Italy is on a collision course with Germany over the latter's proposal to risk-weight European banks' holdings of sovereign bonds, which Germany sees as a key stepping stone to full banking union across the EU.

Germany's finance minister, Olaf Scholz, wrote in the Financial Times that his country would finally consider a Europe-wide deposit insurance scheme, but said banks holding sovereign bonds would have to hold capital against the risks attached to them.

In response, Italian Economy Minister Roberto Gualtieri said changes to the risk-weighting of government bonds would be "damaging and inopportune," Reuters reported.

At present, banks can hold an unlimited amount of sovereign bonds — government bonds denominated and funded in domestic currency — free from capital requirements since they carry a zero risk weight. The result is large volumes of sovereign debt on banks' balance sheets, with a particular bias toward domestic bonds.

Closing 'doom loop'

The present system has long been criticized for creating the perfect conditions for a "doom loop," whereby weak banks and countries drag each other down. When a sovereign country loses market access to bonds, the value of banks' portfolios fall dramatically and they then need help from the government to stay solvent. This in turn increases pressure on the already weakened state and further reduces the value of the bonds.

This problem exacerbated the sovereign debt crisis that hit Europe during the years following the global financial crisis.

Italian banks' large holdings of home-country sovereign bonds, combined with the country's high government debt, have caused concerns that Italy could spark a future euro crisis. Its banks' direct sovereign exposure stands at nearly 22%, for instance, while Germany's is 9.60% and the U.K.'s is 4.33%, according to new figures from the European Banking Authority.

Italian banks' profitability has recovered from the extraordinary lows seen at the height of the eurozone crisis, though only in the past two years. Holding large amounts of high-yield sovereign bonds has its advantages in this respect, too, but only as long as the sovereign remains solvent.

Ireland's banks, similarly hit in 2011, recovered more quickly than Italy's and by 2014 were showing signs of steady returns, while the country's sovereign bond holdings as a proportion of total assets are significantly less than Italy's at 9.81%.

Greece, though, remains the example all Europe would wish to avoid, with profitability scores deeply embedded in negative territory at the height of the eurozone crisis. Today it is in a far better position, while its sovereign bond holdings are significantly lower than those of Italy.

But Scholz has made it clear that he would only accept a deposit insurance scheme, or, more precisely, a reinsurance scheme, if there was a further reduction of risk for banks including the risks associated with sovereign debt.

"We should introduce capital requirements reflecting credit and concentration risks from sovereign exposures on banks' balance sheets in a careful, gradual manner without threatening financial stability," he wrote.

Over time, Scholz wrote, countries would build up more diversified portfolios of sovereign bonds and this would enhance their stability and allow weaker countries to boost their credit ratings.

Jean Pierre Mustier, CEO of Italy's UniCredit SpA, told the FT Banking Summit on Dec. 4 that Scholz's proposals were important but there were key issues to discuss before any progress could be made.

He said he recently spoke to members of the German government and told them that German banks would have to buy Italian government securities because they need to diversify their weight and reduce their exposure to German Bunds.

Danish compromise in question

He also cited issues raised by the so-called Danish Compromise. This allows banks with insurance subsidiaries to include the value of the equity in the unit in the bank's risk-weighted assets.

"What are banks? This is an important concept," he said. "If you look at some of the banks, they benefit from a double-counting of their capital under the Danish Compromise. This creates regulatory arbitrage because a bank and an insurance company as separate entities will hold 2x more capital but if the insurer is a subsidiary of the bank the capital buffer will be counted as for one company."

Mustier said any changes to the way sovereign bond holdings are judged should be accompanied by a full examination of existing regulatory requirements, which could mean the Danish Compromise would be jettisoned, for example.

He said: "Either we look at all of the consolidated government exposure, including the benefit from the Danish Compromise, or you give up this compromise to look at the bonds on the bank balance sheet.

"UniCredit does not have an insurance company so we are going to make sure that the regulators look at all and make sure we close the doom loop fully."