More cracks appear in fragile European Union

With investors still trying to digest the global economic impact of "Brexit," fears are growing about another potential fault line in the European Union: Italy's banks.

Italian lenders are carrying some $400 billion in troubled loans, or about 20 percent of the country's gross domestic product. That is leading some banking industry executives and economists to call for swift European intervention in Italy to avoid a banking crisis that could spread across the continent, feed into political unrest and depress global markets.

Italy's weak economy -- the country's public debt stands at about 130 percent of GDP -- and sagging productivity, coupled with Europe's growth-stunting austerity policies, have done no favors for Italian banks. An index of Italian banking stocks has tumbled 30 percent since Brexit, as fearful investors flee the sector. Also hampering profitability are historically low interest rates and a glut of bank branches, analysts say.

Complicating any plans by Italy's government to rescue individual banks is that European banking regulations limit the country's ability to recapitalize its banks using taxpayer money. A bailout, though no panacea for the Italian economy, could stabilize the banking system as it works through the remnants of the global financial crisis. But the European Central Bank requires investors to accept severe losses -- a so-called "bail-in" amounting to 8 percent of banks' liabilities -- before the government can invest taxpayer money.

The bail-in option is particularly noxious in Italy because retail investors own about half of the country's bank debt and could be wiped out in such a deal. Big losses for retail investors would hurt Prime Minister Matteo Renzi in advance of an October referendum on constitutional reform. He has promised to resign if his agenda fails, which could open Italy to political leadership that's hostile to the European Union.

In fact, two polls since Brexit show Italy's anti-EU Five Star Movement has opened up a lead over Renzi's Democratic Party. The populist movement is attracting support from a growing number of Italians who are skeptical their economy can thrive again as part of the European Union, mirroring the rise of similar movements in other countries in the 28-member alliance.

"We think that investors' worries are justified," wrote economist Jack Allen of Capital Economics in a recent client note assessing the risks of a full-blown banking crisis in Europe.

Earlier efforts to help Italian banks unload nonperforming loans, including partial government backing, have failed to drum up much investor interest, Allen noted. And German Chancellor Angela Merkel so far has rejected calls to suspend two-year-old rules to allow Italy to recapitalize its banks to the tune of $40 billion. The EU rules do allow for recapitalization under "exceptional circumstances," a test that could be met by new European Banking Authority stress-test results due out at the end of July.

"Given the gravity of the situation, we suspect that policymakers will find a way to provide support to the banks," Allen said. "But the situation could get worse before it gets better."

Economists with institutional advisory firm Gavekal Research see three options for Italy in dealing with its troubled banking sector: Follow eurozone rules, a move that would wipe out existing shareholders and many retail investors; break all the rules with a unilateral Italian bailout, which would undermine the currency union; or cut an EU-supported deal with a waiver allowing state aid to recapitalize banks.

Renzi is pushing for the third option. His case could be buoyed by the results of the stress tests on several of Italy's largest banks, due out July 29, which are likely to be grim, Gavekal analysts Nick Andrews and Tom Holland wrote in an investor note.

The analysts said a rescue deal would have to extend beyond the most troubled banks; even Italy's comparatively strong banks could use more capital.

"Anything that falls short of a full-scale recapitalization and restructuring plan encompassing Italy's 10 largest banks ... is unlikely either to alleviate public fears of bail-ins ... or to restart the credit creation process and restore Italy's animal spirits," they said in a note. "With so much at stake, a little bending of the EU's new banking rules is a small price to pay."

Other banking experts express less alarm about the condition of Italy's lenders. Hugo Cruz, Italian bank analyst for Stifel-owned boutique investment bank Keefe, Bruyette & Woods, does not see the country's banks as a potential albatross for the EU. He notes that the ratio of nonperforming loans at Italian banks has been steady for several years. The high levels of bad debt is also a lingering symptom of the global financial crisis, with the country's glacially slow legal system still adjudicating bankruptcies from 2008 and 2009.

Bank deposits are up, capital levels are rising and yields on government bonds are stable, Cruz points out. Plus, he notes that a $40 billion recapitalization of the Italian banks is a rounding error at 2 percent of Italian GDP.

Cruz suggested that some of those saying Italian banks are in trouble would love to swoop in to buy collateral assets at a big discount, below where banks have, in his view, appropriately marked values. He also believes that the contagion risk posed by Italian banks is minimal, reasoning that Italy's roughly 1,400 banks have more in common with U.S. community banks than investment banks.

"These guys have no funding issues," Cruz said in an interview. "Deposits are growing. There's no liquidity issue. It's not Lehman Brothers or Bear Stearns. These are plain-vanilla retail banks."

Cruz suspects it will be too tricky politically for Italy to address every troubled bank at once. Rather, he expects a package of support for Banca Monte dei Paschi di Siena SpA, the worst-hit bank and the country's third-largest with a 6 percent market share.

He said the banks should be allowed to slowly wind down nonperforming loan collateral, a process that should benefit from stable real estate values. But all bets are off if share prices of Italian banks continue their tumble, Cruz acknowledged, a development that would send the confidence of Italians in their banking system down the drain along with their confidence in their government.