The Italian Debt Crisis Could Set Off Chain Reaction That Could Affect Banks Across The EU

How An Italian Debt Crisis Could Take Down The EU

Plagued by another run of bank bailouts and simmering tensions between the partners in its ruling coalition, Italy's brief reprieve following the detente between its populist rulers and angry bureaucrats in Brussels is already beginning to fade. As Bloomberg reminded us on Monday, Italy's $1.7 trillion pile of public debt - the third largest sovereign debt pool in Europe - is threatening to set off a chain reaction that could hammer banks from Rome, to Madrid, to Frankfurt - and beyond.

The Bloomberg analysis of Italy's financial foibles follows more reports that Italy's ruling coalition between the anti-immigrant, pro-business League and the vaguely left-wing populist Five-Star Movement has become increasingly strained. Per BBG, the two parties are fighting a battle on two fronts over the construction of a high speed Alpine rail and a legal case involving League leader Matteo Salvini over his refusal to let the Dicotti migrant ship to dock in an Italian port last summer.

Circling back to the threat posed by Italian debt, BBG's analysis showed that French banks are the most exposed, as BNP Paribas and Credit Agricole own retail banking units in Italy.

To keep operating without massive budget cuts (something neither party in the ruling coalition has shown any sign of supporting) Italy must sell 400 billion euros ($457 billion) of debt per year. But since Italy's banks hold so much of the country's debt, declines in the price of Italian bonds inevitably hurts the shares of Italian banks, and also forces them to hold more capital on their books to ensure liquidity from the ECB. This creates the potential for a negative feedback loop known as the "doom loop".

Put another way, "a government crisis could drag down the banking system or a banking crisis could suck in the government."

...A genuine crisis would exhaust the lending capacity of the European Stability Mechanism (some 410 billion euros or $470 billion) in just a year. With ECB President Mario Draghi set to depart later this year, and German Chancellor Angela Merkel's power on the wane, if the populists don't manage to generate the economic growth that they have argued will be unleashed by their stimulus programs, it's not outside the realm of possibility that the crisis that tears apart the EU and eurozone is centered in Rome.