With Italian government bond yields blowing out in recent months to the highest levels in over 4 years, the one sector that has been hit hardest have been Italy’s banks, which have lost a third of their market value in the 6 months since peaking in April.

While traditionally higher yields tend to be positive for local banks which can earn a greater profit on the net interest margin, Italy has in recent years been an “upside down” basket case in this regard largely due to their massive holdings of Italian sovereign debt. And, as Bloomberg recently wrote, while the balance sheets of Italian banks are much-improved since the Eurozone sovereign debt crisis of 2011, banks used much of the funding later injected by the European Central Bank to buy even more sovereign debt.

As shown below, the country’s financial institutions hold by far the most state obligations among lenders in Europe. Specifically, according to ECB data, Italian banks hold around €375 billion euros of domestic bonds – or 10% of their assets – and the spike in yields, by hurting the value of those holdings, eats into their capital levels, making the especially vulnerable to further rate rises.

This means that as Italian bond prices tumble, as they are doing now, this leads to bank undercapitalization, and if the price drop is large enough, it could even lead to bank insolvency.

Hence plunging stock prices and spiking CDS as default probabilities surge.

Commenting on this structural problem facing Italian banks, Luigi Zingales, a professor of finance at the University of Chicago School of Business said Bloomberg that “Italy is facing a sovereign-bank doom loop that can lead to a crisis similar to the one Italy faced in 2011.” Worse, Zingales warned that “since 2011, nothing has changed at the European level” adding that “without completion of banking union and backstop measures, Italy risks a negative spiral as happened in 2011. Uncertainty is increasing bond spreads, thus affecting the banks’ balance sheets and their cost of funding and ultimately their ability to give credit.”