Italy’s banking crisis a bigger problem than Brexit

A collision between Italy and the EU over a bailout of the nation’s banking system is getting closer by the day.

Italian Prime Minister Matteo Renzi has threatened to resign if Senate reforms are rejected

A collision between Italy and the European Union over a potential bailout of the nation’s teetering banking system is getting closer by the day, threatening to tear up the newly woven fabric of the EU’s banking union and posing a bigger potential threat to Europe’s stability than the Brexit.

As discussed previously, Italy’s banking system is in trouble, with about $540 billion of non-performing loans and a desperate need for new capital.

Given the dearth of willing alternative capital-providers, Italian Prime Minister Matteo Renzi wants to inject the equivalent of about $60bn of public funding into the system to try to stabilise it.

The problem for Renzi and Italy — and the EU — is that the rules of the European Banking Union forbid taxpayer bailouts as the first resort for troubled banks. The rules, years in the making, insist that shareholders and creditors are “bailed in’’ before taxpayers can be called on.

Renzi has tried to take advantage of the instability within Europe generated by the Brexit vote to convince the EU authorities to suspend the prohibitions on state aid and the bail-in rules, threatening to act in defiance of them if Italy isn’t given approval to ignore them. Over the past week there have been negotiations between the Italians and the EU about the issue, but no resolution.

Germany’s Chancellor Angela Merkel and European Central Bank officials have refused to contemplate exempting Italy from the rules, with the ECB suggesting that allowing Italy to bail out its banks would represent the end of the banking union, arguably the key reform the EU authorities have made to their financial system since the financial crisis.

The authorities are concerned about the precedent it would set, the potential for other European countries to follow suit (Portugal is the most likely) and the irreparable damage it would do to the new single eurozone supervisory and resolution regime the banking union was supposed to create.

The EU authorities have provided liquidity to the Italian banks.

However, the key challenge is not liquidity but solvency, which requires a big infusion of equity.

Whether Renzi’s proposed capital injection would be sufficient is a separate issue, given Italy’s deep and prolonged recession and the overly fragmented and inefficient nature of its banking system.

Italy’s economy and banking system have structural challenges that new capital by itself won’t address.

With the results of the latest ECB stress tests due at the end of this month and expected to show that many of Italy’s banks, including some of its biggest, are severely undercapitalised, the potential for a banking crisis in Italy — the ­eurozone’s third-largest economy — is looming.

The EU will be very aware that it isn’t just Italy’s banks that pose a significant threat to the stability of the EU post-Brexit. In October Italians will vote in a referendum on constitutional reforms that would diminish the role and power of its Senate. The reforms are ostensibly designed to increase the stability of an Italian political system that has historically been anything but stable.

Renzi has vowed to stand down as prime minister if the referendum doesn’t approve the reforms, which would create a political crisis.

With all the major opposition parties advocating a “no’’ vote, and the Eurosceptic Five Star Movement gaining real momentum, the combination of a banking and political crisis could create another flashpoint that is a more direct and fundamental threat to the future of the EU than Brexit.

If the eurozone starts to implode at its core, of course, the implications won’t be confined to Italy or even to Europe, something one assumes the EU authorities and their counterparts elsewhere are very conscious of and will do what they can to avert.

Italian political crises are nothing new but, post-Brexit, the prospect of a collapse in a national banking system coinciding with the rapid rise of a Eurosceptic movement in that same economy would be the stuff of nightmares in Brussels, Paris and Berlin.