With Italian government bond yields blowing out in recent months to the highest levels in over 4 years, the one sector that has been hit hardest have been Italy's banks, which have lost a third of their market value in the 6 months since peaking in April.

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While traditionally higher yields tend to be positive for local banks which can earn a greater profit on the net interest margin, Italy has in recent years been an "upside down" basket case in this regard largely due to their massive holdings of Italian sovereign debt. And, as Bloomberg recently wrote, while the balance sheets of Italian banks are much-improved since the Eurozone sovereign debt crisis of 2011, banks used much of the funding later injected by the European Central Bank to buy even more sovereign debt.

As shown below, the country’s financial institutions hold by far the most state obligations among lenders in Europe. Specifically, according to ECB data, Italian banks hold around €375 billion euros of domestic bonds - or 10% of their assets - and the spike in yields, by hurting the value of those holdings, eats into their capital levels, making the especially vulnerable to further rate rises.

This means that as Italian bond prices tumble, as they are doing now, this leads to bank undercapitalization, and if the price drop is large enough, it could even lead to bank insolvency.

Hence plunging stock prices and spiking CDS as default probabilities surge.

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Commenting on this structural problem facing Italian banks, Luigi Zingales, a professor of finance at the University of Chicago School of Business said in late September that "Italy is facing a sovereign-bank doom loop that can lead to a crisis similar to the one Italy faced in 2011." Worse, Zingales warned that "since 2011, nothing has changed at the European level" adding that "without completion of banking union and backstop measures, Italy risks a negative spiral as happened in 2011. Uncertainty is increasing bond spreads, thus affecting the banks’ balance sheets and their cost of funding and ultimately their ability to give credit."

Hence "doom loop."

It now appears that Europe itself is starting to be concerned worried, because as Reuters reports European banking supervisors have stepped up their monitoring of liquidity levels at Italian banks "more intensely than usual" due to market turmoil in recent days, which has resulted in a sharp increase in the country's government bond yields.

And since Italy is the one nation which, after Greece, has the highest risk of a terminal bank run, the last thing the EU wants - or the ECB can afford - is to spark a banking panic simply with the news that the banks are now "intensely monitored", so Reuters cited a senior EU source that "there is no cause for alarm."

Of course, the alternative would be that there is cause for alarm, and overnight lines would form as panicked locals sought to withdraw their deposits and savings and park them in their much safer mattress.

Reuters reports that according to the EU trial balloon, the checks involve both customer deposits and the interbank market that banks use to lend to each other without requesting collateral, the source said, adding that "no sign of alarm" had been detected.

Furthermore, the ample liquidity provided by the ECB during years of ultra-expansionary monetary policy is shielding the interbank market from any tensions, Milan traders said.

More importantly, Italian banks have reportedly not suffered any deposit flights either despite the recent market turmoil and plunging bank prices: to wit, Italian banks' deposits stood at €2.39 trillion in July, down fractionally from €2.41 trillion in June, when the new government was sworn in, and have been broadly stable in recent months.

That may change soon if the EU continues to dig, prompting the local population to ask just why is Brussels so nervous.

Meanwhile, with EU inspectors in town, Italy continues its dispute with the EU over its budget, the country’s sovereign spread keeps widening, rising above 300 bps on Monday, with Credit Suisse analysts warning that a spread above 400bps would not be sustainable for Italian banks. Acording to the report, a 200bps broadening from the end of June would reduce the capital ratio of Italian lenders’ by 66bps on average, according to estimates. And that could trigger the need for capital hikes, the analysts including Carlo Tommaselli said.

For now, the main reason why local depositors have been sanguine in light of plunging stock prices and the accelerating decline in capitalization, is that most are confident that ECB head Mario Draghi would never permit Italian banks to fail, which however in light of the country's populist government may be an optimistic assumption: after all, what better way to teach the new nationalist coalition government a much needed lesson than by sending yields surging even higher and bankrupting one or more banks, focusing public anger on the Di Maio - Salvini government.

For now, the ECB has refused to play this trump card, although judging by the blow out in yields, it hasn't stepped in with aggressive buying either. In August, Goldman Sachs pointed out that Italian banks often provide a steady source of demand at times of crisis, but that mounting political risks and regulatory changes may make them more reluctant to step in.

And the biggest reason for that is that after 3 years, the ECB's QE is finally coming to an end at the end of the year.

Which is why while the EU inspectors may find "nothing alarming", they may want to hang around for the next 3 months as we inch ever closer to the day when the ECB will no longer monetize Italian debt, and backstop Italian banks. We would not be surprise if the dreaded depositor bank lines, which Italy has so far avoided, start forming just a few days before said deadline...