Volatility in the Italian sovereign-debt market intensified in the summer of 2011, with ten-year government bond spreads climbing from below 200 basis points in June to over 500 at end-2011 and falling again in July 2012. In January of this year, they fell further to below 300 basis points. The sovereign turmoil ignited a vicious cycle of rising funding costs for banks, increasing borrowing costs for firms and households, and contracting credit and output. Lending rates to firms and household rose by 100 basis points and 80 basis points, respectively, in the second part of 2011 and – in spite of some decline – remain above the Eurozone average by nearly one percentage point for firms and half a point for household mortgage loans. The 12-month credit growth to the non-financial private sector dropped from 3.5% in November 2011 to nearly -1.7% in March of this year.
What has driven Italian sovereign-spreads movements? And what has been their contribution to recent developments in Italian banks’ funding costs, corporate lending rates and credit growth? Has the impact of sovereign turmoil been different across banking institutions? What is the appropriate policy response to sovereign-debt market volatility and the associated banking-sector woes?
Drivers of Italian sovereign spreads
In the period preceding the global financial crisis, Italian government bonds spreads moved closely in line with those of other Eurozone government bonds, as sovereign risk premiums in the monetary union were mostly driven by a common factor, related to international risk appetite (Codogno et al. 2003). However, after the Lehman bankruptcy, financial markets have become more discriminating among government issuers (Sgherri and Zoli 2009, Caceres et al. 2010).
Starting in July 2011, pressure on Italian government bonds intensified and volatility of spreads also increased considerably. The largest daily changes in spreads took place around the time of important international and Italian related events, such as the announcement of the Outright Monetary Transactions (OMT) programme and the Monti’s fiscal consolidation package.
An econometric analysis on Italian ten-year government bond spreads between January 2008 and October 2012 finds that bad news on the global financial crisis and European debt crisis as well as Italy specific events lifted daily spread by 14-18 basis points on average (Zoli 2013). Conversely, positive international news reduced them by 14 basis points, while bad news in Italy had a larger impact, contributing to a 48 basis point decline of daily spreads on average (see Figure 1). Italy's spreads movements were affected also by other factors, most notably the VIX index, which measures the implied volatility of the S&P stock price index options and is a widely used as a proxy for general risk appetite.
Figure 1. Impact of international and Italian-specific events on daily changes in Italian government spreads1 (basis points)
Sources: Bloomberg and IMF staff calculations.
1Impact is based on a regressions for daily changes in ten-year government-bond spreads estimated over the period 1 January 2008-22 October 2012. The control variables are changes in the lagged dependent variable and the VIX.
From the sovereign to the banking sector
Shocks to sovereign bond yields and spreads can have an impact on domestic banks’ through different channels. Rating agencies cap bank ratings on the basis of the sovereign rating, thus creating a link between the two. Moreover, government bond yields are benchmark rates for banks’ borrowing costs, which, in turn, affect their profitability and risk profile. Declines in government bond prices associated with rising yields reduce the value of government securities in banks’ portfolios, so weakening their balance sheets. Furthermore, banks that cannot be backed by a strong sovereign if needed, are typically seen as more risky by markets. For these reasons, Italy’s sovereign tensions quickly spilled over into domestic banks, slashing their ability to access the international wholesale markets and affecting their funding costs considerably.
While before and throughout the global financial crisis, the credit default swap spreads of the five largest Italian banks had remained close to those of Eurozone peers, after the summer of 2011 the differential between Italian and Eurozone banks’ credit-default swaps spreads widened, mirroring movements in Italian sovereign spreads (Figure 2). Similarly, yields on bonds issued by the five largest Italian banks started to exceed those on bonds issued by Eurozone peers in July 2011, peaking in November 2011, when Italian sovereign spreads were at the apex. Moreover, the correlation between movements in Italian bank securities’ yields and sovereign spreads increased, and became higher than that with the three-month euribor – an indicator of monetary conditions.
Figure 2. Italian banks' vs Eurozone banks' CDS spreads and Italy's sovereign spreads (basis points)
Sources: Bloomberg and IMF staff calculations.
1/Simple average of the five largest Italian CDS spreads minus simple average of the CDS spreads of a group of Eurozone banks. Eurozone banks in the sample are Erste, Raiffesein, KBC, BNP Paribas, Credit Agricole, Societe Generale, Deutsche Bank, Commerzbank, Rabobank, ING Group, Santander, and BBVA.
2/Ten-year government-bond spreads over the Bund.
Econometric analysis on daily movements of Italian banks’ credit default swap spreads in 2007-12, indeed, finds that changes in Italy’s sovereign spreads have been a significant factor in driving the credit default swap spread differential of domestic banks respect to other Eurozone peers (Zoli 2013). There is also evidence that the impact of sovereign risks on perceived bank risk was larger for institutions with relatively lower capital and higher non-performing loans ratios. The econometric analysis also suggests that changes in sovereign spreads contributed to the movements in Italian banks’ bond yields relative to those on other Eurozone banks’ securities. Furthermore, yields on debt securities issued by banks with lower relative capital ratios and higher nonperforming loans were found to be more sensitive to changes in sovereign spreads.
Higher banks’ funding costs and limited access to the international wholesale markets in the wake of sovereign-debt tensions, contributed to tighter credit conditions in Italy. First of all, there was a large impact on private sector borrowing costs, especially for firms. In the second part of 2011 Italian lending rates on firm new loans increased by 100 basis points, compared to an average 30 basis points rise in comparable rates in the Eurozone. Italian firm lending rates have been moving together with sovereign spreads especially from the end of 2009 to July 2012 (Figure 3).
Figure 3. Italy's sovereign spreads and firm lending rates (%)
Source: Bank of Italy.
Consistent with these developments, an econometric analysis by Albertazzi and others (2012) finds that the pass-through from Italian sovereign spreads to lending rates is rapid especially during periods when spreads are high. Based on a monthly vector autoregression model estimated over January 2006 to September 2012, Zoli (2013) also reaches the conclusion that changes in sovereign spreads quickly affect corporate borrowing costs. About 30-40% of the increase in sovereign spreads is transmitted to firm lending rates within three months, and 50-60% is transmitted within six months, with a somewhat higher pass-through for small loans (Figure 4).
Figure 4. Reponse of firm lending rates on new loands to a one-percentage-point increase in ten-year government-bond spreads (percentage points)
Sources: Bank of Italy; Bloomberg; and IMF staff calculations.
The rapid climb in firm lending rates following the surge in government bonds spreads has not been mirrored by an equally swift decline after sovereign spreads tightened. Indeed, the 12-month correlation between Italy’s firm lending rates and sovereign spreads have fallen since August 2012, and turned negative in January this year. In his recent speech at the annual shareholder meeting, the Bank of Italy’s governor argued that “increased risk of corporate default” is what is holding lending rates up. In his view “since the middle of 2012 this has offset the effect of the lowering of official rates and, more recently, of the decline in yields on government securities”.
Turmoil in the Italian sovereign-debt market has also been associated with a sharp credit slowdown and even contraction, especially for small businesses. The 12-month growth in loans to small firms declined from 2.9% year-on-year in June 2011 to -6.0% in February 2013.
As in previous recession episodes, the slowdown in credit growth is partly driven by the decline in loan demand. However, estimates of credit demand and supply based on loan officer responses to the bank lending survey suggest that at end-2011 supply constraints driven by bank funding difficulties at the peak of the Italian sovereign-debt crisis prevailed over weak demand (Zoli 2013). Growth in loan demand is estimated to have exceeded that of credit supply by 0.5 percentage points in 2011Q4 – a gap similar to that observed in the aftermath of the Lehman bankruptcy (Figure 5). In 2012, the situation appears to have reversed with weak demand driving changes in credit more than supply. The protracted loan contraction in 2013 continues to reflect both poor demand for investment, but also the tightening of supply, which, according to the Bank of Italy’s governor, “is in turn linked to a deterioration in customer creditworthiness and its impact on banks’ asset quality”.
Figure 5. Difference between estimated demand and supply in bank credit to firms
Sources: Bank of Italy; IMF staff calculations.
Volatility in the Italian sovereign-debt market intensified since the summer of 2011. The empirical evidence suggests that shocks in investor risk appetite, and news related to the Eurozone debt crisis, as well as Italy-specific news, have been important drivers of Italian sovereign spreads. These findings highlight the importance of reducing country-specific vulnerabilities as well as the need to address general fragilities in the Eurozone to contain Italy’s sovereign risks.
Overall, the Italian sovereign turmoil has had a significant impact on domestic banks and private credit conditions. This may be due to Italian banks holding large amounts of government bonds, and also to banks’ ratings – and therefore their perceived risk profile and funding costs – being linked to that of the Italian sovereign. Banks with lower relative capital ratios and higher non-performing loans were more sensitive to changes in sovereign spreads. This would suggest broader benefits for the economy from continued efforts to strengthen banks’ capital buffer and reduce impaired assets.
Albertazzi U, T Ropele, G Sene and F M. Signoretti (2012), “The Impact of the sovereign Debt Crisis on the Activity of Italian banks,” Bank of Italy Occasional paper, No. 133.
Caceres, C, Guzzo, V, Segoviano Basurto, M A (2010), “Sovereign Spreads: Global Risk Aversion, Contagion or Fundamentals?”, IMF Working Paper WP/10/120, Washington: International Monetary Fund.
Codogno, L, C Favero and A Missale (2003), “Yield spreads on EMU government bonds”, Economic Policy, October, 505–32.
Sgherri, S, and E Zoli (2009), “Euro Area Sovereign Risk During the Crisis”, IMF Working Paper 09/222, Washington, International Monetary Fund.
Zoli E (2013), “Italian Sovereign Spreads: Their Determinants and Pass-through to Bank Funding Costs and Lending Conditions”, IMF Working Paper WP/10/120, Washington, International Monetary Fund.