At the start of July, we revealed that a familiar force had returned to Europe.
According to ECB data, during May when the market saw unprecedented Italian government bond turmoil, Italian bank holdings of domestic government bonds showed record buying over the month at €28.4bn, higher inflows than those seen during the European sovereign debt crisis of 2012. Visually, this is what the single biggest month of Italian bank purchases of BTPs in history looked like.
This vicious circle of Country X banks (in this case Italy) buying Country X bonds during times of stress - with the backstop of the ECB - has for years been Europe's dreaded sovereign bank doom loop. And, as Italy clearly demonstrated, repeated and aggressive attempts by European regulators and policymakers to finally break the doom loop, most recently with the introduction of the 2014 BRRD directive, which sought which sought to remove the need for and possibility of bank bailouts, and instead ushered in bail ins, have been an abject failure.
It is also a major problem.
In a note published by Goldman on Wednesday, the bank's Italy analyst Matteo Crimella writes that "regulatory and supervisory changes, together with the risk of a deterioration in banks’ capital ratios/ratings owing to weaknesses in the sovereign market could, all together, raise the bar for domestic banks to step in as buyers."
In other words, Italian lenders may no longer be as willing to snap up domestic government bonds during market stresses, something which Bloomberg calls "a potentially huge structural shift in demand in the euro area’s second-most indebted nation."
The reason: with the ECB's QE backstop set to come to a close at the end of the year, there is growing doubt whether Italy's banks can, or will continue to serve as marginal buyers, a bid that’s historically stabilized a market seen as Europe’s "Achilles’ heel." As a result, there will be a growing need for a "marginal buyer" of Italian bonds, although it is unclear who would step in:
"Whether domestic financial institutions will continue to act as a steady (and potentially increasing) source of demand for sovereign duration remains a fundamental question for the coming months – and potentially years. The forthcoming end of the ECB’s net QE purchases, together with the tendency of foreign investors to reduce significantly their exposure to sovereign debt in periods of heightened volatility (Exhibit 3), increases the need for a ‘marginal buyer’ of Italian BTPs", wrote Crimella, noting next what we showed one month ago, namely that net foreign investor sales of Italian long-term debt securities (including corporate debt) at about €33bn, most of it absorbed by the domestic financial sector.
A familiar chart we have shown previously, which demonstrates the dominance of the ECB in Italian bond purchases, is shown below, this time courtesy of Goldman: