LONDON — As Italy confronts the ravages of an unexpected threat in the coronavirus, fears are intensifying that the economic damage could trigger a far more familiar danger — a banking crisis.
Italy’s banks and their formidable piles of bad loans have long constituted a central worry in an economy that has not grown in more than a decade. The nation’s lenders are at once big enough, sufficiently integrated with the world, and adequately shaky to pose a constant menace to the global financial system.
European leaders habitually fret that Italy’s banks are but one misfortune away from a calamity that could force them to mount a rescue, lest a shock felt in Milan swell into a continental emergency.
Now, an epic misfortune is playing out.
With Italy effectively quarantined, its industry shuttered, and consumer spending practically nil beyond food and medicine, the economy is expected to contract by 3 percent this year, according to a recent forecast from Oxford Economics.
That may yet prove optimistic, the research institution added. Measures aimed at stopping the spread of the coronavirus — both in Italy and around the world — could further depress economic activity, making a global recession increasingly likely.
If the downturn persists, many Italian companies could find themselves short of the profits needed to repay their loans. That could weaken bank balance sheets to the point of crisis.
“It’s likely that banks will need to be rescued,” said Nicola Borri, a finance professor at Luiss, a university in Rome. “The economy has basically been stopped. We are probably going to see massive defaults. Clearly, Italian banks will be badly hit.”
He was less troubled by the prospect of a rescue from Europe than about the conditions that might accompany such aid. European officials have long portrayed Italy as an irresponsible citizen that has enabled banks to lend recklessly to avoid the humiliation and pain of consigning uncompetitive companies to bankruptcy. Europe has used crises as a means of imposing harsh medicine. It might condition a rescue on Italian banks limiting their lending as they work to rebuild their stocks of capital. That could deprive even strong companies of needed credit.
“That can prolong or deepen the recession,” Mr. Borri said. “More than a concern for the default of the banks, I’m concerned about the consequences that weak banks have on the economy.”
For Italy, worries about the banks are unfolding just as the country confronts a full-blown public health disaster that has taken the lives of more than 2,100 people, overwhelming the medical system and forcing doctors to engage in the grisly calculus of determining who lives and who dies.
The pandemic arrived at a time when traditional anxiety over Italian banks was waning. Total bad loans in the system had shrunk from 350 billion euros in 2015 to less than 200 billion by the end of 2018 (the most recent data), according to the Bank of Italy, the country’s central bank.
Over the same period, bad loans shrank from 18 percent of total bank loans to 8 percent, according to the World Bank.
But beneath that positive development, another trend has played out that may enhance the vulnerabilities of the Italian economy: The banks increased their purchases of Italian government debt, amplifying their vulnerability to broader national troubles.
By February 2019, Italian banks had increased their holdings of Italian government bonds by 14 percent over the previous year, according to Moody’s, the credit rating agency. That revived concerns about the so-called doom loop — the intertwining of the government’s financial health and that of the banks, with fears about each reinforcing concerns about the other.
Italian government debt exceeds 131 percent of its annual economic output, according to the International Monetary Fund. That is the second-highest level in Europe, trailing only Greece. When investors grow anxious about the public debt burden, they demand higher rates of interest for government bonds. That depletes the value of the bonds, because yields and prices move in opposite directions.
As banks see the value of their bonds decrease, they face pressure to cut back on lending to ensure they have enough capital. That deprives companies of credit, weakening economic growth, which in turn amplifies broader fears about the ability of the government to stay current on its debt. Investors are then prompted to demand even more in compensation for the risks of buying Italian bonds.
If banks find themselves in deep enough trouble, they might be forced to raise cash by unloading whatever assets they own — government bonds included. That, too, could lift borrowing costs. If the sales were large enough, they could shift the emergency from the banking system to the government itself.
The coronavirus pandemic has already lifted borrowing costs on anticipation that a recession would force the government to shell out more for medical care, unemployment benefits and support to flagging industries. Since the beginning of the year, the yield on 10-year Italian government bonds has more than doubled from 0.9 percent to 2.2 percent.
The increase in the cost of credit at once indicates alarm and also limits the ability of the government to mount a useful response.
This week, the government approved a package of spending worth 25 billion euros (about $28 billion) to bolster the medical system while helping businesses and households suffering the economic costs of the pandemic.
Economists say a far more robust package is probably required, perhaps 10 times as large. But Italy’s government is afraid to spend more for fear of spooking international investors, who could dump government bonds and drive up borrowing c
“The economy is collapsing, and government debt will go up,” said Nicola Nobile, chief Italian economist for Oxford Economics, based in Milan. “Italy doesn’t have massive fiscal space to spend money on banks. If things get worse, something either at the European level or the international level will have to be agreed.”
One obvious source of support is the European Central Bank, which could buy Italian government debt as a means of limiting borrowing costs.
But the head of the central bank, Christine Lagarde, last week appeared to rule out that objective, saying this was not the institution’s job. That sent borrowing costs soaring and Italian stocks plummeting, while enraging the Italian government. The following day, Ms. Lagarde apologized for what she characterized as poor communication, while affirming her commitment to the European common good.
On Tuesday, Italy’s second-largest bank, Intesa Sanpaolo, said it was providing 15 billion euros in new credit for small and medium-sized businesses whose operations have been hurt by the pandemic.
“We have a duty in this phase of extreme urgency to commit every resource, to give maximum support to Italian companies,” said the company’s chief executive, Carlo Messina, in a statement. “Intesa Sanpaolo has the size, solidity and widespread presence that enable extraordinary interventions throughout the country.”
But Intesa’s fate is linked inextricably to that of Italy’s. The bank’s lending is almost entirely focused on Italian companies. Its stock has lost more than one-fourth of its value since the pandemic emerged.
“We expect a large recession,” said Mr. Borri, the finance professor. “And Italian banks are typically very concentrated on the Italian economy. When the Italian economy goes bad, the banks don’t do well.”