November 23, 2018 / 7:30 PM / 23 days ago

REFILE-UPDATE 1-Bank of Italy warns of damage from rising bond yields

(Refiles to fix headline, no change to text)

* Banks’ capital and liquidity suffering, insurers also hit

* Smaller banks more at risk, CET1 down by 75 bps in Q2

* Asset sell-off eroding households’ financial wealth

By Valentina Za

MILAN, Nov 23 (Reuters) - Rising yields on Italian government bonds are hurting private wealth and undermining the country’s financial sector, making it more expensive for companies to borrow, the central bank warned on Friday.

In its twice-yearly Financial Stability Report, the Bank of Italy listed the damage wrought by the spike in state debt costs caused by the anti-EU stance and spending plans of a populist government who swept to power before the summer.

The Bank of Italy said the average market value of Italy’s 1.98 trillion euros in existing bonds had fallen by 9 percent since May hit by uncertainty over the government’s policies and fears that Italy may leave the euro.

“Foreign investors have heavily disinvested and the liquidity of the secondary market has deteriorated,” the central bank said. “Prices ... have incorporated a significant debt redenomination risk, which is not present in other euro-area countries.”

This is costing Italy an extra 1.5 billion euros in interest payments, a figure set to swell above 5 billion next year and to 9 billion euros in 2020 based on current market rates forecasts, it said.

The central bank said the 3 percentage point drop in foreign holdings of Italian bonds seen in March-June was the biggest quarterly drop since the height of the euro zone crisis in 2012.

The fall in Italian assets’ prices has reduced households’ financial wealth by 2 percent - or around 85 billion euros - in the first half of the year and by another 1.5 percent in the last few months, it said.

Put off by recent losses to their bond portfolios, ordinary Italians this week snubbed a bond tailored for retail buyers, calling into question government’s plans to funnel more domestic savings into its debt which the European Central Bank will stop buying after December.

Meanwhile Italian banks have stepped in to replace fleeing foreign investors, adding a net 39 billion euros to their domestic bond holdings in May-September, the Bank of Italy said.

To limit the damage to capital buffers from the shrinking value of their sovereign holdings, banks have booked two thirds of the new purchases among assets to be held to maturity which, as such, must not be marked to markets.

“Whether or not Italian banks book their government bond holdings at market prices, investors are still going to be fully aware of the risks stemming from a large sovereign exposure,” said Andrea Resti, a professor at Milan’s Bocconi University and an adviser on banking supervision to the European Parliament.

The Bank of Italy said the bond sell-off had increased capital and funding costs for banks while hurting liquidity and capital reserves. Insurers are also heavily affected because they hold one third of their assets in state bonds.

“Should the tensions on the sovereign debt market be protracted, the repercussions for banks could be significant, especially for some small and medium-sized banks,” it said. ($1 = 0.8811 euros) (Reporting by Valentina Za; Editing by Alison Williams)

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