No sooner do we stop worrying a banking meltdown in one EU country, then we’re told to start fretting about another. In September, traders were sweating over Deutsche Bank in Germany. Today, it’s the Italian banking sector. Steve Eisman, the Wall Street trader who foresaw the 2008 financial crash (as brilliantly depicted in The Big Short), is now shouting out fresh warnings about an Italian banking crash. Banking disasters rarely restrict themselves to one country so how worried should investors in Lloyds Banking Group (LSE: LLOY) be?

The Italian job

There are good reasons to fear the Italian banking system, given that the IMF classified nearly one in five loans with a total value of €360bn as troubled at the end of last year. This represents roughly 40% of all bad loans within the eurozone. Eisman has warned that Italian banks are stuffed with non-performing loans (NPLs), written down as worth about 45% to 50% of their original value.

The problem is, he reckons, they aren’t worth anywhere near that much, as they sell for around 20% of the original price. If they were recognised at their full value, the banks holding them would go bust overnight, Eisman says. Italy’s third largest bank, Banca Monte dei Paschi di Siena, emerged as the weakest of 51 major European banks, according to stress tests in July. 

Long and short of it

Eisman was the angry one in The Big Short, outraged at banks selling sub-prime mortgages rated triple-A that were actually junk, but he remained cool enough to net himself more than $1bn by betting against them. However, he praises the Federal Reserve today, saying that US banks have been enormously deleveraged and de-risked, while warning that European regulators have been much more lenient. As he puts it: “Europe is screwed.”

So what about Britain? “I’m not really worried about England’s banks,” Eisman says. “They are in better shape than most in Europe.” That may sound like damning with faint praise, but investors will breathe a sigh of relief. Lloyds has steadily repaired its core tier 1 ratio, which measures a bank’s core equity capital against total risk-weighted assets, which stood at 10.2% in 2010 but hit 14.1% in September, pre-dividend. This is higher than both Barclays at 11.6% and HSBC Holdings at 13.9%. Lloyd’s total capital ratio is 22.1%. Bad loans are increasing, but remain low as a percentage of its overall portfolio.

Tiers aren’t enough

Lloyds has further protection because of its reduced exposure to investment banking, as it focuses on domestic retail and small business banking. However, if Eisman is correct and Italy plunges into crisis, there’s no way UK banks can escape unscathed. Even a hard Brexit wouldn’t protect us from the contagion of a liquidity crunch.

That’s the risk you take when you invest in Lloyds, or any bank. It partly explains why the stock trades at the discounted rate of just 6.95 times earnings, with a yield at 3.8% and growing. That dividend is covered a generous 3.8 times and the yield is forecast to hit 6.2% by the end of next year. These are good reasons to invest in Lloyds, but you should also understand the risks. Keep an eye on Italy.

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Harvey Jones has no position in any shares mentioned. The Motley Fool UK has recommended Barclays and HSBC Holdings. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.