Italian banks caught in sovereign debt crossfire

MILAN (Reuters) - Big holdings of Italian bonds by the country's banks are making them a proxy for funds responding to debt concerns by cutting their exposure to Italy.

Italian banks had hitherto weathered the financial crisis better than their European peers, thanks to a tradition of conservative lending and relatively limited exposure to riskier assets, such as Greek bonds.

But that inward culture, once seen as a strength at times of market turbulence, is now being perceived as a weakness -- making the banks inextricably linked to the fate of Italy's borrowing costs.

Shares in Italy's two biggest banks, UniCredit and Intesa Sanpaolo have dropped about 20 percent since investors began dumping Italian assets at the start of July. Over the same period, the STOXX Europe 600 banking index has fallen about 9 percent.

At current levels, Italy's top three banks have a combined market capitalisation of around 56 billion euros -- well below the 61.8 billion euros of Spain's Santander.

The Italian banks' underperformance has gone hand-in-hand with rising worries about the sustainability of the euro zone third biggest economy's debt -- which at 120 percent of GDP is second only to Greece in the single currency bloc.

The premium investors demand to hold Italian debt rather than safe-haven German Bunds widened to a new euro lifetime record of 385 basis points on Tuesday. The so-called spread stood at around 220 basis points before the market sell-off started on July 8.

At these levels the spread is just a shade under the 397 basis points investors demand to hold Spanish 10-year bonds -- meaning Italy could soon be regarded by the bond markets as being riskier than Spain.

The sell-off in Italian debt pushed 10-year yields above the 6 percent mark. Above this level, concerns about the cost of refinancing Italy's 1.6 trillion euro debt intensify.

"Six percent was seen as a line in the sand for yields and now that that's gone, people don't want any risk apart from Germany," said a London-based bond trader.

For Italy's banks, which hold about 200 billion euros (175.25 billion pounds) of government debt, accounting for around 6 percent of their assets, there is a double curse.

On one hand, they are being seen as a vehicle to short Italian bonds, on the other, a protracted rise in bond yields means higher funding costs and lower profits.

Banks pay a premium over government debt levels to issue their own bonds and analysts estimate that a one percentage point rise in bond yields would cut a bank's earnings per share by between 5 and 10 percent, all else being equal.

"If spread levels do not come back from current levels, Italian banks will have to pay a fortune, literally, to refinance their debt next year," a London-based banking analyst said.

"For the bigger ones it may be a matter of costs, but the smaller ones won't be able to issue new debt," he said, adding however: "We are still light-years away from a 'super' worst-case scenario of an Italian default or an international bailout."

A report by Citi analysts on Monday said Italian banks were "trapped by sovereign risk" and would not come back into fashion unless debt markets normalise and they improve profitability.

It said Italy represented around 82 percent of Intesa Sanpaolo's government debt exposure, 53 percent of UniCredit, and was above 95 percent for all the other Italian banks.

Elaine Lin at Morgan Stanley said Italian banks would be encouraged by new Basel III liquidity rules to buy even more domestic debt, and could purchase as much as 230 billion euros worth of longer-term Italian bonds -- partially offsetting foreign sellers.

But if the spreads keep rising, buying Italian debt may not seem such a palatable option.

"Buying more Italian debt would make them more vulnerable, but they have no other options. Politically, you can't sell your sovereign," said Antonio Rizzo, a banking analyst at Barclays Capital in London.

(Additional reporting by Valentina Za, Michel Rose, Ian Simpson; Editing by Alexander Smith)