Italy is on the brink of a dangerous banking crisis as the red-blooded showdown between Brussels and Rome pushes the country's borrowing costs to a five-year high.

Yields on Italy's 10-year debt spiked to 3.62 per cent after the Lega strongman and vice-premier, Matteo Salvini, vowed to sweep away the existing European order.

He called Jean-Claude Juncker and his Commission aides "enemies of Europe barricaded inside their Brussels bunker".

Read more: Italian nightmare: A crash will cripple the world

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The furious outburst followed the leak of a stern letter from the Commission rejecting the deficit spending plans of the insurgent Lega-Five Star government, and more or less ordering Rome to go back to the drawing board.

The "risk spread" over German Bunds is entering treacherous territory after jumping 45 basis points over the last week to 310.

"At this point it risks going hyperbolic," said Carlo Bastasin from the Brookings Institution.

Italian banks act as the chief accelerant in such crises. They hold €387 billion ($689.4b) of state debt and face automatic mark-to-market losses as their portfolios lose value, eroding their capital buffers.

It forces them to raise fresh equity in a hostile climate, or to cut lending to the real economy and set off a contractionary spiral.

The most vulnerable banks are quickly selling down their sovereign bonds to reduce "concentration risk", still 60 per cent in the case of UBI.

This "doom-loop" of interlinked sovereigns and banks can become a vicious circle in the eurozone's unreformed system.

It is coming into focus as Moody's and Standard & Poor's prepare to issue their ratings verdict on Italy over the coming days or weeks.

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Carlo Tommaselli, from Credit Suisse, warned that spreads of 400 are "not sustainable".

A rise of 200 basis points cuts the common equity tier 1 capital of the Italian banks by 67 points, leaving them under water.

Luigi di Maio, the Five Star leader and Italy's vice-premier, said he did not care whether the spreads blow through 400.

"It should be very clear that the government will not retreat," he said.

"This is a budget to repair the injuries suffered by the Italian people, who have been tricked by the banks."

Italian bank shares continued their relentless slide yesterday, triggering trading curbs on the Milan bourse. Banca Carige and BPM both fell over 6.5 per cent. Unicredit and Intesa Sanpaolo were down almost 4 per cent.

Most lenders have shed a third of their value since Italy's earthquake election in March.

Italian Lega strongman and vice-premier, Matteo Salvini, has vowed to sweep away the existing European order. Photo / AP
Italian Lega strongman and vice-premier, Matteo Salvini, has vowed to sweep away the existing European order. Photo / AP

The banks are being squeezed on multiple fronts. Issuance of subordinated debt has become costly and has ground to a halt, drying up liquidity. Rising spreads eat into tangible book equity, degrading share value.

Lorenzo Codogno, former chief economist at the Italian treasury and now at LC Macro Advisors, said the picture is not yet as bad as 2011.

The European Central Bank has since opened a lending window to the banking system (TLTROs) that should avert a liquidity crisis.

Italian banks have cut their reliance on the wholesale capital markets from 27 per cent to 21 per cent of their funding.

"Yet there could still be a credit crunch and I am afraid that we are -already in a crisis," said Codogno.

"This government is aiming to win the European elections (in May) and it is just crossing its fingers and hoping disaster does not strike."

Capital erosion is the killer for the banks. Citigroup estimates that each 50-point jump in spreads lowers core capital ratios for stronger banks by 19 basis points, or 28 points for UBI and 33 for BPM.

The Commission's letter to Rome leaves little room for any compromise. It states that the planned budget deficit of 2.4 per cent of GDP deviates by 1.4 percentage points from acceptable levels under the complex rules of the Stability Pact.

It said the targets appeared to be a prima facie breach of fiscal discipline and are a serious concern.

"We call on the Italian authorities to ensure compliance with the common fiscal rules," it said.

Ashoka Mody, former deputy-chief of the International Monetary Fund for Europe, said the EU's budget target is theological nonsense, and the weight attached to a few decimal points here or there is false science.

Read more: Italy warns of 'Armageddon' over EU budget pressure

"These numbers are completely meaningless," he told a forum at the American Enterprise Institute (AEI).

"The fiscal rule is economically illiterate and dysfunctional, yet a narrative has grown that it is somehow sacrosanct."

Italy's former premier Matteo Renzi proposed deficits of 2.9 per cent for three years in a row. This was not treated as a great drama because he posed as a good European.

France's Emmanuel Macron also gets away with more latitude. This feeds a suspicion that this dispute is really about political control.

Matteo Salvini is not yet showing any willingness to back down, repeatedly dismissing the rising spreads with a line from nationalist poet Gabriele d'Annunzio - "me ne frego" (I couldn't give a damn).

It is lost on nobody in Italy that this was also the rallying cry of Mussolini's blackshirt squadrons in the Thirties.

He accused Jean-Claude Juncker and the Brussels machine of ravaging the European economy for a decade with destructive policies, and blamed the spreads on orchestrated speculation.

"Behind this surge there is old-style manipulation by speculators, like George Soros 25 years ago, to buy Italian assets at bargain prices," he said.

"But whoever is speculating is wasting their time. This government is not turning back."

Professor Luigi Zingales, an expert on the Italian banks at Chicago University, said the eurozone has done to Italy what foreign creditor powers did to Germany in 1930, cutting off capital flows in a "sudden stop" and then enforcing drastic austerity.

Brussels should not now be surprised at the political consequence of this myopia.

At some point Europe must grasp the nettle. "What do we do about the fact that Italy does not belong to the euro?" said Prof Zingales.

"Either we change Italy dramatically and make it fit for the euro; or we change the euro rules; or we exit the euro. Nothing else is possible."

Desmond Lachman, the IMF's former deputy-director and now at the AEI, said markets are wrong to assume that the Italian drama is under control.

"I don't buy the idea that you can muddle through indefinitely," he said.

"We are at a very different stage of the global cycle, and at a different level of tolerance. When the spreads blow out, it creates a 'new fundamental'. What worked at spreads of 100 does not work at 300. I think Italy may be entering a vicious circle. It is hugely systemic, and could be Lehman in reverse."