Who’s Most Afraid of Contagion from Italy’s Bank Meltdown?

French and German banks.

By Don Quijones, Spain & Mexico, editor at WOLF STREET.

Contagion is the reason Italy’s banking crisis is all of a sudden Europe’s biggest existential threat. Greece’s intractable problems are out of sight, out of mind; Brexit momentarily spooked investors and bankers; but Italy’s banking woes have the potential to wipe out investors and undo over 60 years of supranational state-building in Europe.
The last few days have seen growing calls for taxpayer-funded state intervention, a practice that was supposed to have been consigned to the annals of history by Europe’s enactment of new bail-in rules on Jan 1, 2016. The idea behind the new legislation was simple: never again would taxpayers be left exclusively holding the tab for European banks’ insolvency issues while bondholders were getting bailed out. But even before the new rules have been tried out, they are about to be broken, or at least bent beyond all recognition.
A loophole has already been found in the rules that would allow the Italian government and European authorities to raid European taxpayers in order to prop-up Italy’s third largest publicly traded bank, Monte Dei Paschi, while leaving bank bondholders and creditors whole, as Reuters reported a few days ago:

The rules, which have been in force since January, allow a state to directly acquire a stake in a bank that fails a stress test and cannot raise capital in the markets because of “a serious disturbance” in the domestic economy.

Oh, and no bank is officially allowed to pass or fail the European Central Bank’s 2016 stress tests, as we reported a few months ago, after a number of banks, including nine Italian banks, failed the test in 2014. Clearly, those at the top of the financial pecking order — banks and their bondholders — are protected once again from the disastrous consequences of another market meltdown, one that in many ways they precipitated.

The fact that in Italy, thanks in part to a quirk of the tax code, some €200 billion of bank bonds are held by retail investors adds an extra political dimension to the mix, as The Economist points out:

If the bail-in rules are applied rigidly in Italy, the outcry from savers will both damage confidence and leave the door to power open for the Five Star Movement, a grouping that blames Italy’s economic troubles on the single currency.

But it is the direct contagion effect that has Europe’s policymakers and central bankers most concerned. Contagion is a particularly acute problem in the Eurozone due to the so-called “doom loop” that exists between sovereigns and their banks, thanks in large part to the ECB’s tireless efforts to underpin both Europe’s biggest banks (by providing them with an endless supply of free money) and its bond markets (by doing “whatever it takes” to make European sovereign bonds virtually risk-free).
As a result, banks have been able to make a tidy margin by simply buying government bonds at officially zero risk. Another consequence, whether intended or not, has been to create a very dangerous relationship of mutual dependence between governments and banks. When banks invest heavily in government debt, they become dependent on the government’s good performance, which is clearly not a given, especially in the Eurozone. Meanwhile, the governments depend on the banks to continue purchasing their debt, which for the moment is a given. However, if either one falters, the consequences can be dire for both.
Despite pressure from fiscally hawkish Eurozone countries such as Germany, the Netherlands, and Finland to put an end to the doom loop by removing the risk-free status of certain sovereign bonds, to the barely concealed horror of Italian and Spanish politicians and bankers, recent figures from Standard & Poor’s show that banks across the EU have been investing more heavily than ever in government debt, increasing their exposure to €791 billion. The total amount that international banks have lent to Italy alone is €550 billion.
So which country’s banks are most exposed to Italian sovereign debt (apart from Italy itself)?
France — and by a long shot!
As Die Welt reports, the total exposure of French banks to Italian debt exceeds €250 billion. That’s triple the amount of exposure of the second most exposed European nation, Germany, whose banks hold €83.2 billion worth of Italian bonds. Deutsche bank alone has over €11.76 billion worth of Italian bonds on its books. The other banking sectors most at risk of contagion are Spain (€44.6 billion), the U.S. (€42.3 billion) the UK (€29.77 billion) and Japan (€27.6 billion).
These elevated levels of exposure help to explain why no matter how much Angela Merkel would love for the Eurozone’s new bail-in rules to be universally applied to the letter — for her own political survival, if nothing else — the risk of contagion, including for the already deeply distressed Deutsche Bank, is simply too great to be ignored. If Italian banks began falling like flies, it would only be a matter of time before investors began selling (or shorting) Italian bonds en masse, by which point the Doom Loop would be in full flow. And once it starts, it’s very hard to stop.
“The whole banking market is under pressure,” former ECB executive board member Lorenzo Bini Smaghi told Bloomberg. “We adopted rules on public money; these rules must be assessed in a market that has a potential crisis to decide whether some suspension needs to be applied.”
In other words, European taxpayers, get your wallets out, again. Your banks need you!
Oh, and Smaghi, besides being a former central banker, is also the current chairman of Société Générale, one of France’s biggest banks, presumably heavily exposed to Italian banks and sovereign debt, and as such a large potential beneficiary of a massive taxpayer-funded bailout of Italian banks.
It didn’t take long before David Folkerts-Landau, Chief Economist at Deutsche Bank – whose shareholders have gotten crushed and whose bondholders are getting restless – picked up the baton and told the Welt am Sonntag that a US TARP-like European bank bailout of €150 billion was needed to “recapitalize the banks.” This is code for using taxpayer money to bail out bondholders and stockholders, along with executive compensation, including his own. By Don Quijones, Raging Bull-Shit.
So the European banking crisis is coming into full bloom. Deutsche Bank in February tried a ludicrous ruse: buying back its own bonds. But even that miracle-nonsense has now flopped and its shares and CoCo bonds have plunged. Read…  I’m in Awe at How Fast Deutsche Bank is Coming Unglued