Matteo Renzi.jpg
Italy's Prime Minister Matteo Renzi leaves at the end of the first day of the European Council meeting in Brussels, Belgium, 28 June 2016.

As markets shudder with the political aftershocks of Britain's June 23 decision to leave the EU, worries are growing in Italy and the rest of the European Union about the health of the Italian banking sector.

The symptoms of a pending financial crisis are evident: Share prices in Italian banks, already sharply down since the start of the year, plummeted after the Brexit vote, and the country's lenders have 360 billion euros (400 billion dollars) of bad loans on their books - roughly one-third of the eurozone total.

Now, supervisors at the European Central Bank (ECB) are piling the pressure on the Italian lender with the biggest bad-loan problem, the Siena-based Monte dei Paschi di Siena (MPS).

The officials have urged MPS to slash its load of non-performing loans, worth almost 50 billion dollars in gross terms, by 25 per cent within two years.

A reduction of this magnitude can only succeed if MPS, considered the world's oldest bank with its launch in 1472, sells off the loans at major discounts, incurring severe losses. MPS lacks the necessary reserves for this, despite several capital increases and two state bailouts since the 2008 financial crisis.

Worries are also growing at Italy's largest bank, Unicredit, about new gaps in its books, and the lender's global status means revelations connected to the discrepancies could send shock waves around the world.

Some experts are warning that the crisis could spread to all of Europe. "The whole banking market is under pressure," Lorenzo Bini Smaghi, the Italian-born chairman of the board at French bank Societe Generale, told Bloomberg Television on Wednesday.

"Italy could pose a greater danger to the eurozone than Brexit," adds Neil Wilson of the trading firm ETX Capital.

But the European Commission, under pressure from Germany, is reluctant to let Italy proceed with public rescues.

In the wake of the 2008 financial crisis, when governments paid hundreds of billions of euros to rescue banks, Brussels adopted new rules aiming to put the onus of bailouts on shareholders and creditors, rather than tax payers.

Italy wants an escape clause from these so-called bail-in rules, arguing that imposing losses on investors, at a time when Italian bank sector shares have plunged in value, would further scare markets and increase the risk of bank runs.

So it is no wonder that Prime Minister Matteo Renzi is under huge pressure, both at home and abroad.

"Italian savers and account holders will not have any problems, and that for me is the priority," Renzi said at a press conference in Rome on Wednesday, trying to reassure the public and shift the attention on banking problems elsewhere in Europe.

"The real issue in European finance is not Italian non-performing loans, but rather the derivatives of other banks," he argued, in what was seen as pointing a finger at Deutsche Bank, as the German lender is highly exposed to the risky financial products.

"If the issue about Italian non-performing loans, which can be solved and is being solved, [...] is worth one, the issue of derivatives at other banks, at big banks, is worth one hundred. This is the ratio: one to one hundred," Renzi said.

Morgan Stanley analyst Alvaro Serrano believes that a way out for Italy could come on July 29, when the European Banking Authority publishes stress test results. An exception to EU bail-in rules provides for the use of state money to plug capital gaps unveiled by those tests.

Recent press reports suggested that Renzi was considering a 40-billion-euro package for the banks. His country, however, has to be careful with its spending, as it is the eurozone nation the highest ratio of debt to gross domestic product after Greece.

Italian banks have been major financiers of the government and hold significant chunks of public debt. These huge portfolios of state bonds on the banks' balance sheets are part of the reason why lenders have postponed a cleanup of their holdings.

Unlike conventional loans, state sovereign bonds do not have to be backed up with a bank's own capital. This is a factor which serves to lower any incentive for banks to boost their net worth. The Bundesbank has called for a rule change, but Italy has opposed it.

Renzi is also under political pressure as he considers the banking crisis.

If ordinary Italian savers were to suffer costs related to the bank bailouts, his popularity ratings would likely plummet. That's an unsavory option for the premier, who has staked his political future on the outcome of an October referendum on constitutional reform.

Renzi has promised to resign if he loses the vote. That would mark a return to political uncertainty that could domino with effects on the Italian economy and banking sector - not to mention the rest of Europe.

A 'no' to constitutional reforms in the referendum would usher in "political chaos" and a recession, business lobby Confindustria said on July 1. A day later, Citibank called the Italian vote "probably the single biggest risk on the European political landscape this year."

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