At the start of June, in the aftermath of the late-May Italian bond fireworks which sent 10Y BTP yields soaring by the most on record surpassing even the extremes hit during the sovereign debt crisis, we showed that according to Bank of Italy data on its aggregated balance sheet for May 2018 including its net Target 2 balance, there was a dramatic increase in its negative net balance. Indeed, the net balance deteriorated by nearly €40bn, its largest monthly deterioration since March 2012, to a new record of -€465bn.
Commenting on the move, JPMorgan said that the increase in the Target 2 liability was largely matched by a decrease in deposits from MFIs even as the aggregate size of the balance sheet was little changed, which as JPM’s Nick Panigirtzoglou wrote suggested the worst possible scenario: that some deposits were moved abroad.
Using the available at the time data, we summarized the deteriorating Italian situation as follows:
… with the risk of both Italeave and redenomination rising, the Italian savers are starting to pull a “Greece”, something we observed on Friday in the dramatic spike in Italian bill yields above those of Greece.
Now, as more financial data is released, we get a more comprehensive picture of what took place in those late May days.
Last week, the ECB released data on monetary developments which gives a clearer picture of domestic behaviour over the May volatility, and contrary to what the Bank of Italy reported previously, it showed no sign of deposit outflows.
As Deutsche Bank writes, countering JPM’s previous assessment, Italian bank deposit data for May showed little sign of outflows.
Households’ deposits fell a modest EUR 2.8bn out of a total of EUR 1.1trn outstanding, and well within normal monthly volatility. Moreover, deposits from NFCs rose EUR 5.1bn over the month. Overall, therefore, the May data gives no evidence of a deposit flight on aggregate from Italian banks.
However, maybe even more notable than the paradox over what did/did not happen to Italian deposits, is that as Deutsche Bank notes, Italian bank BTPs showed the largest monthly increase on record over May, consistent with domestic banks stepping in to buy from nonresidents over the month. Here’s Deutsche:
ECB data released this week for Italian bank holdings of domestic government bonds shows record buying over the month at EUR 28.4bn (chart below), higher inflows than those seen over 2012 without adjusting for shifts in market value. In contrast, French banks were relatively heavy sellers of both domestic and other euro-area securities. Indeed, according to BIS data, French banks are particularly exposed to Italy.
And visually, here is the single biggest month of Italian bank purchases of Italian bonds in history.
In sum, DB concludes that the combined evidence of (a) limited signs of Italian deposit outflows, (b) the decline in deposits held at the Bank of Italy, (c) the sharp rise in Italian bank holdings of domestic government bonds and (d) the deterioration of Target 2 balances over May would together be consistent with Italian banks redeploying excess reserves to buy government bonds from non-residents over the volatility seen in May.
And, of course, the reason for this bold move is that Italian banks know they remain fully backstopped by the ECB, which continues to encourage this type of “plunge protection.”
There is, however, one concern looking forward: as DB warns, Italian bank holdings of domestic government bonds have risen over recent months and remain elevated relative to other markets.
This raises the risk that banks’ capacity to step in over longer-term repricing could become constrained by concerns over concentration risks and increased interlink between the sovereign and banks’ balance sheets.
What was not said is that this vicious circle of Country X banks (in this case Italy) buying Country X bonds, has for years been Europe’s dreaded sovereign bank doom loop. And, as Italy just demonstrated, despite 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, has been an abject failure.
Worse, the fact that Europe’s doom loop was not only dormant but just made its biggest Italian reappearance in history, means that Europe is woefully underprepared for the ECB to withdraw its support for Europe’s various capital markets, of which the bond market remains most exposed. This means that if, or rather when the Italian crisis returns, and there is no longer an ECB bid to bonds, whether implicit or explicit, first Italy, and then Europe – which are both intertwined by the various aspects of the “doom loop”, faces a moment of historic reckoning as price discovery, left for dead some time after the ECB started buying up government bonds in 2014, make a thunderous reappearance.
There is one alternative: Europeans throw away their differences and finally agree to a European banking union, which however cedes control over European banks to Germany. The problem, of course, is that this comes at a moment when Angela Merkel finds herself in the weakest position of her political career, with the forces of populism across Europe so ascendant, that Italy’s Salvini is now calling for a pan-European association of nationalist parties.
As such, the only possible backstop was, and remains, the ECB, which however as of this moment has other plans and while keeping rates at zero for at least another year, will end its QE in exactly six months.
One wonders how long until the market starts pricing in what happens next.
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