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All eyes on Italian banks

As the Italian government remains adamant on holding on to promises of increased public spending and lower taxation, all eyes are turning on Italian lenders.

Loss of confidence in public finances has immediate repercussions on public confidence in the banking sector. That point was made on Wednesday by the IMF, two credit rating agencies, and “senior EU sources” speaking to Reuters.

The toll on banks

European supervisors are taking a closer look on Italian banking sector liquidity levels, “although there is no cause for alarm,” Reuters reported citing an anonymous but senior EU source on Wednesday.

Monitoring focuses on both customer savings and interbank lending.

Concerns are triggered because of Italy’s political risk. Italian 10-year bond spreads reached 3,7% on Tuesday, the highest since February 2014.

That is a severe threat to Italian lenders that hold €375bn in government bonds, or 10% of their assets. Their devaluation means their capital buffers depreciate.  That is taking a toll both in terms of public confidence and their stock market valuation.

However, there are no signs of systemic instability.

Until December 2018, the European Central Bank’s (ECB) bond-buying programme ensures the interbank market functions relatively smoothly as it provides ample liquidity. And there is no deposit flight. Since July, Italian deposits seem to be stable at €2,4 trillion.

Still, the perception of political risk is rising.

Rome disagrees with the IMF and Fitch Ratings

The International Monetary Fund (IMF) warned on Wednesday that financial markets could test the resilience of the banking system if confidence in public finances is lost.

In a statement on Wednesday, “The risk is that the link between the banks and the sovereign debt could reignite,” the IMF said in a statement, warning of a contagion effect across the Eurozone.

The Italian government has set a deficit target of 2,4% for 2019, that is, three times the deficit target set by the previous administration. The argument put forward is the public spending will boost growth, allowing the government to reign over it debt-to-GDP ratio.

Markets echo the European Commission and disagree with Rome’s projections.  In a short statement on Wednesday, Fitch Ratings made clear that their next report hinges on the Italian budget.

The Ratings Agency projects a 2,6% budget deficit, deviating significantly from government projections of 2,1%. In 2021, Fitch projects de-escalation to 2,1%, which again deviates from government projections of 1,8%.

Overall, Fitch projects that the Italian debt will drop to just under 130% of the debt-to-GDP ratio in 2021, as opposed to government projections of 126,7%.

Moody’s told CNBC on Wednesday its projections also hinge of the government’s budget.

However, the position of the Italian government remains uncompromising.

 “The budget won’t change because of the spread, or the Bank of Italy say that the Fornero law must not be touched,” Salvini told State broadcaster RAI.