Sovereign bond pile main concern for Italy banks

MILAN Jan 20 (Reuters) - The huge domestic bond piles on the books of Italian lenders could threaten their ability to keep companies going and undercut the banks' own valuations if the euro zone debt crisis worsens.

At the end of June Italian banks between them held around 200 billion euros of Italian bonds or 12.6 percent of the total.

These assets were shunned by foreign investors in late 2011 as concerns peaked over the sustainability of the country's debts.

But not by Italian lenders, which are under a moral obligation to sustain the country at times of stress.

The European Banking Authority, the EU's supreme banking regulator, asked Italian banks to boost capital in the face of lower bond prices at the end of 2011, prompting top bank UniCredit to rush through a 7.5 billion euro capital hike despite choppy market conditions.

The recently-launched funding facility by the European Central Bank, which Italian banks tapped for 116 billion euros in December, has taken away the risk of a sudden bank collapse in Italy.

But if the yields on Italian bonds were to shoot up again, the banks could face new pressures to further shore up capital, exacerbating an impending Italian recession by choking off corporate lending.

The ECB facility "is easing Italian banks' funding strains," said Nicolas Spiro, managing director at sovereign risk consultancy Spiro Sovereign Strategy.

"But it shows the extent to which the crisis is affecting Italy. If the euro zone crisis takes another turn for the worse, the increasing amount of government paper in the portfolio of these banks is going to be once more a source of major concern."

Yields on Italian bonds with a 10-year maturity are trading at around 6.3 percent, below a peak of more than 7 percent they hit in November. Many economists say Italy would struggle to cope with its mammoth 1.9 trillion euro debt if yields around or above 7 percent were to be maintained over the long term.

Italian banks would be able to improve valuations only if the overall question mark over future growth and the country's stability is removed.

"The exposure of Italian banks to their own country's sovereign risk is what the market is still concerned about," said Marco Troiano, an analyst at Berenberg Bank.

"Given the size of the public debt, current bond yield levels and poor growth prospects, there are still doubts over longer-term (debt) sustainability."

Italy is facing a steep recession in 2012, making it more difficult for technocrat prime minister Mario Monti to convince investors the country will manage to put its fiscal house in order through austerity measures.

Tighter credit is bound to exacerbate Italy's economic woes since the small and medium companies which make up the backbone of Italy's productive chain rely almost exclusively on bank lending to finance day-to-day operations.

The International Monetary Fund now expects Italy's gross domestic product to fall by 2.2 percent in 2012 and by 0.6 percent in 2013, according to a draft seen by Italian agency ANSA on Thursday.

Italy's sovereign rating stands at BBB+, at par with bailed-out Ireland, after Standard & Poor's downgraded it last week, just ahead of a heavy redemption schedule.

Yet no Italian bank is seen at immediate risk of falling apart thanks to ECB support through its Long-Term Rifinancing Operation (LTRO).

"(Italian banks) are safe. They are as safe as the ECB. Because the latest LTRO-Program by the ECB implicitly amounts to it acting as a lender of last resort to all systemically relevant banks in the Eurozone," said Bank Sarasin's Chief Investment Officer Burkhard Varnholt.

PAST GLORY

Only a few years ago Italian banks were considered among the safest in Europe.

Their conservative investment stance meant they, with the notable exception of UniCredit, were little tempted by exotic financial structures and sailed nearly unscathed through the subprime crisis of 2007-09.

Their retail banking tradition has also allowed them to benefit from a vast liquidity pool of client deposits.

But this rosy picture was turned on its head once the euro zone sovereign debt crisis began to infect one of their most precious assets -- Italian government bonds.

The EBA said in December Italy's leading banks collectively had a shortfall of about 15 billion euros in capital.

The agency said Intesa Sanpaolo, which tapped the market for 5 billion euros in the spring, did not need additional capital, but asked all the others to fill capital gaps in plans they must hand over to the regulator by Friday.

Fellow banks UBI, Banco Popolare and Monte dei Paschi di Siena also tapped the market last year.

But Monte dei Paschi di Siena, deemed the weakest among major Italian banks, may face questions from the EBA over plans to sell assets for up to 1 billion euros, a source close to the matter told Reuters.

UBI CEO Victor Massiah said earlier in January that the EBA is pushing Italian banks to act procyclically and that lenders may find it easier to cut lending rather than tap the market to further shore up capital.

"At a time of tension for European sovereign debt, Italian banks, like those of other major European countries, are acting as responsible market players and are supporting Italian debt through purchases," said Stefano Caselli, a professor of Finance at Milan's Bocconi University.

"Now, given that the banks do live up to this moral obligation, EBA's request inevitably leads to a weakening in the lending offer."

Bank of Italy data show that growth in bank loans to the private sector slowed in November to 3.5 percent from 4.2 percent in October, the lowest growth pace in a year. (Editing by David Cowell)