The systemic importance of Italy to the euro area is undeniable but concerns about the government’s fiscal policies have exacerbated sovereign debt risks. Learning from this, Scope discusses three institutional changes to help stabilise the euro area.

The size of Italy (BBB+/Stable)’s economy and its inter-connectedness with core euro area member economies raise the country’s systemic relevance for the monetary union. Italy’s high debt levels, fiscal slippage and policy uncertainty have recently contributed to concerns on the country’s debt sustainability.

Spill-overs from an Italian debt crisis to other euro area economies could emerge from at least three sources: i) the non-financial debt channel (via Italian public and non-financial private debt held by euro area institutions outside of Italy); ii) the banking channel (financial risk resulting from the inter-connectedness of euro area banks) and iii) the real-economy channel (risk contagion via trade and other economic inter-linkages).

Until now, we have observed little risk spill-over from Italy to major financial institutions in the rest of the euro area,” said Bernhard Bartels, associate director in the public finance team of Scope Ratings and co-author of today’s report. “However, given that almost half of Italian public and private non-financial debt in banks is held by G-SIBs, risk of more widespread contagion is non-negligible if the Italian crisis were to escalate in the future.”

Italy stands out among euro area countries because of the degree of home bias in the holders of its debt: over 66% of Italian sovereign debt is held by domestic creditors, versus 51% for German and 47% for French debt. “This results in an especially strong sensitivity of Italian banks to Italian public-finance risk, as euro area banks’ cross-border activities decreased after 2008 from low pre-crisis levels and have only gradually recovered since then.”

Italy’s economy remains mainly reliant on domestic credit, which makes it vulnerable to a sovereign debt crisis – given the exposure of domestic banks to Italian public debt securities – meaning any sovereign crisis can quickly result in a credit crunch and a broader economic crisis,” Bartels said.

The inter-dependence between domestic banks’ balance sheets and the sovereign’s public finances generates substantial risks for domestic financial stability but this matters for the entire euro area, given Italy’s economic size and deep trade integration in the euro area. “Learning from the experience with Italy – including issues of the sovereign-bank doom loop, several proposals have been made by academics to complement EU rules via instruments that would restore fiscal accountability and enhance banking system resilience,” Bartels noted.

In Scope’s view, three of the ideas put forward by the Centre for Economic Policy Research (CEPR) could curtail the sovereign-bank nexus and enhance the resiliency of the euro area to sovereign crises: The introduction of risk weights for sovereign debt and/or; A limit on bank holdings of the same country’s sovereign bonds; and The creation of a European safe asset, which Scope published a proposal on last June.

If EU fiscal and bank governance institutions were complemented by implementing a combination of these proposals, this could strengthen the currency union in at least three dimensions: Re-establishment of fiscal accountability at the national level leads to greater market discipline, thereby increasing the resilience of the euro area to country-specific shocks; Less spill-over from instances of fiscal distress to private sectors, reducing the sovereign-bank nexus; and Improved resilience of banking sectors through more diversified sovereign risk portfolios and risk weights that more accurately reflect sovereign risk.

The transition to risk-weights and/or domestic sovereign debt limits alone entails risk to the financial stability of countries like Italy during any phase-in period. This is true for economies whose banks would be either forced to raise additional capital and/or to sell part of their domestic sovereign bond holdings. This in turn could lead to the sovereign-bank crisis that the proposal was intended to prevent in the first place if not managed carefully. The parallel introduction of a safe bond, as such, could help provide the additional demand needed for the excess supply of government debt resulting from the limits/risk-weights, in the process facilitating greater euro-wide sovereign debt diversification on bank balance sheets.