A spike in Italy’s bond yields has put the country’s banks under renewed pressure, raising the spectre of capital shortfalls just as challenging refinancing deadlines near. Domestic government bonds account for 10 percent of Italian banks’ total assets, making them vulnerable to a rise in Rome’s debt costs under the anti-austerity government. Caught in the bank-sovereign “doom loop,” Italian banks replaced fleeing foreign investors during the euro zone debt crisis of 2011-2012, buying up Italy’s bonds. They similarly stepped up purchases of domestic debt in May and June during a market sell-off of Italian assets, before lowering them in August as prices steadied. But as the yield premium Italian bonds pay over safer German Bunds rose, banks lost on average 40 basis points of their core capital in the second quarter and another 8 bps in the third, analysts say. When the new coalition’s spending plans first emerged in mid-May, the Italian-German spread was just 130 bps. It climbed above 300 bps this week after the government unveiled deficit goals that increase the borrowing needs of a country that has the world’s third-largest public debt pile. An increase to 400 bps would force some lenders to tap investors for cash, the head of the Italian traders’ association Assiom Forex, Luigi Belluti, warned last week. Italy’s third-largest bank Banco BPM was among the worst-hit in the second quarter, losing precious capital it needs for a bad loan clean-up. Capital erosion also complicates turnaround efforts at Monte dei Paschi di Siena, bailed out by the state last year. Regulatory pressure? Italian banks have been restructuring in recent years, raising capital to fund disposals of bad debt and cutting costs. But loan losses and negative interest rates hurt earnings and mean returns do not cover their cost of equity. Market stress is meanwhile driving up the cost of funding. Intesa Sanpaolo , one of Italy’s strongest banks, in March paid 1.83 percent to issue a 10-year bond that traded on Wednesday at 3.12 percent. Intesa is the only lender to have raised unsecured funds since the May turmoil, selling five-year debt at a hefty 2.15 percent in August. Traders say the market has now frozen up again. That is an issue for banks such as Monte dei Paschi and Carige which need to replenish their second-tier capital with hybrid debt, and could become a problem across the sector if the hiatus is prolonged. With 240 billion euros (£212.85 billion) in cheap longer-term funds from the European Central Bank, of which they have been the biggest takers, Italian banks have no immediate liquidity concerns. They have not suffered deposit flights and could easily continue to shield their net interest income and get to the end of the year without selling bonds. But market access is crucial. “If the dearth of wholesale issues we’re currently observing were to last for another three to six months it would become a real problem: regulators want banks to be able to tap markets whenever they need to,” said Francesco Castelli, head of fixed income at Banor Capital. Italian banks had an average liquidity coverage ratio (LCR) — one of two key liquidity indicators monitored by supervisors — of 171 percent at end-2017, well above the required 100 percent, according to the Bank of Italy. The LCR ratio measures assets a bank can promptly sell for cash and suffers if rising interest rates erode their value. Published in Daily Times, September 5th 2018.