Analysis: Sovereign debt risk raises pressure on Italian banks - Reuters

By Lisa Jucca

MILAN | Wed Dec 1, 2010 2:20pm EST

MILAN (Reuters) - Euro zone sovereign debt concerns may soon put added pressure on the capital adequacy ratios of Italian banks even though analysts say it's too early to raise the red flag on the country's financial system.

After an 85 billion-euro bailout for Ireland failed to reassure markets on Sunday attention has shifted to looking at which country might be next to need help. And after Portugal and Spain, some investors are now raising concerns that Italy may also be swept up in the crisis.

Italy's effective 10-year borrowing cost on Tuesday rose to 4.75 percent, a year high, and the spread over German bunds rose to a euro life-time high.

The eurozone crisis elsewhere has shown just how intertwined the financing problems of banks and governments are.

Worries have now turned to Italy where the banks are looking relatively undercapitalized in the context of a notoriously unstable political system, public debt standing at nearly 120 percent of domestic output and the need to refinance 280 billion euros of key government debt next year.

Italian lenders, traditionally cautious and able to rely on retail deposits for funding, fared better than many European peers in the financial crisis as they avoided risky subprime bets and did not need emergency government funding.

But despite their comparative strength, the threat of risk to Italy's sovereign debt has had an obvious impact on Italian banks and insurers, who are major holders of domestic bonds.

"The Italian banks are safer and there's much less earnings risk as they are better funded by customer deposits," said Andrew Lim, analyst at Matrix in London.

"But if Italy as a sovereign finds itself in the same sticky situation as Ireland you have the worry about default risk."

CAPITAL RATIOS

As a result capital adequacy ratios of around 8 percent of assets at major Italian banks now look inadequate compared with some of their European peers and especially those in Switzerland, Britain and the Nordic region.

"Regulators are clearly aiming for an increase of capital ratios, which is also the main objective of Basel III, and will continue to pressure banks in this direction," said Giada Giani, an analyst with Citi.

"That was, for instance, the solution found for Ireland, an injection of funds to boost ratios. This will likely be the solution for the rest of the system, including Italian banks."

European bank shares rallied on Wednesday on speculation the ECB could take decisive steps such as the purchase of government bonds to combat the threat that its debt and banking crisis could spread from Ireland to other countries.

But Evolution Securities named Unicredit, Italy's biggest listed bank, as one of Europe's banks most in need of capital, estimating it had a 5 billion-euro ($6.55 billion) capital shortfall.

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