May 30, 2018 / 7:45 PM / 3 months ago

Factbox: What could spur the ECB into action in Italy?

FRANKFURT (Reuters) - Italy is engulfed in political and financial turmoil of a kind not seen since the euro zone’s debt crisis at the start of the decade.

The Italian flag waves over the Quirinal Palace in Rome, Italy May 30, 2018. REUTERS/Tony Gentile

The country has searched for a government since inconclusive elections, with two anti-establishment parties the latest to fail to form a ruling coalition, after the president demanded a change in their cabinet lineup.

With repeat elections likely to lead to a eurosceptic government in Rome, long-dormant speculation about an Italian exit from the euro has resurfaced.

The European Central Bank does not see a need to react for now, however, because key financial indicators have yet to show signs of acute stress.

Here are some examples of the indicators ECB President Mario Draghi and his colleagues are likely to be monitoring:

BOND SPREAD

This spread measures the premium investors demand for holding debt issued by Italy over that of top-rated Germany.

It is considered a gauge of investor nerves about Italy’s debt situation.

While this spread has widened markedly in recent weeks, it’s still at roughly half the record levels hit in 2012, before Draghi pledged to do “whatever it takes” to save the euro.

BETS ON QUITALY

Economists, including at the ECB, have used the price of credit default swaps on government debt in euros and dollars to gauge whether investors were betting on a country leaving the euro zone.

For Italy, this gauge of redenomination risk is even higher now than it was at the height of the debt crisis.

BANK-TO-BANK LENDING

The rate at which banks are prepared to lend to each other is a measure of their mutual confidence.

In Italy’s case, it is not showing any change and Italian banks, like their peers in large euro zone countries, are still paying a negative interest rate — that is, they are actually getting paid — to borrow against collateral. This is the result of the ECB keeping its own deposit rate below zero, effectively charging banks for their idle cash to spur them to lend.

Unlike during the financial crisis, however, banks are now mostly lending to one another against collateral via repurchase agreements, or repos.

Repos are a safer form of credit because the lender gets to keep the collateral — in Europe, typically a high-rated government bond such as Germany’s — if the borrower can’t pay back.

USE OF ECB CASH

If banks run out of the best collateral, they can always turn to the ECB, the euro zone’s central bank.

So far, however, they haven’t. This is probably due to the 2 trillion euros ($2.33 trillion) of cash the ECB has already pumped into the system over the past three years via its bond-buying stimulus programme.

Banks, particularly in richer countries like Germany and France, are replete with money and even happy to pay a small price to lend it out and avoid depositing it at the ECB overnight at a penalty rate.

This means few need to borrow from the ECB overnight.

Demand at the ECB’s weekly auction, where banks can borrow at zero percent, has also dwindled to next to nothing.

We will only know in several weeks if Italian depositors have started withdrawing their cash and it will be up to the Bank of Italy to say if any lender has asked for Emergency Liquidity Assistance.

This is a relatively expensive cash lifeline granted to solvents bank that lack the investment-grade-rated collateral needed for regular ECB auctions.

April’s data, however, showed they did not need much cash at weekly auctions.

BANK SHARE PRICES

Italian banks have seen their stock prices plummet over the past week as investors marked down the value of the Italian bonds on their balance sheets and saw the odds on Greek-style financial turbulence shorten.

The value of a bank’s equity is key for its ability to raise capital on the market and extend loans against it, and is closely watched by the ECB, which is also the top banking watchdog in the euro zone.

Shares in Italian banks are still worth much less than they were before the financial crisis, reflecting their struggle with unpaid loans and a domestic economy growing more slowly than that of neighbouring countries.

But the ratio between their share price and the stated value of their book — a gauge of investor confidence in the health of their balance sheet — is now close to where it was in 2008 and not far from par.

($1 = 0.8581 euros)

Reporting by Francesco Canepa; Editing by Catherine Evans

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