BBC News - Referendum adds to Italian banks' woes

The focus of the news from Italy this weekend will be political - there's a referendum on constitutional reform.

The Prime Minister, Matteo Renzi, has said he will resign if the proposals are rejected.

This could be followed by new elections which could in turn benefit the Five Star Movement, an anti-euro group led by the former comedian Beppe Grillo.

The Movement is one of many protest parties that have surged in popularity across Europe in recent years.

But behind the politics in Italy there's a background of persistent economic weakness and a more immediate problem in the banking industry.

There are real concerns that a defeat for Mr Renzi's proposals could unleash a chain of events that would set back the country's economy once again.

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Image captionItaly's economy is roughly the same size as it was at the turn of the century

Italy's banks are currently one of the main trouble spots for the eurozone.

They are struggling with a burden of bad debt, loans that are unlikely ever to be repaid fully.

The banks are a potential flashpoint in an economy that has for some time been seen as posing wider risks to the EU's currency area.

However, it is the size of the Italian economy and government debt that make the country a smouldering financial volcano. The risks are aggravated by the political situation.

Italy is the third-largest economy in the eurozone. The government debt burden, depending on which figures you look at, is certainly one of the largest in the eurozone. In fact, on one measure its debt burden is the largest.

One of the roots of the problem is Italy's two decades of dismal economic performance. Measured by total economic activity (gross domestic product, or GDP), the economy remains about 8% smaller than it was at the onset of the international financial crisis.

It is roughly the same size as it was at the turn of the century.

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Image captionFixing Italy's banks has become more difficult due to the political uncertainty

That has made it harder to generate the tax revenue needed to keep the government's debt burden down. It has also increased the chances of businesses getting into difficulty and being unable to maintain their loan payments.

The result: Italian banks are weighed down with a massive problem of bad debts, or non-performing loans (NPLs), worth €360bn (£307bn), equivalent to about a fifth of the size of country's economy.

Heavy losses

The problem has been exacerbated by the country's bankruptcy legislation, which made it very slow for lenders to get their money back when a borrower has failed financially. The law has been changed under the government of Matteo Renzi, but it has taken time to make itself felt in practice.

One way that banks can deal with problem loans is to sell them to other investors. But the delays in the foreclosure procedures that enable creditors to recover the money mean these deals involve deep discounts.

That, in turn, would mean the banks would have to acknowledge heavy losses in their accounts, further undermining their financial foundations.

At best, the NPL problem inhibits the banks' ability to provide the new credit that Italian businesses need to generate a more convincing economic recovery.

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Image captionBanca Monte dei Paschi di Siena, one of the most troubled banks, is trying to raise €5bn to deal with bad debts

At worst, there is a risk that the failure of a large bank could set off a wider financial crisis and set the recovery back more severely.

One of the banks at the centre of this crisis is the world's oldest and Italy's third-largest, Banca Monte dei Paschi di Siena. It has been ordered by the European Central Bank to reduce its holdings of bad debt.

The bank is trying to raise new capital to the tune of €5bn, and plans to do it by issuing new shares and by asking some creditors to convert the debts they are owed into shares.

Several other banks have problems too.

Political uncertainty

The referendum plays into this problem simply because repairing the banks is more difficult in the face of profound political uncertainty. The worry is, will investors want to put their money into a struggling lender when the political environment is so hard to read?

The Five Star Movement is anti-euro, although that does not mean that eurozone exit would directly follow a defeat for Mr Renzi in the referendum.

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Image captionMatteo Renzi has said he will resign if voters reject his proposed reforms

There are many steps that would have to be taken first, and in any case European Commission surveys have consistently suggested Italian public opinion favours sticking with the currency.

But then, who would bet that those surveys are a reliable gauge to how a referendum might turn out? There is plenty in Italian politics to unsettle financial markets.

One option that has been considered for the banks is a bailout by the Italian government. There are two problems with that; one financial and one legal

The financial issue is that the Italian government's dismal finances mean it really doesn't need the additional burden of propping up the banks.

The legal point is that European Union rules, agreed in the wake of the financial crisis, require a bank's creditors, in particular its bondholders, to take losses before the taxpayer steps in.

It's an approach that can make sense. Bondholders are usually professional investors who can handle losses and are also, in theory, better able to monitor banks and discourage them from taking excessive risks in the first place.

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Image captionIf Italians reject the reforms, surveys suggest they would want to keep the euro - but how accurate are the polls?

But in the case of Italy, many of these bonds are owned by retail investors. So, following the EU rules and imposing losses on this group would be very unpopular in Italy and many would say unfair.

The rules are part of a very important project in the eurozone, called banking union. It was a response to the region's financial crisis, intended to make the banks more resilient and to break the malign link between weak banks and financially-stressed governments.

Those are two serious problems in the case of Italy and the referendum brings them once again into focus.

By Andrew WalkerBBC World Service economics correspondent