Will Italy and its ailing banks trigger the next global financial crisis?
Nicholas Spiro says populism in Italy, vulnerable European banks and a tightening of monetary policy could tip financial markets into crisis
Judging by the continued jitters in Italy’s government bond market, which has suddenly become the most closely watched gauge of investor sentiment, last week’s panic over the formation of the first populist and Eurosceptic government in a leading European economy was justified.
More worryingly, Italy’s political crisis has exposed the vulnerability of Europe’s banks which – unlike their US peers that were recapitalised and subjected to rigorous stress tests soon after the global financial crisis erupted – remain saddled with non-performing loans (NPL) worth around €1 trillion (US$1.17 trillion) and have been forced to grapple with negative interest rates, which have eroded their already weak profitability.
Confidence in Europe’s banking sector has once again been undermined by the “doom loop”, a self-reinforcing and highly contagious cycle of financial stress stemming from banks’ large holdings of government bonds, resulting in weak banks and risky sovereigns dragging each other down during periods of market turmoil.
This is what happened last week when concerns about Italy, the country with the second-largest public debt burden in Europe and one of the highest NPL ratios in the euro zone, rippled through global markets as investors questioned the nation’s commitment to the euro. Even Italy’s own central bank governor warned that the country “was a few short steps away” from losing “the asset of trust”.
The STOXX Europe 600 Banks Index, a leading gauge of European bank shares, plunged 8.5 per cent in the last week of May, with French and German banks – which hold significant amounts of Italian bonds – coming under strain. The debt of Italy’s own lenders, meanwhile, suffered steep declines as markets fretted that the turmoil will stymie efforts by Italy’s banks to dispose of their more than €170 billion in bad loans.
That a sell-off whose acute phase lasted little more than a day was able to place Europe’s banking sector under such severe strain (even the shares of several major US and Japanese lenders fell sharply) is an indication of the extent to which the “doom loop” between European bank and sovereign risk – and in the case of Italy the link, however tenuous, between sovereign risk and the possibility of Italy exiting the euro zone – threatens markets.
The Italy-induced jitters are a foretaste of things to come and the most likely catalyst for the next global financial crisis.
While there are plenty of other potential triggers for the next crash, ranging from the pitfalls of unwinding years or ultra-loose monetary policy to a sudden re-emergence of concerns about China’s economy, the scope for Italy’s banking woes to rapidly become a systemic threat to the global economy is considerable, despite efforts over the past several years to “de-risk” Europe’s banking sector.
The fundamental problem, spelled out by a group of German and French economists earlier this year in a hard-hitting report that should be mandatory reading for all investors right now, is the failure to complete Europe’s banking union which would break the “doom loop” once and for all.
Not only do regulators still treat all euro-zone government bonds as risk-free, encouraging Italian banks to load up on their home country’s debt as if it were as safe as triple A-rated German bonds, the public safety net for European banks remains at the national level, making it more likely that vulnerable banks end up endangering the creditworthiness of entire countries.
The report, published by the Centre for Economic Policy Research, a network of academics, outlines a six-point plan to overhaul the governance of the euro zone which addresses both German demands for more market discipline and French pleas for more risk-sharing within the bloc. The report warns, ominously, that in the absence of reforms that seek to overcome long-standing political divisions in Europe, the next euro-zone crisis, “could come with a vengeance”.
Optimists will point to the crucial role of the European Central Bank which has been supporting Italy’s bond market through its purchases of the country’s debt. Yet, on Wednesday, two senior ECB policymakers gave their strongest hint yet that Europe’s central bank is preparing to call time on its bond-buying programme later this year.
Combine Italian populism with the end of quantitative easing and a vulnerable banking sector, and it is once again Europe that is sowing the seeds of the next financial crisis.
Nicholas Spiro is a partner at Lauressa Advisory