By Danilo Masoni
MILAN (Reuters) - Italian banks have lost nearly 40 billion euros ($45 billion) of market capitalization since May, with small and mid-sized lenders worst-hit by a sell-off on concerns that Rome's budget crisis will lead to a capital crunch in the third-largest euro zone economy.
Faced with the government's unwillingness to accommodate European Union demands for fiscal discipline, investors have been dumping Italian government bonds, which account for about 10 percent of Italian banks' total assets. That has forced lenders into costly write-downs, lifted funding costs and darkened their profit outlook.
The hefty loss in market capitalization comes as the euro zone banking watchdog releases results of its latest stress test of European lenders, with Italian banks under the greatest scrutiny.
The impact on their results has been manageable so far but markets look to be anticipating even more pain ahead, with investors considering scenarios in which bond prices fall to levels last seen during the euro zone debt crisis of 2009-2011.
Thibault Douard, who helps manage around 14 billion euros of assets at Tikehau Capital, said a further 200-300 basis point widening in government bond spreads would be problematic for some weaker banks.
GRAPHIC: Market cap loss - https://tmsnrt.rs/2P24xEz
CHEAP BUT NOT DISTRESSED
Italy's banking index has lost as much as 37 percent since May and its banks are now priced at less than 0.6 times book value, bringing the discount to euro zone peers to 12 percent, the widest in nearly two years. Earlier this year they were priced at nearly 0.9 times.
Analysts say the cheap valuations reflect risks of possible capital increases. State-controlled Monte dei Paschi di Siena (MI:BMPS) and Milan-based Banco BPM (MI:BAMI) trade below 0.2 times and top lenders Intesa Sanpaolo (MI:ISP) and UniCredit (MI:CRDI) stand at around 0.6 and 0.5 times respectively.
On the earnings front there has been no relief either, with Italian banks suffering 23 consecutive weeks of earnings downgrades.
Against this backdrop, traders say a budget compromise with the EU could bring some relief, but further turmoil could smash valuations to the distressed levels hit during the debt crisis.
"Italian banks look attractive at current valuations, but amidst continued volatility we think the risk will remain on the downside," said Credit Suisse (SIX:CSGN) analyst Carlo Tommaselli.
GRAPHIC: Valuation gap widens - https://tmsnrt.rs/2P2gRVl
($1 = 0.8821 euros)
(Reporting and graphics by Danilo Masoni; Editing by Josephine Mason and Catherine Evans)