Banking Union does not protect European banks from spillovers of the Italian budget dispute, says EconPol researcher

The budget plans of the new Italian government have the potential to trigger a new financial crisis, according to EconPol Europe researcher Timo Wollmershäuser.

A warning from Louis Rouanet, economist at the US-based Mises Institute, that the previous Italian government’s June 2017 bailout of banks Veneto Banca and Banca Popolare di Vicenza would give the deathblow to the European Banking Union has proved prescient, argues Wollmershäuser in a newly released paper.

“The correlation between risk premia for sovereigns and banks has sharply increased since the bail out, to the high levels observed before the start of the Banking Union,” he says. “It was exactly this ‘disastrous sovereign-banking nexus, in which shaky bank balance sheets degrade the solvency of their sovereigns, and vice versa’, that the Banking Union was aiming to sever, and the budget plans of the new Italian government have the potential to trigger a new financial crisis.”

The Italian government’s plans and associated dispute with the EU Commission have led to a significant increase in risk premiums for Italian debt instruments, from a relatively stable average of 1.3 percentage points between January and April 2018 to a high of 3.3 percentage points in November 2018, following the coalition agreement of the current Italian government.

Although risk premiums have since fallen slightly, levels are still significantly higher than before the elections.  The result is an immediate loss of creditors’ equity and an increase in the likelihood of default. “The average risk premium required by investors to insure loans to Italian commercial banks, which hold roughly 20 percent of the outstanding amount of Italian government securities, has quadrupled since the beginning of 2018,” says Wollmershäuser. But, he adds, foreign commercial banks hold a significant proportion of Italy’s public debt. Since May 2018, their risk premiums have doubled as a result of the slump in prices of Italian government bonds.

An escalation of the budget dispute not only endangers the stability of the Italian banking system; it may also be transferred to the banking systems of other countries which hold claims against the Italian government. If banks get into financial difficulties, the probability increases that the risks associated with a bank rescue may be transferred to the state in which the banks are located.

“During the global financial and euro crisis, it was precisely this vicious circle that led to an escalation of the European sovereign debt crisis,” continues Wollmershäuser. “The banking union was supposed to sever the nexus between the default risk of sovereign and commercial banks. However, the pickup in synchronization between risk premia for sovereigns and banks since 2017 indicates that this credibility has been gambled away. The liquidation of Veneto Banca and Banca Popolare di Vicenza, aided by €12 billion in state guarantees from the Italian government and cash injections of €5 billion from the European Commission, is likely to have contributed significantly to this.

“The case shows once again that the rules drawn up by the European community of states to achieve a more stable monetary union offer sufficient loopholes for the objectives associated with the rules not to be achieved.”

Read the full paper:
Timo Wollmershäuser: The death of the European Banking Union, EconPol Opinion 15, February 2019.