Money markets italian downgrade compounds bank funding problems

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* Downgrade set to follow for Italy's banks* Some Italian bank debt could near "junk"* Repo funding opportunities disappearBy Kirsten DonovanLONDON, Jan 16 Standard & Poor's decision to strip Italy of its single-A rating means many of the country's banks are likely to see their debt move closer to non-investment grade, compounding their funding problems. Italian banks, shut out of funding markets, are already highly reliant on the European Central Bank for both short- and longer-term funding. S&P on Friday cut Italy two notches to BBB+, three notches above "junk". It is normal for a rating agency to cut a country's banks shortly after downgrading the sovereign."Italy at BBB+ means Italian bank debt will be closer to high yield," said Alberto Gallo, credit strategist at RBS."The biggest short-term risk here is the potential downgrade of subordinated bank debt out of the investment grade benchmarks."

Italian banks' borrowing from the ECB has already risen sharply -- to nearly 210 billion euros in December from 153.2 billion euros at the end of November -- mirroring the take-up of three-year funding at the end of the year which will help meet maturing bond repayments. Indeed, Societe General credit strategist Suki Mann said only "quality" banks in the core euro zone countries have access to longer-term funding markets."I'd be surprised if we see an issue from a peripheral bank for at least 6-months, maybe even longer," he said."There is a non-trivial probability that February's three-year ECB funding operation will not be the last one."

Euro zone banks borrowed almost half a trillion euros of three-year money in December and have another opportunity to take such funding in late February."There will probably be a lot of demand and if things deteriorate again I wouldn't rule out them doing another one," said Commerzbank rate strategist Christoph Rieger."But I wouldn't underestimate the impact of these (operations), they're very important to avoid a full-blown credit crunch."The sovereign rating downgrade also means the country's bonds will not be eligible as collateral when raising funds in parts of the repo market.

Repo clearing house LCH. Clearnet considers the lowest rating allocated by the three major rating agencies when it allocates bonds to its AAA, AA and A-rated general collateral (GC) baskets -- bonds in the basket are eligigle for delivery in exchange for cash for a set period of time. The cost of using a government bond as collateral for funding increases if the bond drops to a lower GC basket, which also means it will cost more to raise funds using French bonds after S&P stripped the country of its triple-A rating."Market repo financing looks set to become more difficult for most issuers, especially for Italy," Commerzbank strategists said. The two clearing houses involved in Italian repo operations also raised their margin requirements on trades using the debt on Friday, increasing the cost of funding for those wanting to borrow specifically against Italian bonds."We need to stop thinking about normal as what it used to be," said SG's Mann."The non-core banks are going to continue to be reliant on the central bank facilities."Another worrying sign is that Italian banks non-bank and non-government deposits fell by 37 billion euros in November, according to JPMorgan, while Spanish deposits fell by 7 billion euros after a 25 billion euro fall in October. Although the declines are relatively small, after Irish bank deposits started to decline, they fell 20 percent in a year, while Greek deposits were 27 percent off their peaks at the end of November, JPMorgan noted.