MILAN (Reuters) - Italian banks are near saturation point after two years spent frantically buying their own government's bonds, forcing the Treasury to find alternative investors at home and abroad to finance a 2-trillion euro debt.
Lenders' ability to soak up yet more Italian sovereign debt depends largely on the European Central Bank - which in turn says Italy is crucial to the fate of the entire euro zone.
In the coming year the ECB will make strict health checks on banks across the bloc, including a provisional 15 inItaly. It must also decide whether to roll over billions of euros in cheap long term loans which the banks have used profitably to accumulate government bonds, but fall due in early 2015.
Both events will determine how much domestic banks can keep up their support for the Treasury which was vital when the euro zone's third biggest economy teetered on the brink of a Greek-style debt crisis in 2011 and foreign investors fled.
Much is at stake. The ECB has made clear that Italy must tackle its debt and economic problems for the greater good.
"Its fate will critically determine the fate of the euro area," ECB board member Joerg Asmussen said last month. "In this sense, the future of the euro area will not be decided in Paris or Berlin, or in Frankfurt or Brussels. It will be decided in Rome.
During the euro zone crisis, the ECB launched two long-term refinancing operations (LTROs), showering banks with cheap three-year loans. Italian lenders used these to load up on higher-yielding government bonds, propping up their profits which had been hit by recession.
In August, they held 397 billion euros ($538 billion) in Italian government bonds, near a record 402 billion in June. This is nearly double what they had at the end of 2011, meaning they used most of the 255 billion in LTRO funds borrowed from the ECB in 2011 and 2012 to buy their own government's paper.
SKETCHY DETAILSThe banks may have to start shrinking these large portfolios. The LTRO loans must be repaid in January and February 2015 and the cheap long-term funding will dry up unless the ECB decides to repeat the exercise, which it staged to help the banking system through the depth of the crisis.
Another factor will be the ECB's asset quality review. Last month it promised to put top euro zone banks through rigorous tests. These aim to unearth risks hidden on balance sheets before it starts supervising the lenders under the European Banking Union project.
It will use Basel III global banking rules, under which sovereign bonds are classified as risk-free, even though the crisis showed that in the case of governments such as Greece's this was far from the case. This means banks do not have to set aside extra capital to cover for any losses on government debt.
However, the European Banking Authority may also consider exposure to sovereign debt when it conducts tests of banks' ability to withstand future crises in a parallel exercise, although details are still sketchy.
"We wondered if the heaviest users of LTRO, and thus most exposed to sovereigns, would be given an informal nudge to reduce these balances," Morgan Stanley analysts wrote.
Italy's budget deficit is relatively modest and should stay within the European Union's limit next year. {ID:nL6N0I63AJ}
However, the huge size of its existing debt means it has to borrow heavily to roll over bonds that come due. If domestic banks do pull back, the Treasury will need new borrowers.
Italian think-tank Prometeia says it will have to target mostly households and foreign investors to sell an estimated 65 billion euros in new debt in 2014. "The banking sector will hardly be able to absorb such an amount," it said in a report.
Hit hard by the crisis and forced to boost their capital base, Italian banks are shutting hundreds of branches, shedding 19,000 jobs and cutting back on lending as Italy battles with its deepest recession since World War II.
One of the few things banks kept investing in was Italian bonds. Prometeia's analysts say sovereign debt holdings now total 10 percent of Italian banks' assets, double the share in 2007 and a little higher than the equivalent for Spanish banks.
Prometeia says Italian banks now hold 22 percent of the country's debt, below the Spanish level of 39 percent but still high as Italy's debt is more than twice Spain's.
FOREIGN DEMANDAfter threatening to spiral out of control in late 2011 and reaching dangerous levels again in mid-2012, Italian government funding costs have fallen due to an ECB promise to preserve the euro. Foreigners have resumed buying the bonds of weaker euro zone issuers despite persistent political instability in Italy.
Foreigners bought nearly two thirds of a seven-year bond last month. Bidders even came from countries such asLebanon, Malta, Latvia and Libya.
That trend needs to continue next year. "It will be crucial that foreigners increase their buying of Italian bonds," said Intesa Sanpaolo strategist Chiara Manenti. Foreigners hold just over a third of Italy's debt, or 690 billion euros, down from more than 800 billion in mid-2011.
The treasury is also looking to attract wealthy Italian households with new four-year bonds tied to domestic inflation, called BTP Italia, that have so far raised 44 billion euros.
The next issue of the BTP Italia is scheduled for this week and analysts target a takeup of around 10 billion euros.
When the banks scooped up government bonds, they were not acting merely out of patriotism. By reinvesting the cheap ECB loans into the high-yielding debt, they were able to offset a sharp drop in income from lending.
A Deutsche Bank report last week estimated that such carry trades will make up 20 percent of 2013 net interest income - a measure of a bank's profitability - of Intesa Sanpaolo
That figure rises to 23 percent for Banco Popolare
Intesa's domestic government bond portfolio has more than doubled over the past two years to 65 billion euros at the end of June. But analysts say that banks will need to rely less on carry trades and more on making their traditional businesses profitable - and that means cutting costs.
(additional reporting by Eva Taylor in Frankfurt; editing by David Stamp)
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