Italian banks near saturation point on government debt


* ECB tests, end of cheap loans may curb bank bond buying

* Treasury must attract private Italian, foreign investors

* ECB says euro zone's future will be decided in Rome

By Silvia Aloisi and Valentina Za

MILAN, Nov 5 (Reuters) - Italian banks are near saturationpoint after two years spent frantically buying their owngovernment's bonds, forcing the Treasury to find alternativeinvestors at home and abroad to finance a 2-trillion euro debt.

Lenders' ability to soak up yet more Italian sovereign debtdepends largely on the European Central Bank - which in turnsays Italy is crucial to the fate of the entire euro zone.

In the coming year the ECB will make strict health checks onbanks across the bloc, including a provisional 15 in Italy. Itmust also decide whether to roll over billions of euros in cheaplong term loans which the banks have used profitably toaccumulate government bonds, but fall due in early 2015.

Both events will determine how much domestic banks can keepup their support for the Treasury which was vital when the eurozone's third biggest economy teetered on the brink of aGreek-style debt crisis in 2011 and foreign investors fled.

Much is at stake. The ECB has made clear that Italy musttackle its debt and economic problems for the greater good.

"Its fate will critically determine the fate of the euroarea," ECB board member Joerg Asmussen said last month. "In thissense, the future of the euro area will not be decided in Parisor Berlin, or in Frankfurt or Brussels. It will be decided inRome."

During the euro zone crisis, the ECB launched two long-termrefinancing operations (LTROs), showering banks with cheapthree-year loans. Italian lenders used these to load up onhigher-yielding government bonds, propping up their profitswhich had been hit by recession.

In August, they held 397 billion euros ($538 billion) inItalian government bonds, near a record 402 billion in June.This is nearly double what they had at the end of 2011, meaningthey used most of the 255 billion in LTRO funds borrowed fromthe ECB in 2011 and 2012 to buy their own government's paper.


The banks may have to start shrinking these largeportfolios. The LTRO loans must be repaid in January andFebruary 2015 and the cheap long-term funding will dry up unlessthe ECB decides to repeat the exercise, which it staged to helpthe banking system through the depth of the crisis.

Another factor will be the ECB's asset quality review. Lastmonth it promised to put top euro zone banks through rigoroustests. These aim to unearth risks hidden on balance sheetsbefore it starts supervising the lenders under the EuropeanBanking Union project.

It will use Basel III global banking rules, under whichsovereign bonds are classified as risk-free, even though thecrisis showed that in the case of governments such as Greece'sthis was far from the case. This means banks do not have to setaside extra capital to cover for any losses on government debt.

However, the European Banking Authority may also considerexposure to sovereign debt when it conducts tests of banks'ability to withstand future crises in a parallel exercise,although details are still sketchy.

"We wondered if the heaviest users of LTRO, and thus mostexposed to sovereigns, would be given an informal nudge toreduce these balances," Morgan Stanley analysts wrote.

Italy's budget deficit is relatively modest and should staywithin the European Union's limit next year. {ID:nL6N0I63AJ}

However, the huge size of its existing debt means it has toborrow heavily to roll over bonds that come due. If domesticbanks do pull back, the Treasury will need new borrowers.

Italian think-tank Prometeia says it will have to targetmostly households and foreign investors to sell an estimated 65billion euros in new debt in 2014. "The banking sector willhardly be able to absorb such an amount," it said in a report.

Hit hard by the crisis and forced to boost their capitalbase, Italian banks are shutting hundreds of branches, shedding19,000 jobs and cutting back on lending as Italy battles withits deepest recession since World War II.

One of the few things banks kept investing in was Italianbonds. Prometeia's analysts say sovereign debt holdings nowtotal 10 percent of Italian banks' assets, double the share in2007 and a little higher than the equivalent for Spanish banks.

Prometeia says Italian banks now hold 22 percent of thecountry's debt, below the Spanish level of 39 percent but stillhigh as Italy's debt is more than twice Spain's.


After threatening to spiral out of control in late 2011 andreaching dangerous levels again in mid-2012, Italian governmentfunding costs have fallen due to an ECB promise to preserve theeuro. Foreigners have resumed buying the bonds of weaker eurozone issuers despite persistent political instability in Italy.

Foreigners bought nearly two thirds of a seven-year bondlast month. Bidders even came from countries such as Lebanon,Malta, Latvia and Libya.

That trend needs to continue next year. "It will be crucialthat foreigners increase their buying of Italian bonds," saidIntesa Sanpaolo strategist Chiara Manenti. Foreigners hold justover a third of Italy's debt, or 690 billion euros, down frommore than 800 billion in mid-2011.

The treasury is also looking to attract wealthy Italianhouseholds with new four-year bonds tied to domestic inflation,called BTP Italia, that have so far raised 44 billion euros.

The next issue of the BTP Italia is scheduled for this weekand analysts target a takeup of around 10 billion euros.

When the banks scooped up government bonds, they were not acting merely out of patriotism. By reinvesting the cheap ECB loans into the high-yielding debt, they were able to offset asharp drop in income from lending.

A Deutsche Bank report last week estimated that such carrytrades will make up 20 percent of 2013 net interest income - ameasure of a bank's profitability - of Intesa Sanpaolo,Italy's biggest retail lender.

That figure rises to 23 percent for Banco Popolare and 26 percent for Banca Popolare di Milano, twocooperative lenders, according to the report.

Intesa's domestic government bond portfolio has more thandoubled over the past two years to 65 billion euros at the endof June. But analysts say that banks will need to rely less oncarry trades and more on making their traditional businessesprofitable - and that means cutting costs.

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