Italian banks are vulnerable because of their large holdings of bonds issued by the government of Italy, one of the most indebted countries in the world. Italy’s ratio of government debt to GDP is around 135% and, like most nations, that ratio is climbing as tax revenues plunge and spending soars to combat a pandemic-induced recession. (Before the Covid-19 crisis, that ratio for the rest of the EU was closer to 80%.) Domestic banks are estimated to hold more than 15% of Italy’s government bonds, according to Antoine Bouvet, a senior rates strategist at ING.

“Clearly the doom loop is still there,” said Lorenzo Codogno, who was previously the director general at the Treasury Department of the Italian Ministry of Economy and Finance. “If you have this strong link, if you have a widening of spreads, inevitably that puts pressure on the banks.”

Despite mounting concerns about Italy’s finances, the country’s interest rates have been mostly contained. That’s because the ECB has purchased billions of euros of bonds to keep yields from spiraling higher. The central bank also supports the banking sector and the broader economy through targeted longer-term refinancing operations, known as TLTROs. While policy makers in Frankfurt have shown over the years that they will do “whatever it takes” to protect the euro zone, their capacity to do so was threatened recently by a German court ruling.

Last week, Germany’s constitutional court challenged the ECB’s asset purchase program, ordering the central bank to show proportionality—that is, demonstrating that the negative effects of the bond purchases don’t outweigh the gains from the program. While that proportionality should be simple enough to satisfy, it has caused a showdown between German courts and the European Court of Justice, which had already backed the ECB program.

The conflict could set a dangerous precedent for the EU, opening the door for other nations to challenge the ECJs authority while also limiting the central bank’s scope to keep markets operating smoothly in Europe. The gap between German and Italian 10-year government bond yields—a key measure of investor confidence in the Italian economy—has grown wider since the end of February.

Institutions at the EU level have pushed back against the German court. ECB president Christine Lagarde said the central bank remains “undeterred” by the ruling, while the European Commission has threatened to bring legal proceedings against the German court. That suggests the underpinnings for vulnerable countries like Italy, and the euro system itself, have been rattled but are still in place.

“Clearly the ECB stands behind the European government bond market, as they keep buying quite intensively,” said Codogno, who is now the founder of an advisory service. “By doing so, the spreads will likely remained contained—but that’s only because of ECB buying.”

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