Ultra Brexiteers are acting as if they were a separate party (they would say they are putting country before party); Northern Ireland’s DUP have turned against Mrs May (in my view with good reason); and Labour, sensing blood, has managed to put on a show of unity (even though their own policy on Europe is confused and confusing – and they are just as split as the Tories).

Never miss an issue of Master Investor Magazine – sign-up now for free! Read the latest Master Investor Magazine

There was also another key factor: Mr Speaker Bercow, who is an arch Remainer, is using his office quite nakedly to undermine the government’s position. It was his decision alone to permit an unprecedented vote on whether the government was in contempt of parliament by not providing the Attorney General’s full legal advice. (When it was released there was nothing we did not know already.)

This bizarre development has significant constitutional implications. It is a flagrant violation of the ancient Anglo-Saxon principle (as my American readers will recognise) of client confidentiality (which applies as much to governments as to criminal defendants). Thanks to former Director of Public Prosecutions (DPP) Sir Keir Starmer, we may be heading for a legal system much closer to that of the Russian Federation (where there is no concept of client confidentiality) than that of the USA.

The pound actually rose in response to this drama: the boys in braces believe that it makes a no-Brexit outcome more likely. There is now a real possibility that the House of Commons, in which Remainers have an in-built majority, will push for a second referendum as a way of getting out of this pickle – though in fact, it would do no such thing, and would divide the nation even further. For a start – what would the question be? And it could not happen without rescinding Article 50 as there would not be time to organise such a referendum before the spring…But I am getting ahead of myself.

Just to refocus: as I have been arguing for years now, the advent of Brexit and the unfolding crisis in the EU are two aspects of the same conundrum. First, the EU is facing a crisis of legitimacy which even the shiny technocratic presidency of the youthful President Macron cannot detoxify – in fact he now stands for everything which ordinary, decent Europeans loathe about the European elite. Second, the European monetary union is inherently flawed. Third, EU institutions are inappropriate to a union of 28 states, 18 of which are in a currency union and the rest outside. As the great Lord King wrote this week:

The political nature of the EU has changed since monetary union. The EU failed to recognise that the euro would demand fiscal and political integration to succeed, and that countries outside the euro area would require a different kind of membership. It was inevitable that, sooner or later, Britain would withdraw from a political project in which it had little interest apart from a shared desire for free trade…[ii]

You would have to be a Harvard-and-Oxford educated ex-Goldman Sachs globalist nincompoop not to appreciate the luminous clarity of Lord King’s words.

Who knows where we shall be one week hence. (I have a few ideas – which I’ll share then.) The bare facts are that, as I argued last week, the EU is very poorly positioned to sustain the shocks that will now inevitably follow a “disorderly” Brexit. The UK market has desperately underperformed over the last two years and is now at its level of eighteen years ago; but it is not as if the European market is a refuge. In fact, it is time to sell European equities in general – not just its increasingly fragile banks.

[i]See: https://www.newsweek.com/anti-vaccine-italian-government-sacks-entire-health-expert-board-1242759?fbclid=IwAR2rFvqO6tqJoU6qu-36Em7kpV-zM4VVzhm2G_2na1h1rbzIMkOgRbUJkB4

[ii]Project Fear has become Project Impossible. It is incompetence on a monumental scale, by Mervyn King, The Daily Telegraph, 05 December 2018.