Even as Europe grapples with the repercussions of the UK’s vote to leave the European Union, a dispute over tens of billions of euro is also threatening to roil the region’s €14.5 trillion economy.

The Italian government, according to some estimates, needs to spend €40 billion to shore up its banks burdened with bad loans. Fears that European authorities will bar the government from providing that support are adding to the turbulence caused by Brexit.

It may seem difficult at first to understand how the lenders of a medium-sized country, none of which is particularly large or engages much in risky activities, could be spreading fear through global financial markets. But they are, and their problems reveal what can happen when well-intentioned regulations bump into reality. And this is creating tension among the leaders of Europe. The situation may drag through the summer, keeping investors around the world on edge.

So how bad could this get?

The steep declines in shares of Italian banks suggest that a storm is ahead. The stock price of Banca Monte dei Paschi di Siena, the oldest bank in the world and one of Italy's most troubled lenders, is down 80 per cent in the last 12 months.

Its shares also trade at under 10 per cent of its book value – a measure of its net worth – a sign that investors really think the bank needs new capital. But when bank stocks sink that much, banks find it almost impossible to raise new capital in the markets.

Shoddy lending

While banking crises in Spain and Ireland were rooted in property bubbles, Italy’s stems from a culture of cronyism, poor governance and shoddy lending. The banks’ sickness has hurt the broader economy, too: as borrowers defaulted, banks withheld credit, dragging down growth.

Monte dei Paschi is only one of a group of Italian banks beset with €360 billion of nonperforming loans which they have so far failed to adequately address; that is some 20 per cent of Italy’s gross domestic product.

The banks have set aside significant reserves to absorb losses in these loans, effectively valuing them at 40 per cent of their original value, according to some analyses. Investors, however, appear to think that these loans are worth even less.

The theory is that the banks would now have to bite the bullet and value the loans at an even lower level. But this could produce losses, and some banking experts say €40 billion of support is needed to help the banks take those hits.

A simple response would be for the Italian government to hold its nose and plough that sum into the banks, roughly mimicking what the US government did with its Tarp spending in 2008. But such a bailout may be illegal under EU rules on dealing with bank failures that aim to protect taxpayers and instead force investors in the banks to provide financial support in times of trouble.

Investors lend money to banks by buying their debt securities. Under the anti-bailout rules, those securities would be forcibly turned from debt into new equity, which could absorb any new losses taken on the bad loans. Under such a “bail-in”, the equity would in theory be worth less than the debt securities, leading to losses for investors who held the debt.

It sounds straightforward, but in Italy it is not. Retail investors rather than faceless investment houses hold many of those debt securities.

According to Bruegel, a research organisation that specialises in European economic issues, families own about a third of Italian banks’ debt securities. Not only would bail-ins focus the pain on households, the fear of losses might also prompt investors to stop lending to banks and lead depositors to withdraw their money. This would make a bad, but manageable, situation much worse.

Italy could try to focus the losses on institutional investors, but, as Silvia Merler, an affiliate fellow at Bruegel, has noted, picking winners and losers could only add to the confusion among investors in bank debt.

To try to avoid this sort of mess, Italy's government is hoping EU leaders will let it put money into its banks. But there is tension over the question, as shown by a sharp public exchange between German chancellor Angela Merkel and Italian prime minister Matteo Renzi.

State aid rules

A compromise doesn’t look impossible, though. Europe’s leaders, seeing the specifics of Italy’s problems and wary of the stresses caused by Brexit, may decide it makes sense to give Italy a pass this time. And the rules provide ways to do that. There are, for instance, exemptions in the Europe’s state aid rules that aim to force bail-ins. One kicks in if a bail-in could have “disproportionate results”.

Dan Davies, senior research adviser at Frontline Analysts, says the Italian government could argue that forcing losses on retail investors would fall under that exception.

Yet even if Italy is not given a green light to directly bail out its banks, Luigi Zingales, a professor at the University of Chicago, has suggested that the Cassa Depositi e Prestiti, a large investment entity controlled by the Italian government, could provide the bailout funds.

Zingales was a critic of Tarp and says investors in the bonds of US banks should have been made to participate in bail-ins. But, because of the retail investors and the potential for financial panic, he says that “you cannot do the same thing in Italy”.

If Italy does bail out its banks, will they stop being a problem? Or will they resurface as a destabilising force two summers from now?

To stop that happening, analysts say government support must come with a plan to overhaul the industry. Davies says mergers would help if done at valuations that make sense.

Alberto Gallo, head of macro strategies at Algebris Investments, a hedge fund, says steps must be taken to make the industry much more efficient. "This injection would need to come with a restructuring of the system," he says. – ( New York Times/Bloomberg)