Pub skittles, the Italian version

By A.P.

THE metaphor of choice during the euro-area crisis has been that of dominoes falling. First came Greece, then Ireland, and then Portugal; next in line would be Spain. The fear now, with Italian government bonds suffering another day of widening spreads, is that contagion will strike less predictably. Less like dominoes, in other words, and more like pub skittles.

The latest jitters about Italy, whose debt ratio is second only to Greece's in the euro zone, seem to have been sparked by speculation about the future of Giulio Tremonti, the Italian finance minister. But the inability of euro-area policymakers to resolve Greece's debt crisis, and this week's Moody's downgrade of Portugal, have not helped. Spreads between Italian ten-year bonds and German Bunds have today hit another euro-era record. Domestic financial institutions have been hit, too: shares in Unicredit, a big bank, were suspended today after a sharp fall, and credit-default-swap spreads on Generali, an insurer, have surged as well.

If Spain has long been considered too big to fail, then a full-blown Italian debt crisis would be cataclysmic. The country's bond market is the third-largest in the world, after America's and Japan's. That has been seen as a source of a comfort: bond investors find it hard to avoid a market that big and liquid. But it is also a source of widespread financial infection.

Take a look at the table alongside, drawn from the first-quarter results of Dexia, a Franco-Belgian bank with a very spotty record during the crisis. There are all sorts of reasons to be bearish about Dexia (as markets are): it is too dependent on short-term financing, it has lots of toxic legacy assets, its old business model of financing public entities looks shot to pieces, and so on. But investors have also been spooked by its exposure to peripheral sovereign debt, notably Greece's.

So long as countries like Greece, Portugal, Ireland and even Spain are the ones in the frame, banks like Dexia can try to argue that the size of their exposures is small enough to withstand disaster. Its exposure to Greece of €3.7 billion ($5.3 billion), for example, is the highest among European banks after that of France's BNP Paribas, but at 19% of Tier-1 capital, you can just about make the case that it is manageable.

Italy is an entirely different story, for two reasons. First and most obviously, there is the scale of Dexia's exposures. At close to €16 billion, Italian sovereign debt is the biggest of Dexia's sovereign investments, amounting to 85% of the bank's Tier-1 capital. No one is yet seriously talking about a Greek-style crisis in Italy, of course. These numbers are large and scary, but the danger of a meltdown still feels reasonably remote.

Horrors in the trading book
The second reason to worry, however, is more immediate. As with other European banks, most of Dexia's sovereign exposures are held in the banking book, so fluctuations in the value of bonds do not have an effect on their carrying value in the accounts. That means, in effect, that things only get really hairy if there is a debt default or restructuring. But banks also hold bonds in the trading book, where they are marked to market. Dexia holds €725m of Italian bonds in its trading book, compared with virtually no other peripheral-country debt. It is a similar story with other banks: the 2010 stress tests showed that Italian debt accounted for more than a third of European banks' trading-book exposures to euro-area debt.

So if spreads on Italian debt keep widening, that will have a greater impact on banks' results than moves in the value of other peripheral debt. It may also affect banks' access to repurchase markets if Italian collateral is seen as less safe. And it also means that an obvious question for this year's round of stress-test results on European banks, due out on July 15th, will be what assumptions regulators have applied on Italian debt. The stress tests are widely seen as too soft because they impose haircuts only on banks' trading-book holdings of sovereign debt. If Italy continues to judder, even that bit of generosity will have an edge to it.

Read on: Scandal touches Italy's finance minister at a time when he least needs distractions