How Italian turmoil in the bond markets could spark a domino effect across Europe

Banks in major European economies could be severely hurt by political developments in Italy given their exposure to Italian debt, with France’s lenders leading the potential losses.

Recent political turmoil in Italy has increased the borrowing costs for the euro zone’s third-largest economy, but it has also raised questions about potential contagion to other countries. Calls from certain Italian politicians to leave the euro zone and to challenge European fiscal rules sparked concerns over a potential break up between Italy and the rest of the bloc, which would ultimately question the future existence of the euro area itself.

At the same time as Italy’s government found it more expensive to fund itself, those who already owed Italian debt found their investments riskier and less profitable. This is because when yields rise it means there’s a higher perceived risk. It also means that the chances of seeing a return on their Italian bonds are reduced. So, troubled times for Italian debt also extends to those holding it too.

“Italy is by far the biggest threat to euro area stability … The economy suffers from a dangerous mix of weak growth, poor competitiveness, high public debt and a struggling banking sector,” Shweta Singh, the managing director at TS Lombard, said in a report published Monday.

According to her research, France owns the highest proportion of Italian debt — $311 billion, which represents 12 percent of French GDP (gross domestic product), making it the most vulnerable to a crisis in Italy.

However, Singh told CNBC via email Tuesday that “a banking crisis in Italy would create severe dislocations in the rest of the euro zone, not just in France.”

“The European banking system is closely inter-linked and it has huge direct and indirect exposures to Italy. For instance, French banks have 12 percent of GDP worth of claims on Italy, Dutch banks have 13 percent of GDP claims on France, U.K. has 4 percent of GDP claims of the Netherlands … and so on,” she said explaining the domino effect that would emerge.

Looking back at those who hold the highest portion of Italian debt, Spain, the Netherlands and Portugal form the top four debt holders.

The recent concerns over Italy may have eased following the formation of a new government and remarks from Italian ministers that the country will remain committed to the euro. But, Singh warned that the risks still remained.

“While the risks associated with Quitaly/Italexit have eased with the formation of a new government, they have not gone away,” she added.