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The global economy is unlikely to topple because of Cyprus, a country with a gross domestic product (GDP) half that of South Dakota. But, revelations that the country's largest bank was completely insolvent may lead to increased focus on troubled bank balance sheets in the larger countries of southern Europe. Authorities may not like what they find.

The biggest negative surprises would be expected to come from Italy, where the central bank recently warned that loan loss provisions in the financial system were far too low to adequately cover expected shortfalls. According to CNBC :

"Total gross bad loans rose to €125-billion ($165.5-billion) in Italy at the end of 2012, up 16.6 per cent from a year earlier…. At 40 per cent, Italian banks' coverage of doubtful loans is well below the European average of 53 per cent and a 60 per cent coverage for Spanish banks, Mediobanca Securities analysts say, adding that they see scope for €21-billion of additional loan-loss coverage in the sector."

Italy's economic slide has continued in 2013, and non-performing loans should continue to pile up. The most recent data for GDP show that Italy's economy is contracting at a three per cent annualized rate. Industrial production for December fell a dreadful 9.3 per cent year over year, and industrial orders, a forward-looking indicator of economic activity, plummeted 15.3 per cent.

If the economy doesn't pick up shortly, the €21-billion in extra provisions urged by the Bank of Italy may only be the tip of the iceberg. The central bank does project that bad loans will peak during the first half of 2013, but this is dependent on a "second half recovery" – an eyeroll-inducing phrase we've heard too many times before.

Since last August, markets have largely ignored bad economic and loan data from southern Europe, confident in the ECB's willingness to backstop ailing sovereigns. The central bank evidently felt it could afford to take a cavalier attitude towards Cyprus, but it will act long before an Italian bank run becomes likely. If events in Cyprus lead industry analysts and prominent institutional investors to start loudly contemplating worst case scenarios for Italian banks, however, global financial stocks could be in for a nauseating rollercoaster rise before the ECB steps in.

Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here for more of his Insights, and follow Scott on Twitter at @SBarlow_ROB .

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Tickers mentioned in this story

Study and track financial data on any traded entity: click to open the full quote page. Data updated as of 28/03/24 3:37pm EDT.

SymbolName% changeLast
EUFN-Q
Europe Financials Ishares MSCI ETF
-0.18%22.74

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