Bailouts and downgrades? What Italy's future could look like

Italy's banking sector is looking increasingly vulnerable and analysts are starting to fear that the euro zone's third largest economy could "go under," warning of the potential for bank runs, credit rating downgrades and the threat to the wider European banking system.

"Italy could be a bigger threat to euro zone stability than Brexit," Andrew Edwards, chief executive of London spread better ETX Capital said in a note on Tuesday. "The nation has a creaking banking sector that could undo all the European Central Bank 's efforts to save the euro if not handled correctly."

"Unlike other countries, Italy did not carry out a full spring clean of its banks post-Lehmans and there is trouble brewing with the country's banks holding 360 billion euros ($400 billion) in non-performing loans (NPLs) - a third of all the euro zone's bad debt and about a fifth of all consumer loans in Italy," Edwards noted, highlighting the extent of Italy's banking vulnerabilities.

While most market attention and turmoil has been focused on the fallout of the U.K.'s vote to leave the European Union (EU) a few weeks ago, Italian banking stocks have been on a roller-coaster ride since the vote.

Stocks plunged further on Monday after Banca Monte dei Paschi di Siena (BMPS) (Milan Stock Exchange: BMPS-IT), Italy's oldest bank, disclosed that the ECB warned it that it had to cut its bad debts by 40 percent over three years .

Despite the brief reprieve for Italian banking stocks on Wednesday, after an Italian market regulator banned the short-selling of BMPS shares, now attention has focused on how Italy's banking sector – and its wider economy – can be saved.

Earlier this week there were reports that Italy could be ready to break new EU banking regulations by using state funds to bail out its most troubled lenders although an Italian government spokesman dismissed such speculation. EU banking union rules mean that depositors, rather than taxpayers, have to bear the brunt of any bailout.

But such a scenario is unpalatable for Renzi given the extent of Italian households that could be affected by a "bail-in." Italian households hold about 29 billion euros ($32.17 billion) worth of bank-issued bonds that are subject to being written down or converted into equity in case those banks need to be rescued, according to an April report from the Bank of Italy.

If a "bail-in" appeared to be on the cards, however, Edwards warned that Italy could see a run on the banks similar to that seen in Greece and Cyprus where depositors rushed to get their money out before capital controls were imposed at the height of their financial crises.

"A bailout that meets current rules would likely mean haircuts for depositors and a potential run on banks that Rome wants to avoid at all costs," Edwards said. The alternative was to use public finances to prop up the banks, defying EU banking rules that are designed to instil global confidence in Europe's banking system..

"Italy could bail out its banks and Prime Minister Matteo Renzi has hinted he is willing to use public funds to do so, in breach of EU rules if necessary. But such a clear intervention would deliver a major blow to new European banking rules and undermine what's still a fragile system," Edwards said.

Reluctant to ask for a bailout from its euro zone partners, Italy has tried to shore up its banking system already this year by designating a near-$5 billion rescue fund (the Atlante fund) to recapitalize Italy's weakest banks but it is seen as far too small by some analysts to cover the NPLs held by Italian banks . Still, Edwards said that a compromise was needed between Italy and the rest of Europe to prevent another euro zone economy from collapse.

"Ultimately a solution should be found quickly or the world's oldest bank could fail and bring down the rest of Europe's embattled banking sector with it. The EU needs to show flexibility or Italy could go under."

The euro zone is no stranger to bailouts with Ireland, Greece, Portugal and Spain all given varying degrees of financial aid since the financial crisis in 2008. Problematically for euro zone leaders, however, Italy is seen as "too big to bail out" and its funding needs too great.

It already has massive public debt pile at 132.7 percent of gross domestic product (GDP), second only to Greece, and only recently recovering economic growth (forecast to be 1.1 percent in 2016), according to the European Commission.

As such, investors are worried that any Italian bank collapse could cause an economic crisis in Italy, a country already facing political upheaval; Prime Minster Renzi has called a referendum on constitutional reform which will be held in October and has said he will resign if he loses the vote, meaning new elections will have to be held.

Stuck between facing the anger of Italian voters (and potential financial chaos) of bailing in depositors to save the banks (as per EU rules) and the anger of Europe if it uses public finances, Italy was "in a bind," according to analysts at Rabobank.

"If Italy does manage to get a green light for the recapitalization, the funds required to reinforce the Italian banking system may well be coming from Italy's public finances. And this is where the real pain could come from," Richard McGuire, Lyn Graham-Taylor and Matt Cairns said in a note on Wednesday.

"Although the extra funds that the government is planning to provide to the financial sector are relatively small in terms of Italian GDP, these could be the straw that breaks the camel's back. With only tepid growth since the global financial crisis, and with an already mountainous debt burden, adding even more debt to this debt pile might very well be a trigger for rating agencies to consider a downgrade of Italy's credit ratings," they added.

"Italian ratings are already at 'BBB-' for S&P (and) if these ratings start to come under pressure from the agencies, this could lead to speculation that Italy may eventually fall out of the investment grade bucket," they said, warning that this would have a "major impact" on the country, particularly if the political scene is thrown into disarray.

"If Renzi were to lose this vote in October, this could cause a period of uncertainty, harming the Italian economy … and adding more stress to the banking sector. Moreover, new elections might very well be won by the anti-establishment Five Star Movement, which is campaigning to pull Italy out of the euro zone. With the Five Star Movement only trailing Renzi's Democratic Party by a small margin in recent polls, the prospects of new elections and the very uncertain outcome could send Italy into a tailspin," they added.

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