Remember the so-called doom loop that threatened to bring down countries and their banks during the scariest moments of the eurozone crisis in 2011? Well, it’s back - and, in Italy at least, the problem is much bigger than it was back then.
Banks in Italy, the epicentre of the latest eurozone crisis, now hold over €400bn of government debt compared with the €240bn they held during the crisis seven years ago, according to data from the European Central Bank.
The increase comes despite pledges from policymakers to tackle the feedback loop that emerged in 2011 as a systemic vulnerability at the heart of the European financial system, acting as a conduit for contagion between government bond markets and banks.
Back then, what began as a sell-off in the government bond market rapidly spread, severely affecting the day-to-day operations of banks across the continent. The climate became so fearful that interbank markets froze, as banks hoarded cash rather than risk lending to rivals.
Starved of liquidity, many were forced into survival mode. BNP Paribas and Societe Generale shut down large parts of their US operations to reduce funding needs. Others were simply unable to stem the bleeding: Dexia collapsed, sending further panic through the system.
A €1trn shot of liquidity from the European Central Bank finally saved the day, helping to prevent further failures. But policymakers, aware of just how close many banks had come to collapse, pledged to break the vicious circle they saw as the cause of contagion.
The doom loop was simple: as countries became less able to service debts, the solvency of banks holding large amounts of government debt was put into question, increasing the risk of bailouts, which in turn put further pressure on government finances.
WORSE THAN 2011
But today, with another European crisis brewing, it is clear that policymakers haven’t only failed to break the doom loop - they have allowed it to grow bigger in the very eurozone countries most vulnerable to another downward spiral.
Annual reports from Italy’s biggest banks confirm this. UniCredit had €51.5bn of Italian government bonds at the end of last year compared with €35.4bn seven years ago; at Intesa Sanpaolo it was €76bn compared with €60bn, while at UBI it was €10.7bn compared with €9.2bn.
With Italian sovereign debt once again selling off – two-year BTP yields doubled on Tuesday as anti-euro, fiscally expansive populists of the Five Star and League parties looked set to take power – fears set in that the doom loop might once again come back to bite.
“This could be a very big problem,” said Megan Greene, chief economist at Manulife. “If Italian sovereign debt is put back on an unsustainable path, as seems likely if Five Star and League take power, then the banks are in big trouble.”
“Italy could once again turn into a conduit for contagion,” she said.
In many ways, actions taken by policymakers have worsened the problem. Much of the €1trn the ECB injected into banks via its longer-term refinancing operations, launched in 2011, fed the doom loop. Banks loaded up on more government debt in order to lock in juicy yields on offer.
While the ECB made tweaks to its subsequent liquidity injections from 2014 onwards to discourage banks from using the funds to buy government bonds, instead making them conditional on increased lending, that failed to stop the buying.
Government bond holdings reached a peak €1.9trn in early 2015.
Incentives to buy are hard-wired into European capital rules. Banks don’t need to hold capital against government bond holdings, making returns much more lucrative. Policymakers have long talked about changing those rules, but pushback has been intense.
“The euro area needs to address the doom loop and in many ways the last few years would have been the ideal time to do that,” said Frederik Ducrozet, senior economist at Pictet Wealth Management. “But it is complicated: how they do it, and what do banks buy instead? It may still happen: hopefully the banking union and capital markets union … will go some way to addressing that.”
Loading up on debt may have seemed like a good idea a few years back when the ECB was launching its quantitative easing programme. But the ECB is now bringing that programme to an end. Without that support, and with the political tensions rising, the risk is that yields start to spike very quickly.
“The downside risk to European banks loading up on national sovereign debt has been muted as long as the ECB has been willing to buy up assets through QE,” said Greene. “Now that the ECB is poised to end its QE programme, the risks associated with this strategy are reemerging.”
One reassuring thought for Italian banks is that they are in good company: the country’s central bank, which buys Italian government bonds for the ECB under its QE programme, has accumulated €340bn of exposure to Italian govvies. If the banks do run into trouble because of their exposure to the sovereign, they won’t be on their own.